Best Buy may be a better buy at a lower price: high-margin U.S. consumer electronics retailer is valued at a high earnings multiple - Co Inc

Money Digest, Sept, 1999

Best Buy Co., Inc. (NYSE: BBY; Recent price: U.S.$65.81) is America's number one consumer electronics specialty retailer. Best Buy has more than 312 stores in about 40 states coast to coast. There are plans to open 45 more stores in the near future as a part of a plan to increase the store count to around 550 in five years.

Best Buy sells home office products (computers, telephones, copiers), consumer electronics (TVs, VCRs, audio systems), entertainment software (CDs, video games, DVDs), and appliances (microwaves, vacuum cleaners). Currently, it is concentrating on higher-margin goods.

Its strategy to concentrate on digital products has led to sharp revenue increases. Many investors noticed and its price has soared to $80 (from its 52-week low of about $16. At current price levels, Best Buys doesn't qualify as a value stock.

However, the sharply decreasing prices on digital TVs and DVD players (digital VCRs, in essence) are expected to encourage consumers to buy superior models at lower prices.

Some analysts estimate that if consumers decide to replace their older equipment with newer ones, it will generate $15 billion in sales. The Federal Communications Commission has mandated that all U.S. stations broadcast a digital signal by the year 2006. This might further encourage consumers to replace their older systems with the newer ones.

There is a number of new products (many of them in the pipeline) that might attract buyers: flatpanel plasma screens (with this, you will be able to hang your TV on the wall, as though it were a painting), air conditioners connected to the Internet and refrigerators

Best Buy

CEO                            Richard Schulze
Headquarters           Eden Prairie, Minnesota
Employees                               45,000
Dividend                                  None
Recent share price                      $45.00
Shares outstanding                 201,800,000
Institutional holders                      66%
Fiscal 1999 revenue            $10,073,000,000

that keep track of their contents, to name just a few.

Management and merchandise

Best Buy's special expertise in the field is likely to favour its growth. It has installed inventory and feedback systems that gauge consumer demand on a store-by-store basis. This enables the company to allow each store to customize its merchandise mix, at short notice.

Like Dell, Best Buy has cut the time it takes to turn over its inventory. It's current turnover ratio is 6.6 times a year, an improvement from 3.6 times just three years ago.

The result? Best Buy's net margins rose from 0.02% in 1997 to 2.2%. The stock price soared from $2 in 1997 to $80 in just about two years!

Best Buy is run by its founder Richard Schulze, who owns 18% of the company. Under his leadership, the company has weathered many crises and has grown into a $10-billion plus company.

Personal computers account for almost 30% of its sales. Software, printers, and other computer peripherals contribute another 8%. Consumer electronics account for 27% of sales.

Digital products such as digital TVs and DVD players do not contribute significantly to overall sales, but this is expected to change in the coming months and years.

Appliances account for 8% and entertainment products account for 20% of Best Buy's sales. Best Buy also sells CDs and DVDs on the Internet.

Best Buy's main direct competitor is Circuit City, which owns more retail outlets (but has lower sales). However, of late, its strategy has not been effective in depressing Best Buy's sales. Best Buy also has a number of competitors on a product-by-product basis.

Consider stock at lower levels

Why bother about Best Buy? If you believe that consumers will buy a lot of electronic goods because (a) a number new products are coming into the market; and (b) much better versions of older products are available at a cheaper price, then Best Buy has positioned itself to profit from this trend. But at $65 a share, Best Buy is far from cheap, with its price-to-earnings ratio standing at around 54.

Although many analysts expect Best Buy's earnings per share to grow by 25% annually over the next five years, if you are a value conscious growth investor, you should wait for the price to decline substantially before taking a position.

A major attraction of a stock like Best Buy is that a one-percentage-point improvement in net margins can result in an increase in earnings per share of roughly 40%. If just one or two of its main products become hits in the next two years, Best Buy's profits can soar. But wait for the price to come down first!

This is a growth stock that has spiked up and down over the years. It's currently a favorite of momentum investors, who flee a stock as quickly as they pile into it. To hold this stock, you need a strong stomach.