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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Wednesday, January 9, 2008

Best Buy Deserves a Close Look

Best Buy is the leader in the electronic retail space and with the troubles at Circuit City (nyse:CC), BBY’s competitive position should strengthen. Best Buy stands to increase market share and bargaining power with its suppliers. In addition, Best Buy’s fundamentals are attractive and its management has proved effective. Best Buy may be a lucrative investment long-term, yet given the weakness in the economy, additional research and analysis is needed.

Direct Competition from Circuit City is Doubtful:
Circuit City is not competitive, losing money for the last 4 out of 5 quarters. Analysts expect -$1.06 EPS for fiscal year ending 2/08 and -$.44 for FY 2/09 (Yahoo Estimates). Circuit City shares have fallen to $3.83 from its 52-week high of $22.

Clearly, the company is in trouble. In my opinion, CC cannot compete head-on with Best Buy, and if it chooses to continue to do so, then CC will have to shut it doors. Circuit City’s only hope is to differentiate itself by offering goods and services that do not directly compete with Best Buy. In essence, Circuit City needs to exit the electronic retail business that overlaps with Best Buys offerings.

The industry shakeout is a replay of the Wal-Mart and K-Mart showdown years ago. Wal-Mart gained bargaining power with its suppliers from being the primary industry player once K-Mart went bankrupt.

For the past 10 years, Circuit City’s net margin never exceeded 2% translating into paltry returns on assets and invested capital, which likely lagged its cost of capital. A primary component in CC’s low returns is its cash conversion cycle. Recently, it takes 40 days for cash to cycle through CC’s balance sheet stemming from 70 days of inventory and 35-40 days of trade credit. Contrasted to Best Buy, its cash cycle is around 7 days with lower days of inventory and higher trade credit.

Best Buy Will Benefit from Reduced Competition:
If Circuit City fails or exits, Best Buy is positioned to capture 12 billion in annual revenue from CC thus increasing market share. This will further enhance economies of scale from spreading fixed costs over a larger revenue base thus expanding margins.

Best Buy’s pricing power will improve from the moderation of competition. In the absence of Circuit City, price battles will no longer transpire and consumers will have the CC alternative to BBY.
Possibly the most significant outcome will be the transfer or bargaining power from suppliers to Best Buy. When manufacturers have multiple alternatives in the retail channel, they possess leverage over the retail outlets.

To expand, Sony sells TVs to BBY and CC, and it BBY attempts to battle for better terms then Sony can divert shipments to CC. If BBY wants a better price on the Wii, then Nintendo could choose to supply CC only. Consumers demand these products and will purchase then from whomever. Best Buy, as well as all other retailers, depend on these hot products to generate store traffic and revenue.
When manufacturers face very few retail alternatives, they lose bargaining power.

To illustrate, Best Buy demands better terms on Sony’s big screen LCD TVs and if Sony doesn’t like it, where can they turn? Naturally Circuit City, but if CC is gone then Sony lacks any similar alternatives. Sure, there are other avenues, but think of all the LG, Toshiba, etc. LCDs that BBY will sell and the volume of potential sales Sony will pass up.

In addition, CompUSA is shutting its doors. Consumers seeking premium computers with sales assistance confront fewer options.

Best Buy’s Fundamentals are Attractive:
Best Buy is current trading around $46 with this year’s EPS expected to be $3.18 (2/08) and next year’s EPS coming in at $3.67 (Yahoo), thus BBY’s multiples are 14.6x and 12.7x, respectively. Those estimates translate into annual growth of 14% (current) and 15.4% next year. Best Buy has averaged 18% annual EPS growth for the past 5 years.

With respect to Best Buy’s P/E multiples; it appears to be relatively inexpensive. Best Buy deserves a premium multiple given its growth history and future opportunities. In addition, ROIC has consistently been around 18-19% for the past 7 years with 22% ROE.

Profit margins and asset turnover (sales/assets) drive rates of return, hence these areas warrant close attention. Best Buy’s profit margins have been trending upwards. If Circuit City ceases to be a direct competitor, BBY should be able to sustain or improve margins through increased leverage with suppliers and pricing power with consumers. Working capital needs could decrease from stretching payment to inventory suppliers.

Best Buy offers value added services such as PC service and support, as well a home theater installation. Attributes such as these assuage competition based merely on price. This helps to set BBY apart from Wal-Mart and online retailers.

Conclusion:
The health of the economy is in question, and BBY EPS estimates are likely to be revised downward, hence the share price could fall. Yet, taking a long-term approach Best Buy may be a worthwhile investment and any further share price deterioration makes BBY more attractive in regards to a long-term holding.

Further research is needed before committing funds; I plan to dig deeper and present my findings shortly.


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