Last year, electronics retailer Best Buy Co.’s stock was the third-worst performer in the S&P 500. Falling sales and huge losses fueled speculation it would suffer the same fate as its former rival, Circuit City.
In 2013, however, shares of Best Buy (NYSE: BBY) have jumped more than 202 percent year to date, as of Aug. 26 close. It’s now the second-best S&P performer this year. Last week, it surprised Wall Street with stronger-than-expected earnings and posted its first quarterly profit in a year.
So what exactly is driving this dramatic turnaround? Is the chain retailer merely a showroom for Amazon.com, or has it truly turned the corner by increasing sales? Let’s take a look.
All Profits Are Not Made Equal
Best Buy’s $266 million net profit in the fiscal second quarter came as a surprise, and it largely drove the most recent uptick in stock, up 18 percent in the last five days.
Upon closer examination, topline sales of $9.3 billion were lower than a quarter ago ($9.4 billion), as well as compared to the same period last year ($10.5 billion). Same-store sales, a key metric for retail companies, actually declined from a year ago by 0.4 percent. And those figures could probably be far worse, if Best Buy hadn’t launched a price-matching policy last quarter (more on that later).
Best Buy’s sudden profitability is due to aggressive cost-cutting. Operating expenses for the recent quarter were 4 percent lower than last quarter, and a whopping 15 percent lower than the same period in 2012. The lower cost resulted in $413 million of operating profit compared to $33 million a year ago.
Trimming fat is necessary for a company undergoing a restructuring, and Best Buy is doing so by laying off managers at its Minnesota headquarters, closing underperforming stores, and tightening its supply chain.
Best Buy’s CEO, Hubert Joly, talked about tackling its two biggest challenges at last November’s annual meetings: declining same-store sales and declining margins. We can see that the first problem is still present, if not getting worse, and the second problem was temporarily curbed via aggressive cost-cutting.
Chairs on the Titanic
Unfortunately, Best Buy’s turnaround plan is akin to rearranging deck chairs on the Titanic.
Firstly, the company spent money last quarter revamping stores and building “stores-within-a-store” including mini boutiques for Samsung and Microsoft. Joly’s strategy is similar to what Ron Johnson attempted to build at J.C. Penney last year, with disastrous results, albeit on a more modest scale. The move will drive store traffic, but whether it translates into sales will depend on Best Buy’s pricing strategy.
This is where the next move comes in. Best Buy rolled out an aggressive price-matching program to match Amazon.com and Wal-Mart for identical products. It has stopped the recent sales bleed, but it will hit the bottom-line. Until the company trims more expenses, and indications are that it will, Best Buy simply has too much overhead to compete with Amazon on pricing, and must keep too much inventory to compete with Wal-Mart, which has less selection at more aggressive price points.
Lastly, Best Buy is banking on overseas growth. It has stores in Canada and China, and international sales are a growth engine. It is expanding from a point of strength as the world’s biggest electronics retailer with brand awareness. On the pricing front, “we don’t see a need to be lower. We just don’t want to be beat,” Joly said at a conference call with analysts on Aug. 20. While it has some underperforming international stores, this is one area to keep an eye on.
Best Buy is embarking on this turnaround at a time when retailers from Macy’s to Wal-Mart are pessimistic on consumer confidence and lowering their sales targets. When Wal-Mart and Target are worried about shoppers struggling withthe cost of consumer staples, it’s doubly so for Best Buy, which relies on consumer discretionary spending.
Apart from Best Buy, the retail sector has some of the worst performing stocks over the last month. Since Aug. 1, the S&P Retail Select Industry Index has underperformed the S&P 500 by 188 basis points. Despite its recent surge, the deck is stacked against Best Buy.
But there are some steps it can take to boost its chances. To attract, and more importantly, retain customers, Best Buy should overhaul its sales model. As a brick-and-mortar store, it must provide additional value to a customer’s shopping experience on top of what Amazon or any other online retailer can offer.
It must employ an experienced sales staff that possesses in-depth knowledge of electronics, computers, and accessories. It already does this in certain departments such as home theater, but in other areas the knowledge is inconsistent at best, and severely lacking at worst.
Some other strategies it can employ include getting rid of low-sales or low-margin departments (i.e. music CDs) and focus on experience hubs and stores-within-a-store such as home theater and display kitchens where it can show off its deep expertise and customer service. It should also make its website a stand-alone online retailer to better compete on price against Amazon.com. Last quarter, Bestbuy.com only generated around 5 percent of total sales ($477 million), which is unjustifiably small given its name recognition.
Piper Jaffray analyst Peter Keith said it best in a research note last week, “Best Buy doesn’t have a traffic problem.” What it does have is a conversion problem, which will remain due to competitive pressures from online retail and discount chains.
Best Buy is now the lone major electronics retailer in the United States, so it is unlikely to go away as there will always be a segment of consumers who are uncomfortable shopping online. But similar to another brick-and-mortar stalwart, Barnes & Noble Inc., future growth is likely to remain elusive.
Given the rather poor fundamentals, the company’s recent stock surge is based purely on hope. We’ll find out after the holiday shopping season whether it’s false hope.
Frank Yu is a contributor to the Epoch Times.