Friday, November 16, 2012

"Renew Blue" Is A Good Start for Best Buy

When I followed Best Buy as a sell-side analyst in the early nineties, it wasn't even "chopped liver" on Wall Street.  Specialty retailing analysts who followed electronics unanimously preferred Circuit City, the foie gras of electronics retailers. Between Circuit City's taking the higher end, tech savvy consumer and Wal-Mart's capturing the low-end, the only future for Best Buy was bankruptcy. Even Radio Shack got more respect for high sales per square foot and its gross margins.

This is a perfect scenario for a value investor, like myself.  When the Street hates a stock, it's easier and more fun to conduct in-depth research. Those of you who've read this blog over the years know how much I learned from Ben Graham's approach, and from his accomplished disciples like Max Heine, Bill Ruane, Warren Buffet, Charlie Munger, Chris Browne, John Spears and others.

In the spring of 1994, I put a 'Buy' recommendation on the stock, and by mid-July it was at a three month low and had fallen 11 percent in one day on fears of slowing growth. The shares got caught up in negative market sentiment about high multiple stocks, and there were fears about Circuit City's aggressive entry into the Twin Cities market with their new superstore format.  Needless to say, the shares did exceptionally well from that point, as did a number of large institutional investors in Boston who came on board in front of rapidly improving fundamentals. 

This is just for context and not to ressurect history.  I've never lost touch with this story.  I can honestly say that for the past decade, Best Buy has made about every fundamental market, operating, strategic and cultural mistake that a maket leader can make. 

Technology product cycles and frothy equity markets can often mask weakening fundamentals.  Just as sentiment worked against them before, analysts are now negative: 2 hold 'Buy' ratings, with 19 'Hold' ratings, and 2 'Underweight' or 'Sell.' 

The fundamental issues at Best Buy have nothing to do with "showrooming," but everything to do with the company's own internal issues.  Back in the time when I rated the stock a 'Buy' the internal organization and culture were strengths, while during this long down cycle, the opposite has been true. 

So, CEO Hubert Joly's investor presentation "Renew Blue" is most definitely on the right track.  What's surprising to me is that Best Buy is still in a relatively strong market position despite shooting itself in the foot in ways which are handled gingerly in the slides. I believe that I can also see the imprint of the new CFO on the presentation.

Best Buy's core market is $228 billion for fiscal 2012, and it has been growing at a three year CAGR of 3.2%.  This is certainly a nice market to be in, and just as in 1994 it is still fragmented.

48% of Best Buy's market is served by retailers with market shares of 4% or less. 

According to Best Buy's research, it still has the number 1 market share at 16%, followed by Wal-Mart at 15%, followed by Apple, Sears, Target, and Amazon with a 4% market share. 

Best Buy has lost connection with its customers, which is the biggest knock against management.  Their big market characterization of their customers a few years ago, which probably cost millions was foolish. Their current survey shows that they have even managed to lose their "low price" identity, which is quite a feat.

They are shown to have one of the largest customer loyalty data bases in the industry, but it isn't an effective program, especially for inducing activity among inactive customers.  Office Depot, for example, has a better program that requires no customer effort to update and use. This can be easily fixed.

Best Buy's website looked like something from the 1970s, and the navigation and functionality were primitive.  It looks a lot better since Mr. Joly has come on board, and it can do much, much better.  Despite this, the company drew 1 billion online visitors and generated $2.3 billion in sales from the online channel.

For all the talk about "low hanging" fruit, some of the fruit, like the operations at Best Buy Canada, is lying on the ground. The cultural and organizational issues, which are much more subtle, can yield a lot, but they will take time.

Appliances are still a square peg in a round hole.  The good news is that nobody in the
"big box" format does a very good job, with the exception of Sears which is a historical artifact ready to be picked off by a better merchandiser.

The presentation about ROIC in the stores is very interesting.  It parallels issues faced by Home Depot in the recent past.  When they fixed this issue, the stock took off in a period of peer and market outperformance.

The Geek Squad is their best acquisition, but still underleveraged.  Experiments like Simplicity need to be multiplied and rolled out when ready.

Some analysts suggest vendors might not have an interest in Best Buy surviving.  Just like 1994, I can't understand what these folks are thinking.  Vendors need Best Buy.  Best Buy hasn't treated the vendors like partners and it hasn't demanded, or merited, the best from them.  This can be fixed.

The whole managment tier under the top management has to be redone, both the cast and the script.  This will be critical to translating this presentation into sustained performance in earnings and in shareholder returns.  Now that the overture has played, I'm anxious to see Act I. 

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