Thursday, February 27, 2014

Best Buy's Q4 FY14: Many Points of Light

We go back a long way with Best Buy, recommending the stock when they were on the ropes, with Circuit City knocking at the door. Best Buy did exceptionally well, the stockholders were well rewarded, and the grim reaper eventually came for Circuit City and for many other smaller, specialty electronics retailers.

Renew Blue was a great start to digging out from under a long period of mismanagement that created the opening for Amazon and others to walk through, as electronics became like the grocery store's loss leaders.
Like a patient with heart disease, things looked fine on the surface--snappy new corporate HQ, consultants all over the place, expansion in China--while the patient was heading for the critical, life threatening event.

Like a cardiac patient, putting a stent in isn't the magic bullet by itself.  Renew Blue's first phase was like that stent.  So, in the Q4 FY14 earnings call, the CEO and CFO's commentary struck a good balance among the holiday season, the fourth quarter, and the next phases of Renew Blue.  If this program continues to be executed well, the Best Buy three or four years from now will have been almost totally transformed.  Let's hope the stock doesn't get ahead of itself in the meantime, as it's always had a habit of doing in the past.

Quarterly revenue of $14,470 million declined 3% from the prior year period. On the face of it, the same store sales decline of 1.2% was a bit better than last year's decline of 1.4% but disappointing. The non-GAAP operating margin declined 120 bp to 4.5%, off the long-term goal of 5-6%.  However, against the backdrop of  industry product cycles, competitive dynamics, and Best Buy's own internal changes, this performance seems encouraging.

CEO Hubert Joly said that the management team's focus in the quarter was on the corporation's own controllable levers, maintaining price competitiveness and on keeping the promises made to customers. There were a number of factors that put downward pressure on margins, e.g. 100 bp compression came from changes to a mobile warranty program, while another 125 basis point margin compression came as a result of investment in price competitiveness and promotions.  The press release and financial tables spell out the year-over-year non-comparable factors in detail

On an adjusted basis, the CEO characterized the domestic same store sales decline as being 0.6%, or relatively flat; the non-GAAP operating margin decline of 120 bp, abstracting from some of the tactical investments and other factors declined about 70 bp.

The CFO also noted that the company's guidance for the fiscal fourth quarter had been for a year-over-year decline in the operating margin between 175-180 bp, versus the non-GAAP reported 120 basis point decline. The CFO noted that a less promotional environment than a year ago, vendor support, and cost disciplines were better than expected going into the quarter.

Domestic online sales grew by 25.8% over the prior-year period. Although the company's website has improved dramatically over the pre-Joly version, it still could use a lot more work, and it sounds like things are going to change.

Project Athena was mentioned, which sounds like an internal database project to build customer-by-customer records including website visits and clickthroughs which, in turn, will generate customized texts and email offers based on the visitor's expressed preferences or inquiries. This won't happen overnight, but it is the way the company has to go.

The profitability of online sales today is lower than that of comparable in-store visits. Certainly looking at Amazon's financials, that would seem to be the case, but Best Buy is really changing its customer-facing presence and it will take some time.

Non-GAAP SGaA of $2.3 billion was 15.7% of sales, compared to $2.5 billion or 16.6% in the prior-year period. Domestic SGaA expense was $1.96 billion of 16% of revenue compared to $2.06 billion or 16.5% of revenue in the prior-year period.  Renew Blue's annualized run rate of expense reduction had been targeted at $725 million, and the fiscal year ended, the CEO said., at a rate of $765 million.

In the coming 24 months, the company's Renew Blue will focus on the real guts of the retailing function, namely Merchandising, Marketing, Operations, Stores, Supply Chain,General Systems and Employee Engagement.  The absolutely amazing thing is how much room for improvement there still is, with the stock already having more than doubled.  

The company's local advertising circulars are vendor-paid 1970s vintage to pick on one irritant I see every Sunday. They bear no relation to what is trending in the marketplace.  The CEO has now raised the ante on Renew Blue to run annualized savings of $1 billion!  Merchandising will be tasked with coming up with tailored assortments that matter, not what the vendors want or what the stores want to drive margin through mix. The company loses about $400 million a year from damaged merchandise: very hard to believe in a company this big with this history. 

The Employee Engagement task will not be easy, because the new model revolves around an empowered General Manager, who has variable compensation targets for individual store performance.  This model, especially given the nature of most centralized structures, is not easy to implement.  I have heard this story dozens of times, but I've only seen it done a handful of times..  The corporate functions like to think that they are the brains of the operation.  Mr. Joly's task will be to make them the servants of the stores who are the ones who can see and feel what the customers want or don't like.  

The systems and ordering tasks are onerous and detailed, but they've been done many, many times.

The overall message is that the Best Buy ship has stopped taking on water, has been righted and is once again at sea.  Cash flow from operations of $1.1 billion looks down from last year's $1.4 billion, but much of it seems like timing, apart from what looks like the closing of lots of square footage with the inventory still on hand, not being returned or sold. This number should get significantly better.

Samsung stores, which we wrote about positively at the outset, could do much better next year, as that company slowly seems to be unleashing its innovation engine in phone, phablets, and other consumer health and electronic items. Microsoft's stores too should do better.  

Management's challenge will be to manage expectations and to change around the internal teams and culture, with restructurings and new hires, to transform the company's way of dealing with vendors and customers in the new retailing structure of the future. 

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