Best Buy Disappoints As Expected

By Dr. Duru written for One-Twenty

December 13, 2006

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After Best Buy (BBY) last reported earnings on September 12, 2006, I claimed the subsequent rally was overdone given the headwinds Best Buy faced from competitors. The market did not care and kept on pushing the stock to a peak in October that almost matched BBY's all-time highs. On November 4, 2006, I chose to scold the analysts one more time for ignoring the warning signs even as Wal-Mart (WMT) made known its aggressive plans and moves into consumer electronics. The buyers stepped in and bought the dip and the optimists successfully defended those price levels as I suspected they would. And finally, as expected, Best Buy's latest earnings report on December 12 disappointed earnings expectations even as revenues came in fine. Suddenly, early November's price base became resistance in a heartbeat. BBY closed the day below its 200 DMA and a 5% drop in price. $52.10 was the high on the day which just happened to correspond to the closing price on November 3 when BBY dropped hard on the WMT news.

Best Buy put a brave face on its business prospects and maintained its earnings guidance for the current fiscal year - although the range of $2.65 - $2.80 is still below the consensus forecast of $2.81. On the conference call, a Best Buy executive offered a story about his shopping experience on the day after Thanksgiving as reason for maintaining optimism. He took his son with him to see the shopping in action at a store in Minnesota - bright and early at 5am. He admired how well the store accomodated the nearly 2000 shoppers who faithfully waited in line and jumped on the deals of the day. The bumrush did not lead to pandemonium as he feared. Instead, the whole show went off without a hitch. Surely, Best Buy is a master of execution! I share BBY's relief that all went well with America's time-honored tradition of turning Christmas into a stampeding celebration of capitalism. Once again, the consumer proves it is alive and well. The economy is fine. But I maintain that what is not fine is BBY's profitability. For example, gross margins fell from 24.4% to 23.5%. It seems to me that BBY's brave face comes from a confidence that they can continue to take market share from competitors. In fact, Brad Anderson, vice chairman and CEO of BBY had this to say in the earnings report: "While a very competitive climate put pressure on our margins, resulting in earnings below our original expectations, I continue to support the strategic choices we made. The market share gains we saw, and the new customers we acquired, give us momentum as we begin our fourth quarter, which generates the largest percentage of our earnings for the year."

Given BBY's competitors are getting aggressive with price, I can only assume that BBY also plans to use price to defend sales and in the process make up the margin loss on volume. Do not forget that BBY has already announced a massive expansion in floor space by opening many more news stores across the country. Apparently, BBY is also making bigger moves into China. Margins could remain under pressure just to keep these initiatives successful. Who knows, maybe if BBY really gets pressed to the wall, they will go ahead and deliver on these persistent rumors of its interest in acquiring Radio Shack (never mind that Radio Shack is suffering from BBY's successes). Nothing like a timely acquisition to keep a growth story going!

Anyway, given all of this, I am looking for BBY to disappoint again. Enough analysts and pundits should continue to claim that everything is fine so that the stock will not sell off too much further. If BBY does indeed disappoint again, I expect the market to be much less forgiving than it has been lately. The good news is that such a sell-off may represent a good opportunity to buy into BBY on the cheap....of course, if the economy slows down too much then BBY could always get even cheaper. As always, time will tell. (I do not have any positions on BBY at this time. Read disclaimer here.)

Be careful out there!
DrDuru, 2006