Description

Best Buy Co. Inc, (“Best Buy”, “BBY”, or “the Company”) is a Richfield, Minnesota-headquartered retailer with physical operations across North America. The Company had 1,144 stores as of YE FY 2022, with 984 within the U.S. (Domestic) and 160 in Canada (International) segments. BBYs store portfolio is highly concentrated, with California (135 stores / 14% of total domestic), Texas (98 / 10%), Florida (61 / 6%), New York (49 / 5%) and Illinois (43, 4%) representing 39% of the total Domestic footprint. BBY’s 160 stores within International are split between Ontario (69 / 43%), British-Columbia (27, 17%) Alberta (24 / 15%), and Quebec (23, 14%). Roughly 95% of the store portfolio is leased. BBY combines omnichannel capabilities and vendor store-within-a-store concepts to allow closer vendor partnerships and a higher quality customer experience. 

BBY claims to “continuously look for opportunities to optimize [its] store space, renegotiate leases and selectively open or close locations to support [its] operations.”

BBY sells products across six key categories, including:

1)     Computing & Mobile Phones - desktops, notebooks and peripherals, mobile phones (incl. related mobile network carrier commissions), networking, tablets and wearables (including smartwatches);

2)     Consumer Electronics - digital imaging, health and fitness products, home theater, portable audio (including headphones and portable speakers) and smart home;

3)     Appliances - large appliances (including dishwashers, laundry, ovens and refrigerators) and small appliances (including blenders, coffee makers and vacuums);

4)     Entertainment - drones, gaming (including hardware, peripherals and software), movies, music, toys, virtual reality and other software;

5)     Services - consultation, delivery, design, health-related services, installation, memberships, repair, set-up, technical support and warranty-related services; and

6)     Other - other product offerings, including baby, food and beverage, luggage, outdoor living and sporting goods.

Like other leading retailers, BBY has developed digital capabilities to both conveniently meet its customer’s shopping behaviors, as well as to improve product availability and delivery times. Customers within BBY’s Domestic and International segments who purchase product online have the choice to pick up product at a Best Buy store (including curbside pick-up at most stores), at an alternative pick-up location or take delivery direct to their homes.

Most of BBY’s merchandise is shipped directly from manufacturers to its distribution centers. According to management, BBY’s ship-from-store capability has allowed the Company to improve product availability and delivery times, which aids in converting sales and driving repeat business. 

Where BBY most differentiates itself from other retailers is within its Services offerings. BBY provides customers a full suite of services to complement its product offerings, including consultation, delivery, design, installation, memberships, protection plans, repair, set-up, technical support, and health, safety and caregiving monitoring and support. While Services is a low percentage of consolidated revenue (5% of total FY 2022 revenue and 5% in Q2 FY 2023), Best Buy is leaning into this capability, attempting to position in the minds of consumers as a trusted source of technical expertise and a valuable ‘second opinion’ to the customer’s own primary research. 

I think BBY is a short given retail macroeconomic dynamics, as well as the fact that BBY's Totaltech offering will not move the needle on earnings or cash flow.

1. Can Best Buy sell consumer electronics at pre-pandemic gross margins, or will industry-wide inventory issues and inflation-impacted consumer hurt revenue, earnings and cash flow?

The current debate between retail bulls and bears is focused on a few key questions:

1. The health of the consumer in 2023 amid double-digit inflation.

2. The level of promotional activity required to clear remaining inventory bloat in 2H 22 / 2023 relative to 2019.

3. Normalized gross and operating margins relative to 2019, and

4. The extent of unit growth v. price growth in 2023.

Companies answering these questions directly at Goldman Sachs’ September 7^th, 2022 Global Retail Conference gave decidedly mixed responses, and therefore not much can be gleaned.

Accurately assessing the health of the consumer is a challenge.  Bank of America Merril Lynch sees US Goods consumption around 5% above pre-pandemic levels.

This is despite Michigan Consumer Sentiment Index hovering around 4yr lows across all terciles of income levels.

Inflation is a top concern as it impacts the level of real spending by consumers. Consumer Price Index (CPI), a widely quoted (but potentially understated) data set tracking inflation is up 8.5% YoY in July, while Personal Consumption Expenditure (PCE) inflation is up 6.3% YoY. The Federal Reserve is expected to continue hiking interest rates over the near- to medium-term in order to cool inflation.

Although inflation is running hot, data indicates spending is still healthy. Monthly card spending per household excluding food, gas, and utilities appears to have rebounded in August, while household savings and checking balances by income are well above pre-pandemic levels. 

Taken together, this data suggests consumers have adequate “dry powder” to weather higher prices.

Further, a slide from Best Buy’s 2022 Investor Day presentation indicates that consumer spending on technology has remained stable since 2000.

 
Source: Best Buy 2022 Investor Day Presentation

The second big retail question addresses promotional activity across the industry, as major retailers work to clear the level of excess inventory which was pulled forward through a combination of stimulus-fueled demand, supply chain constraints, and a violent correction in both technology stocks and market sentiment amid macroeconomic and geopolitical fears. In July 2022, Target and Walmart pulled their previously issued full-year guidance as they pre-announced earnings misses, driven by markdowns and impairments to clear bloated inventory levels. Within retail, apparel and electronics are the two categories which have been the most exposed categories.

On Walmart’s Q2 2022 Earnings Call, CFO John David Rainey fielded a question around inventory markdowns:

Kelly Ann Bania - BMO Capital Markets Equity Research

…Can you clarify the dollar amount of inventory that you estimate would be excess? And can you help us understand how much of that is in apparel or other categories and the magnitude of markdown that you expect to clear through that and the timing of when you expect to get back to a clean position?

John David Rainey - Executive VP & Chief Financial Officer

Sure…So if you …just take the U.S. inventory increase in the second quarter of $11 billion. If you decompose that, about 40% of that is due to inflation. So don't think units, think just dollars…In terms of the types…the inventory issues were most acute in apparel in the second quarter. As we look into the third quarter, I'd say it's home, electronics and apparel are probably the areas that stand out the most.

Several companies at Goldman’s conference noted some recent improvement in the level of markdowns. However, one month does not form a trend, and there will be considerable consternation ahead of the Q3 and the extremely important holiday shopping season.

The third question around normalized operating margins at retailers is important to consider as labor expenses continue to rise. Best Buy’s 2022 Investor Day indicates average wage rate has risen by 20% in the last two years. Given the importance of Services such as Geek Squad to the Company’s holistic offering, Best Buy may have less room for SG&A cuts than other retailers.

The fourth question around price versus unit growth is also unknown. Best Buy’s management believes three things:

1. The average U.S. household now has a total of 25 connected devices, across 14 different categories compared to 11 in 2019. There is an overall larger installed base of consumers using technology. People own more tech devices than ever before.

2. People will continue to use technology more and need or want to replace or upgrade their products. 30-50% of people who purchased tech items specifically for COVID reasons plan to upgrade or replace those purchases.

3. Iterative innovation in consumer technology drives upgrade cycles.

Bulls will argue consumer technology is more relevant a category than ever before. A study of 11k RescueTime users found iPhone users spent an average of 3hrs & 15 minutes on their phones every day. The 2019 US Census found average one-way commute time was 27.6 minutes. This means the iPhone has roughly ~6.5x more utilization than a car, just on usage time alone. Bears will argue that the ‘base level’ technology has become so effective that the latest consumer devices are no longer providing step-function benefits, which will slow upgrade cycles going forward, especially as disposable income budgets increasingly get cut.

A Morgan Stanley August 2022 research piece on various retail categories indicated that Consumer Electronics’ share of Real PCE has only fallen 10.5% from COVID-19 peaks, suggesting the category has considerable room to fall on both pricing and unit growth before inventory levels normalize. This gives ammunition to both bull and bear arguments. Bears might argue that Best Buy will struggle to realize pricing growth within consumer technology retail sales until the reversion enters the 40 – 60% mean reversion zone. Bulls might argue consumer technology spending resilience is a feature of the increasing dependency on best-in-class devices, and that spending will remain resilient as it has since 2000.

Taking a view on each of these four questions is imperative before investing in any retailer ahead of the FY 2022 holiday season. Bloomberg's headline that Apple was planning to pause production of the iPhone 14 at select manufacturers was enough to convince me that BBY's stock had asymmetric skew to the downside in the broader technology retail space. While this is not enough info to underwrite the short, it's evident to me that macro trends are not working in BBY's factor - the consumer will not be bailing the Company out when other retailers have all cut estimates for 2H 2022.

2. Can BBY drive higher share of consumer’s wallet in Consumer Electronics by achieving success with its Totaltech subscription offering?

Totaltech is a $199 annual membership offering launched nationwide on October 5^th, 2021, a supplement to the existing, free-to-join My Best Buy membership which has 120mm existing members. Totaltech subscribers (“members”) receive perks such as unlimited, 24/7 Geek Squad support, special member pricing discounts on merchandise, up to 2 years of protection on most purchases, and free shipping and installation, among other offerings. BBY disclosed in its 2022 Investor Day materials that Totaltech currently has 4.5mm members. On the Company’s Q2 FY 2023 earnings call, , CEO Corrie Sue Barry stated the Company’s goal with TotalTech is to “create a moat around the consumer…[a]nd to make it kind of inconceivable for them to buy [Consumer Electronics] anywhere else.” BBY hopes Totaltech can help the Company grow incremental spend from members, increase frequency of purchase, and grow its share of wallet. Management has not yet disclosed how many Totaltech subscribers are currently being retained beyond their initial sign up. However, Management did provide some anecdotal context around how the Company is approaching the upfront investment as well as early indicators that the strategy is, in their view, working.

BBY’s March earnings call presentation disclosed that Totaltech is “profitable on a standalone basis.”

Source: March 3, 2022 Earnings Presentation

Management's commentary here should be taken with a large grain of salt - this could mean anything. Management's lack of disclosure to build out Totaltech indicates to me they are hiding something here. My perosnal view is the total value of services BBY provides is actually cannibalizing the lifetime profitability of its core customer. While there is not sufficient unit economics data to prove that out, there's little debate Totaltech is weighing on margins.   

BBY’s efforts to invest in Totaltech comes at a cost to profitability. In BBY’s Q2 FY 2023 10Q, the Company stated that its Totaltech membership offering was the primary driver of lower services margin rates, primarily due to incremental customer benefits, and associated costs. On BBY’s Q2 FY 2023 earnings call, CEO Corrie Sue Barry provided investors a bit of clarity into management’s strategic thinking around the program, but stressed its impact is still too early to gauge.

“As we have previously shared, from a financial perspective, Totaltech is a near-term investment to drive longer-term benefits. Over time, we expect the incremental spend we garner from members will lead to higher operating income dollars.” BBY’s management team stated “there are several things [the Company is] seeing with the program that give [them] confidence that customers value the membership and that [their] thesis in general is playing out. At the same time, consumer electronics is a low-frequency category. And [the Company is] in a unique macro environment, meaning it will take time…to truly assess the performance.” BBY Management commented they are “encouraged with the pace at which [the Company is] acquiring new members” and that “in Q2, nearly half of the new members joining the program were either new or lapsed customers, reinforcing how the value of this program resonates beyond [the Company’s] existing loyal customers.”

On the Q2 earnings call, management guided for 60 – 80 basis points of services gross margin pressure attributable to Totaltech, which is anticipated to “abate a bit” as [the Company] get[s] into Q3 and Q4 and Totaltech’s initial launch is lapped. BBY management sees “about 100 basis points gross margin pressure” from BBY’s pre-pandemic level, which should subside as more customers sign up and drive more incremental product sales. However, all of this must be proven out in the numbers before the market will care about it.

A key debate in the stock has emerged around how sticky Totaltech customer subscriptions will be. While bulls can argue unlimited tech support, warranties and special discounts could incentivize customers to renew their subscriptions, bears can argue that installation of major consumer electronics, appliances and home theatres is much more of a ‘one-time’ purchase that wouldn’t necessarily require a subscription.

Another debate in the stock around Totaltech is how much the subscription can drive higher operating income through increased share of wallet. Management anecdotally believes early indicators are proving their thesis is correct.

“As we have previously shared, from a financial perspective, Totaltech is a near-term investment to drive longer-term benefits. Over time, we expect the incremental spend we garner from members will lead to higher operating income dollars…there are several things we are seeing with the program that give us confidence that customers value the membership and that our thesis in general is playing out. At the same time, consumer electronics is a low-frequency category. And [BBY is] in a unique macro environment, meaning it will take time for [the Company] to truly assess the performance...[management] will continue to monitor the program and iterate on the offering as [the Company] learn[s] more.”

Bulls may argue that Best Buy is showing some greenshoots that the Company has able to drive higher share of wallet through its strategic initiatives. Management call out success with the Best Buy branded credit card as driving “a valuable and sticky relationship with…customers. [The Company] continue[s] to see growth in cardholders. More than 25% of [BBY’s revenue is transacted on [the] Best Buy branded card. And cardholders have been increasing the use of their card outside Best Buy stores as well. These customers tend to be more engaged with Best Buy over time, with higher frequency and spend than non-cardholders.” However, management’s reticence to publish the figures while pulling FY 2025 guidance just 6 months ago makes it clear that the subscription service alone cannot carry the company through its myriad of industry-wide and macroeconomic issues. 

On rough math, if Best Buy were able to utilize Totaltech to grow its share of Consumer Electronics customer wallet by 10% from FY 2022 figures, that implies an annual revenue uplift of $2bn. Further assuming EBIT margins of 6% (a discount to management’s previously issued FY 2025 Non-GAAP EBIT margin guidance of 6.3% - 6.8%), on today’s share count of 225mm, this implies an $79.65 stock, 8% above where it trades today.

Note that Best Buy’s 2022 Investor Day Slides indicate the Company believes 20% wallet growth is achievable. This implies 12% upside to the stock price.

Source: Best Buy 2022 Investor Day Presentation

To conclude, even in BBY's blue skies scenario of 20% wallet share growth, the stock is 8% - 12% up, with a lot of downside.

This isn't the most polished idea, so apologies in advance. I'm continuing to refine my thoughts here.

Catalyst

Incremental Totaltech disclosure, Apple earnings on Oct 27.