Best Buy's financial health and competitive strategy analysis

Best Buy is an American retailer focused on the consumer electronics segment of the market. The company has operations in the U.S., Canada, the UK, Turkey, Mexico and China (Best Buy.com, 2010). In the 2010 fiscal year, which ended at the end of February, Best Buy recorded revenues of $49.694 billion and profits of $1.317 billion. While the revenue figure was a record high for the company, the profit figure was not. Best Buy traces its history to 1966 and introduced the discount store concept in 1989. The company has a number of subsidiaries including Geek Squad, Pacific Sales, Speakeasy Inc. And Magnolia Hi-Fi. The business is primarily segmented by geography, however (2010 Form 10-K).

Best Buy has adopted a mass market cost leadership strategy. The company leverages its high sales volume to sell products on slim margins. This serves to attract customers but it also serves to give Best Buy a competitive advantage on many products due to its ability to sell those products at lower prices that competitors can. Major competitors in this segment, each of which markets consumer electronics and appliances to some degree, are Wal-Mart, Target and Costco. All told, Best Buy has 1069 stores in the U.S., 2453 stores in Europe (mostly phones), and 322 stores internationally, most of which are in Canada and China (2010 Form 10-K)

Financial Ratios

There are a number of ratios that can be used to analyze the financial health of Best Buy. The ratios used in this analysis are the current ratio (current assets / current liabilities); cash ratio (cash / current liabilities); gross margin (gross profit / revenues); net margin (net income / revenues); inventory turnover ( COGS / avg inventory); receivables turn (revenue / avg. receivables); asset turn (revenue / avg assets); debt/equity ratio; earnings per share; ROE and ROA. The ratios are tabulated in the following chart:

2010

2009

2008

Current ratio

1.17

0.97

1.08

Cash ratio

0.21

0.06

0.22

Gross margin

24.5%

24.4%

23.8%

Net margin

2.6%

2.2%

3.5%

Inventory turn

7.3 x

7.2 x

6.9 x

Receivables turn

25.6 x

37.2 x

73 x

Asset turn

2.9 x

3.1 x

3.0 x

Debt/Equity

1.89

2.4

1.80

EPS

$3.09

$2.39

$3.12

ROA

7.7%

7.0%

10.6%

ROE

24.0%

21.9%

26.3%

Ratios calculated using figures from MSN Moneycentral (2010).

These ratios indicate that the company is relatively healthy, but does not have an exceptional financial condition. The trend is varied for Best Buy as well in that the firm was in a generally upward trajectory with respect to its financial ratios but had a rough fiscal 2009 (which was basically calendar 2008). The company still saw revenue growth that year, but other measures generally declined. The company recorded an unusual expense of $255 million that year, which reduced net income significantly.

Best Buy is liquid. The firm has a healthy current ratio and cash ratio. In 2008, there was some concern as the cash ratio had declined to 0.06. The steep decline in cash flow can be attributed to heavy investments in upgrading stores (Jacobs, 2008) and expenses relating to the $121 billion acquisition of Napster (Adegoke, 2008). The company has a debt-equity ratio that is considered to be comfortable, but its leverage position could be lower. More encouraging is the fact that the general capital structure of the firm has changed little from 2008.

Best Buy's margins are within the expected range for a firm with a cost leadership strategy. Net margins are low, but the firm still earns over $1 billion in profit because of the high volume of business that it does. The net margins are within the range of Wal-Mart (3.5%) and Costco (1.7%), for example. Best Buy's efficiency ratios are fairly good, although there has been a downward trend. For example while Best Buy recorded a receivables turn of 25.6 times in 2010, that metric was 73 times in 2008 (MSN Moneycentral, 2010). The company has been building up its accounts receivable over the past few years.

Best Buy's returns follow the same pattern. They are healthy, but they have seen a decline from levels of 2008. Overall, the company's financial ratios appear to be rangebound at present. When the off year of 2009 is removed, the ratios have either changed little or declined since 2008. Profits show the same pattern. The only measure that does not is revenue, which has increased steadily. A theory for why this pattern has emerged is that Best Buy has lost its pricing power, but that does not bear out in its gross margin. Selling, general and administrative expenses have, however, increased slightly as a percentage of revenue from 18.4% in 2008 to 19.8% in 2010 (MSN Moneycentral, 2010).

Recommendation

Knowing that Best Buy's stock roughly performs as would be expected based on the company's own financial performance and the performance of the general market, it is difficult to recommend anything beyond a "hold" for Best Buy stock. There are a couple of reasons for this. The first is that any security that performs as expected should be fairly priced. Thus, the value of Best Buy stock is as it should be. A buy rating would be applicable if the stock is undervalued and a sell rating if overvalued. The hold rating reflects a firm that is fairly valued at present.

The second reason for a hold rating is that the company is not a stellar performer. The financial ratios are indicative of a firm that performs well, but not spectacularly. There is little reason to believe that Best Buy is going to jump-start growth to become a rapid grower. More likely, the company has largely saturated the domestic market and is set to enter the maturity phase of its lifecycle. The company's dividend is $0.60 and this is growing slowly. Without much room for stock price appreciation beyond market expectations, the dividend yield of 1.4% is not particularly compelling.

Using the dividend discount model, the stock should be priced as follows:

$0.60 / 10.4 -- 7.1 = $18.18, significantly lower than the current price. Using CAPM (QuickMBA.com, 2010), the return on the stock should be = Rf = ?(Rm-Rf) or approximately 10.4%. With 1.4% coming from the dividend, it is unlikely that the stock is going to appreciate 9% in the next year. By either measure, then, the stock is probably overpriced. Knowing that introduces significant risk to the purchase of Best Buy stock. It is unlikely that the stock will fall to $18, as it did not do so even during the darkest days of 2009, but these findings raise the issue of what the upside of Best Buy stock could possibly be. There is little reason to believe that the upside is going to be sufficiently high to place a "buy" rating on the stock.

Returns are likely to be either in line or below what the beta implies unless Best Buy is able to find new ways to grow. More likely, it will be subject to increased competition from its major competitors and will be forced to cut margins further in order to retain its current sales levels. Thus, there is little compelling about Best Buy stock but there are many reasons to be worried about its capacity for appreciation in the coming years. Given that, only a hold recommendation makes sense. Best Buy is a good company, with a strong name and a substantial market share, but it lacks the upside that other major retailers in its category have and for that reason as well as the ones listed above it is difficult to get too excited about Best Buy stock at present.

Works Cited:

Adegoke, Y. (2008). Best Buy to buy Napster for $121 million. Reuters. Retrieved November 30, 2010 from http://www.reuters.com/article/idUSN1550308820080915

Best Buy.com website, various pages. (2010). Retrieved November 30, 2010 from http://www.bestbuy.com

Best Buy Fiscal 2010 Form 10-K. Retrieved November 30, 2010 from http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9NDQ3NTB8Q2hpbGRJRD0tMXxUeXBlPTM=&t=1

Jacobs, K. (2008). Best Buy profit below view on expenses, shares off. Reuters. Retrieved November 30, 2010 from http://www.reuters.com/article/idUSWNAB134620080916

MSN Moneycentral: Best Buy. (2010). Retrieved November 30, 2010 from http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?Symbol=BBY

QuickMBA.com (2010). Investment management. QuickMBA.com. Retrieved November 30, 2010 from http://www.quickmba.com/finance/invest/