DEEP ANALYSIS: Here’s Why We are Downgrading Best Buy

The following is an excerpt from a report compiled by Michael Pachter of Wedbush Securities.

We are downgrading our rating on Best Buy (NYSE:BBY) to UNDERPERFORM from NEUTRAL, and lowering our 12-month price target to $14.50 from $20 to reflect lower visibility, lack of FY:13 guidance, reluctance to entertain  acquisition overtures, and our skepticism about the company’s new CEO.  We believe Best Buy has been unable to stem sustained comps declines and eroding margins, and remains at a significant disadvantage to its lower-priced and lower-cost peers. Our price target reflects a P/E multiple of ≈ 5x our revised FY:14 EPS estimate of $2.90, and is well below Best Buy’s historical 12-15x multiple.

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Q2 earnings were well below expectations, despite lofty restructuring charges. Revenue was $10.5 billion vs. our estimate of $10.8 billion, and consensus of $10.6 billion. Non-GAAP EPS was $0.20 (excluding $0.16/share of restructuring charges) vs. our estimate of $0.38, and consensus of $0.31.

The lack of FY:13 guidance and addition of a CEO with no retail experience increases uncertainty over the company’s future. The company expects lower earnings (previously for non-GAAP EPS of $3.50 – 3.80), but did not provide a revised range. We expect new CEO Hubert Joly to take some time to learn the business and to formulate a turnaround strategy. In the meantime, we expect comps and profits to continue their downward trend.

The company eliminated its share repurchase program. While this may be prudent in light of declining cash flow, we note that just last November, Best Buy paid $1.3 billion to buy out Carphone Warehouse’s (CPW’s)  interest in its U.S. mobile profits at a multiple of 10x operating profit.  Best Buy shares trade at around 3.5x estimated FY:13 operating profit, leading us to conclude that the company’s board is inconsistent in its capital allocation strategy.

In our view, Best Buy requires a plan for substantially reducing its store level overhead.  We believe that Best Buy’s store level economics place it at a ≈ 10% price disadvantage to online retailers, and we believe that increasingly sophisticated consumers with mobile Internet access will value lower prices over service, ultimately making Best Buy’s big boxes obsolete.

We are decreasing our FY:13 estimates for revenue to $49.7 billion from $50.4 billion, and for EPS to $3.20 from $3.72. We are decreasing our FY:14 estimates for revenue to $48.2 billion from $49.4 billion, and for EPS to $2.90 from $3.30.

Michael Pachter is an analyst at Wedbush Securities.

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