The following is an excerpt from a report compiled by Michael Pachter of Wedbush Securities.
Best Buy (NYSE:BBY) reported Q1:14 results this week. The company reported comps of down 1.3 percent (adjusted to eliminate an extra week last year). Overall sales were down 9.6 percent, below our estimate of down 7.8 percent. Non-GAAP EPS was $0.32, compared to our estimate of $0.19 and consensus of $0.25. Non-GAAP EPS excludes positive EPS contribution from discontinued operations of $0.04 (a loss of $0.53 on a GAAP basis). The non-GAAP EPS figure nets out a write-off of $173 million ($0.51/share) in asset impairments from Best Buy Europe, and it is unclear what is included in this figure.
Other than non-GAAP EPS, results were mixed. Non-GAAP SG&A was much lower than expected, reflecting solid cost cutting, with domestic SG&A at 20.6 percent vs. our 21.8 percent estimate and international SG&A at 24.3 percent vs. our 26.3 percent estimate. However, gross margin was also significantly lower than we had expected, coming in at 23.1 percent overall, well below our 24.3 percent estimate and last year’s 25.0 percent. The weaker-than-expected gross margin was driven by a greater investment in price competitiveness (including promotional activity in mobile and computing), higher inventory shrinkage, and increased product warranty-related costs.
Our initial takeaway on Q1 is that price competitiveness, and to a lesser extent, price matching, are significantly eroding margins, while doing little to stem comp declines. However, the pace of cost cutting is more rapid than we had expected, allowing EPS to exceed our expectations. We think the company’s cost control is impressive, and expect management to find additional sources of cuts going forward.
However, price competition is unlikely to subside, and in our view, continuing comp declines are likely, while cost cuts will be more difficult to achieve going forward. We think that Best Buy’s eroding comps are a sign of gradual migration of purchase habits to the Internet, and we are not optimistic that the company’s online initiatives will allow it to retain its market share.
Cash flow continues to be weak. Free cash flow (cash flow from operations minus capex) totaled negative $179 million, down from positive $238 million last year, $680 million in FY:13 ($965 million after one-time adjustments to inventory and accounts payable), and an estimated $2.5 billion in FY:12.
Full-year cash flow is currently tracking well below last year’s level, placing even greater pressure on holiday sales to drive cash flow back close to last year’s level. We are pessimistic that Best Buy’s initiatives to date will drive traffic in Q4, and we expect full-year cash flow to come in significantly below last year’s level.
The lone bright spot is expense management. The company eliminated $175 million in spending in addition to the $150 million eliminated in the prior quarter. CFO Sharon McCollam warned in her prepared remarks that ongoing investment in price competitiveness will continue in Q2 and will once again pressure gross margins and EPS. She also warned that disruptions from deploying the Samsung Experience Shops (OTC:SSNLF) and optimization of Best Buy’s retail floor space are expected to have operational impacts in Q2.
The company also expects a greater negative impact from Renew Blue and SG&A investments in Q2 in online, mobile, the multi-channel customer experience, and the replatforming of bestbuy.com. The financial benefits from this replatforming are not expected to be realized until FY:15 at the earliest. In the aggregate, we believe these statements reflect management’s expectations for a difficult Q2, along with a challenged financial performance for the near-term at least.
The company is clearly focused on online growth. Domestic comparable online sales were up 16.3 percent, excluding the impact of an additional week of evenue last year. While this number is impressive, it was more than offset by the $88 million decline in comps (after eliminating the effects of the additional week last year).
It is possible that online growth will outpace domestic comp declines, but we don’t believe that is likely, especially in Q4; rather, we think domestic comp declines will accelerate at holiday from increased price competition from online merchants, and we believe that Best Buy is positioned to significantly disappoint later this year.
Gross margins are tracking much worse than we expected, while comps are in line, meaning that Best Buy is not getting much lasting benefit from price competitiveness and price matching. Although the company has cut $325 million from its cost structure, management commentary about Q2 indicates that spending may tick back up as the company continues to invest in various initiatives, including online expansion.
We reiterate our UNDERPERFORM rating and 12-month price target of $9. Our target reflects our expectations for further operating margin erosion, low visibility, lack of FY:14 guidance, the unlikelihood of a buyout, and our doubts about the company’s turnaround plan. We expect comps declines to continue, with price competitiveness eroding margins further.
Risks to attainment of our share price target include changes to the macroeconomic outlook, variability in new product release timing, the effects of competition from other consumer electronic and big-box retailers, and changes in consumer demand for consumer electronics.
Michael Pachter is an analyst at Wedbush Securities.