For those who know me, I’ve been talking about Best Buy for a little while but my research kept getting interrupted by finals. This trip to the Berkshire Hathaway Shareholder Meeting gave me the time to finish my research & determine if it was worth an investment. Sorry for the delay in getting through all of this.
I found Best Buy through one of my talented friends, Greg Herman. Not that there was much to find; it’s a pretty well-known business in the U.S. & I only took a look because Greg claimed it looked pretty cheap. He was right, it does look cheap, but not cheap enough at today’s prices for my standards.
Best Buy was founded in 1966, but the company didn’t resemble it’s modern self until they began mass-merchandising consumer electronics in 1983. Richard Schulze, one of the original founders, still holds a 17% stake in the business and has been with them for all 45 years. He is the current Chairman, although he has Brian Dunn in the CEO role. I think this is the best board structure to have; a large inside ownership by a non-CEO who will keep the management team honest and shareholders’ interests close to heart (it’s why I like CNU’s board a lot). Other than some botched acquisitions the past 5 years which I’ll discuss later, he’s done a good job allocating capital to do well for his shareholders. Also, there are many insider transactions between Schulze, his family members, and the company. Normally I would take issue with it, but it doesn’t bother me much due to his large insider stake & the relatively small size of the transactions ($2 MM in leases/year, some legal fees, a few family members being hired as compared to almost $2 B/year in value creation). In any event, keeping a close eye on Schulze is a good idea for the future; while some are worried that Best Buy may lose its relevancy to Amazon or others, Schulze continues to hold his large (almost $2 B) stake. If we see heavy insider selling, as with Netflix‘s founder Reed Hastings, it may be a serious cause for concern.
As with all retailers, it’s important to remain cognizant of the product mix and where the growth has come from in the past so you can determine if its sustainable or not. Here are Best Buy’s product segments:
- Consumer electronics- video & audio products (TV’s, GPS, cameras/camcorders, e-Readers, DVD & Blu-Ray players, MP3 players, home theater audio, musical instruments, and automobile audio systems)
- Home office- computers, tablets, monitors, mobile phones, hard drives, networking equipment. (includes Best Buy Mobile concept)
- Entertainment- video gaming hardware & software, DVD’s, Blu-Rays, CD’s, computer software
- Appliances- major appliances & small electronic components
- Services- warranties, computer-related services, product repair, delivery & installation of home theater audio
- Other- snacks & beverages
As you can see above, the product mix has shifted away from consumer electronics and moved more into mobile phone sales (Home Office). This is to be expected, seeing as they have opened 177 Best Buy Mobile stores in the U.S. and acquired a 50% interest in 2,440 CarPhone Warehouse stores in Europe over the last 5 years. As I learned from studying RadioShack in detail (sorry for not posting, wasn’t worth a solid investment), mobile phone sales contribute to lower margins and higher working capital needs mainly through receivables from wireless carriers. Also, in Best Buy, the comparable store sales have flatlined; it’s either a function of its current environment of skittish customers or mobile phones not increasing their same store sales at all. In either case, margins are down slightly and the business has only grown through adding additional stores; very little, if any growth came from increases in store efficiency, even with this shift in their product mix. While I would not call this a recipe for success, they aren’t failing either. The business remains remarkably consistent (comparable to Wal-Mart) and I don’t have too many worries about their current operations. If you look over their financials, it’s as if the business didn’t see any affects from the recession in the U.S.
However, unlike their current operations in the U.S., their international expansion has cost shareholders. Much of their value creation went to a so-far-unsuccessful European acquisition in 50% of CarPhone Warehouse’s retail operations. In looking over the numbers, I’m not pleased in the slightest. Margins are extremely low at about 1%, returns on capital are terrible, and they may have been better off buying something like RadioShack or just paying a larger dividend. I realize why they want to expand abroad; their model works like a charm in the U.S. (consistent 5% op. margins, 20+% returns on equity the past 2 decades). However, other than Canada, they really just don’t have the talent to expand abroad right now. I don’t blame Schulze or anyone else; they just know their home country better than foreign ones. So far, they opened 8 Best Buys in China which are all since closed because they didn’t work, 71 in Canada, and 6 in Europe (I’m guessing in the U.K.). To gain a foothold in China better, they bought up Five Star and have been expanding it across China aggressively with this concept. It hasn’t made a material impact on their financials so far, so I’m not going to pay it much attention. Canada seems to be their best market & I feel good about expansion there at about 10% per year. All things considered, their international expansion is disorganized, not the powerhouse we’re seeing in the U.S. markets, and has the chance to do serious harm to shareholders by destroying the value created in the U.S. It’s a good thing this low-margin business in the international markets is only 25% of their business; otherwise you’d see much lower company margins overall.
So, with the U.S. business being extremely successful & consistent, the international expansion inconsistent & costly, and overall capital allocation outside the international expansion pretty good, what is the business worth? Their operating cash flows/year are $2 B after normalizing working capital changes and their maintenance capex averages out at about $200 MM/year. Their growth capex is at about $225 MM/year, but it’s contributing value in some markets so I won’t subtract that to calculate owner earnings. Overall, I’d call it an even $1.8 B/year in owner earnings today with the potential for future growth if the international expansion succeeds. As for now, I won’t be betting on that because the last 5 years have been pretty bad overall in that category. Because I’m worried about cash flow investment into these markets, I’ll demand an 18% yield to owner earnings. This is no complex formula; just what seems right to me today based on everything I’ve read. Therefore, I’m willing to buy Best Buy today for $10 B. Best Buy’s current market valuation is $12 B or so, so the stock still needs to come down 17% to hit my purchase price, currently calculated at about $26/share. There you have it folks- buy it at $26 and you’ll do well. I’m hoping Best Buy screws up one more time to send the stock just a bit lower…
For those of you know me, you know I’m as stubborn as Charlie Munger would be if you tried to put him in a nursing home when it comes to valuation. If it doesn’t meet my criteria, I won’t consider it. As with H&R Block, where I missed out on a quick 70% gain after having understood their business quite well and not buying, I do not feel Best Buy meets my criteria right now. I will say this- buyers today will very likely do well & get something like 10-12% annualized unless more international expansion is screwed up, but I’m not in the game for investing without a better margin of safety and more upside. I plan on keeping a close eye on Best Buy in the future and seeing if they ever do hire some international talent; if so, I’ll be on board immediately at prices like we see right now. Until then, on to the next one…
If it seems this is a little lacking, it’s because I focused on the main points. I have extensive research done & am sharing just the important points.