Best Buy Faces Stout Headwinds as Consumers Trim Spending and Industry Shifts Further Online

Equity Analyst

Sean Dunlop

Associate Equity Analyst

Grace Na

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We believe Best Buy is taking adequate steps to shore up its competitive position in an intensely competitive consumer electronics space. As the preeminent offline consumer electronics retailer in the U.S., the firm has invested heavily in seamless omnichannel access, building relationships with its 40 million active loyalty members, and cutting out nonessential costs.

In the aftermath of COVID-19, it has become clear that how people shop has permanently changed—with Best Buy now seeing 33% of sales come through digital channels (up from 19% prior to the pandemic) and estimating that consumers' install base of connected devices has roughly doubled over three years. Consequently, the firm has prudently been leveraging its store footprint for fulfillment and post-sale services, emphasizing its services offerings, and experimenting with newer store formats. While the margin drag from digital orders is likely to prove permanent, that channel is a competitive necessity in an industry that generates the majority of its consolidated sales online, augmenting the importance of efficiency improvements and successful loyalty touchpoints.

On balance, we take a neutral view of the firm's paid membership program, with its nearly 6 million members receiving some combination of home tech support, VIP access to phone and chat teams, free delivery and standard installation, members-only pricing, and extended warranties on Best Buy purchases. We continue to wonder if a program designed to increase customer frequency in a high-price, low-frequency category is cogent, though management appears committed to the endeavor. One way or another, either through program success or reformulation, we expect the firm to recapture the lion share of its initial program investment, which represented a nearly 100-basis-point margin drag in fiscal 2023.

Finally, Best Buy Health remains intriguing, with lower-price elasticity and auspicious tailwinds from an insurer pay model, though intense competition limits the firm's viable addressable market, in our view.

Business Strategy & Outlook

The consumer electronics market is intensely competitive, with readily available price comparisons across identical stock-keeping units (SKUs), aggressive discounting, and short product lifecycles forcing companies to operate at a breakneck pace of innovation to remain abreast of quickly evolving customer demands. As e-commerce retailers like wide-moat Amazon have revolutionized the market, and as mass merchants like wide-moat Walmart and no-moat Target have pushed electronics product sales through their brick-and-mortar footprints, customer expectations have continued their inexorable upward march, with omnichannel fulfillment, ever-faster delivery, and 24/7 platform access representing table stakes in the industry. In this environment, only a handful of firms have been able to meaningfully differentiate themselves, carving out moats around intangible assets or scale-driven cost advantages—often arising in conjunction. In our view, Best Buy warrants a narrow economic moat rating, with a trusted brand driving traffic to its stores and with a sufficiently differentiated service model that ingratiates the firm with both key vendor partners and customers. Strong manufacturer relationships drive better product availability, better pricing than smaller competitors, and incremental volume, particularly as anchor brands like narrow-moat Apple and narrow-moat Samsung utilize Best Buy stores as hubs for post-purchase customer services. Our view is corroborated by average five-year historical goodwill-adjusted ROICs of 18%, healthily outpacing our 8.8% WACC estimate, which we believe should persist through the 10-year horizon implied by our narrow moat rating.

Admittedly, brand intangible assets are tricky to quantify for businesses that compete primarily along the lines of value, since the ability to generate similar or higher margins than competitors while holding prices at or below those of rival sellers is the hallmark of success. In our view, brand intangible assets for these firms are best judged by metrics that capture their ability to generate sales growth exceeding category inflation, principally comparable store sales, since a key portion of their value proposition involves generating growth through traffic and sales mix rather than pure pricing. Best Buy scores well along these lines, with a sharp turnaround in 2015 seeing the firm string together average comparable store sales growth of 3.5% over the last five years, handily outstripping modest category deflation during that period (BLS data, consumer price index for IT, hardware, and services). The firm’s pivot has positioned it well to meet the demands of today's retail consumer, with stores repurposing square footage for omnichannel fulfillment and allocating space for key vendors to showcase new products, offer post-purchase services, and foster relationships with customers. Despite our forecasts for ongoing declines in retail square footage, we’re encouraged by Best Buy’s consistently improving productivity, with sales per square foot clocking in at $1,152 in fiscal 2023—up 5.8% annually over the last five years and well in excess of retail industry benchmarks (roughly $400, per Colliers, albeit somewhat apples to oranges). In our view, the firm has built a brand edge around its superior service offerings, brand-name product selection, and role as a demand generator for new technologies, which we view as enduring.

We contend that COVID-19 pulled forward demand for technological solutions to in-home problems, resulting in a much larger install base across home entertainment, kitchen appliances, and home office solutions that should drive structurally higher sales levels over time, and while mass merchandise competition adds a degree of pressure, we believe that the resulting displacement is likely to prove less onerous than initially foreseen. With longer replacement cycles for laptops, home entertainment, and appliances than the three to four year cycle for mobile phones, we don't believe that we've (yet) realized the benefit of pandemic-induced spending, even if consumers choose to leave certain devices—like children's school from home devices—unreplaced. We suspect that industry players have reached something of a competitive equilibrium, with Amazon and Walmart competing more aggressively for purchase occasions where customers are nearly perfectly price-elastic—knowing which SKU they want to purchase—while Best Buy outperforms for sales in which customers need help navigating choice of various product specifications, concerns about interoperability, and product installation—a view corroborated by Best Buy’s relatively stable 35%-40% market share in offline consumer electronics sales. As we see it, Best Buy remains particularly well positioned to capture sales among expensive, bulky, difficult to return items, and those for which stakes are higher, like home theater and appliance purchases.

Considering the surfeit of no-moat brick-and-mortar retailers in our coverage, we believe that it’s pertinent to pause and highlight key differences that support our rating—the lack of a scaled brick-and-mortar competitor in the consumer electronics space, the firm’s improving underlying operating results (while many retailers have seen sales and margin stagnate or decline), and a services-led value proposition that positions Best Buy to outperform e-commerce operators for purchase decisions that are time sensitive, lend themselves to showrooming, or require some degree of expert support. 

With nearly 40% of B&M sales in the consumer electronics category (against 31% at narrow-moat Apple, which wouldn’t carry competitors’ products, 3% at Micro Center, and 1% at Conn’s, per Euromonitor), we view Best Buy as operating in a category of one for offline consumer electronics sales. While market share in and of itself doesn’t attest to a competitive advantage, it certainly mitigates concerns that channel diversification by key vendors would result in huge volumes of sales transfer, while positioning Best Buy well to maintain inventory levels and upstream relationships even to the extent that suppliers engage in vendor rationalization. No other firm offers access to the category-dedicated customer base that Best Buy does, while the firm’s service reputation, with Geek Squad, TotalTech support, and in-home advisors provides a reliable experience for vendor partners like Apple, Samsung, HP, LG, and Sony, which effectively outsource their brand experience to downstream partners when selling through retail channels. While vendor relationships pose a source of idiosyncratic risk, with the firm’s top five suppliers accounting for more than half of purchase volume, we believe that the firm’s attention to maintaining partners’ desired brand experience with in-store hubs, role as a retail touchpoint for post-purchase services, and willingness to service vendors’ products for their 5.8 million paid membership customers at the end of fiscal 2023, even if those products weren’t purchased through Best Buy, represents a compelling and difficult-to-replicate value proposition. For smaller partners, Best Buy acts as a demand amplifier, introducing customers to cutting edge technologies like wearable fitness products, 5G-enabled devices, and 8K UHD televisions, serving as an important channel for exposure and widespread adoption among a customer base that disproportionately features “early adopters” of new technology. The firm’s scale allows it to remain price-competitive with larger peers, offers a meaningful source of incremental revenue for suppliers, and includes a sprawling store footprint that reduces reverse logistics (principally returns) costs—which can represent as much as one quarter of selling prices, per a study released by narrow-moat Shopify—creating strong barriers to success for brick-and-mortar-focused entrants built in Best Buy’s image.

Further, though, Best Buy has strategically opted to close underperforming stores, consistent with industry trends, it's also been able to improve underlying productivity, distinguishing it from no-moat department and apparel stores that have seen declining comparable store sales, square footage productivity, and income over the last few years. Investments in omnichannel capabilities, supply chain automation, efficiency improvements, and reshuffling display square footage to better accommodate digital orders have helped drive consistent square foot productivity improvements, competitive same-store sales growth, and have pushed operating margins structurally higher. To this effect, our forecasts call for 4.7% long-term margins, slightly up from 4.5% in the five years prior to the onset of COVID-19, with the firm poised to benefit also as the margin drag from its investments in membership program and Best Buy Health roll off. 

Finally, we believe that Best Buy’s turnaround efforts have positioned it to effectively compete for purchase occasions that are time sensitive, with 70% of the population living within 10 miles of a Best Buy and 80% of BOPIS orders available for pick-up within 30 minutes, involve a showroom aspect, carry service contracts, or sell at higher price points. Customers still remain reluctant to have a $1,000 piece of electrical hardware sitting on their doorstep, for example, relative to a much lower-priced consumer packaged goods product or household staple—though storage lockers and delivery windows have at least partially addressed that pain point.

We continue to view auxiliary services as the most important differentiating factor for Best Buy, with its network of 20,000 Geek Squad support members, its 5.8 million paid membership customer base, and a suite of high-touch in-home services like installation, removal, repair, and in-home advising as strengthening relationships with vendors and allowing the firm to outperform competitors for “uncertain” product sales—those where customers don’t know in advance exactly which SKU would best meet their needs. While top-line values aren’t breathtaking—direct service revenue clocks in around 4% of aggregate sales—we posit that they touch a much larger portion of revenue than figures would indicate. For example, the firm disclosed in 2019 that 2.8 million personal computer (PC) services were performed by Geek Squad remote support; with an average PC sales price (per CTA data) of $550 in the category, this would imply that digitally delivered PC services alone touched $1.5 billion of product during the year—3.6% of aggregate sales—to say nothing of in-person repair services, installations, or other service-intensive categories like appliances and entertainment--which together represent a combined 21% of 2022 sales. Moreover, the services line omits key customer touchpoints like in-home-advisors, which provide services free of charge, generate 17.5-point higher NPS scores than in-store transactions, and see 95% of customers return for future projects. As a result, we anticipate that a material portion of Best Buy sales are tied in some capacity to its service offerings and posit that Best Buy’s willingness to service products sold through competitors’ channels (as well as its own) should offer the firm an attractive foothold “in the home” for years to come.

While much ink has been spilt regarding manufacturer’s pivot toward more profitable “direct to consumer,” or DTC, channels, we view concerns as potentially overblown, with the difference in profitability between channels likely quite a bit smaller than 20%-25% wholesale price discounts would suggest. Wide-moat Nike's gross profit margin has remained relatively range-bound despite a meaningful increase in direct channel sales, for example, with vendor discounts at least partially offset by incremental advertising, supply chain, and store maintenance costs. We suspect that the direct channel truly is more profitable for the larger brands, or else the largest apparel chains wouldn't be running in that direction, but note that investors would be wise to consider incremental operating expenditures, investments in more expansive fulfillment center networks or physical stores, longer cash conversion cycles, and the loss of any incremental sales from downstream partners as part of the equation when considering vendors’ incentives to “go it alone.” Our research suggests that retailers create upstream value to the extent that they offer access to a different customer base, geography, or level of service than the brand could tap into on its own, which appears to be the case at Best Buy—with a dedicated, consumer electronics-focused clientele, nearly 1,000 U.S. stores through which to service vendors’ products (alleviating a key pain point for Apple, with less than 300 U.S. stores and a capacity-stretched “genius bar”), and willingness to support partners’ brand cachets by adhering to minimum resale prices and offering attractive post-sale services. Attesting to the firm’s value as a downstream partner, four of its five largest vendors have remained the same since 2008—Apple, Samsung, Sony, and HP.

In our view, the 10-year horizon for excess returns implied by our narrow economic moat rating appears to appropriately balance the strides the firm has made in omnichannel development, expansions into less price-elastic product categories like elder care, the well-documented decline of traditional brick-and-mortar retail, and an intensely competitive environment. While the future of retail will undeniably look markedly different than today, and while the offline specialty electronics segment will likely continue to modestly contract, we suspect that a non-negligible portion of sales will continue to occur in-store, with Best Buy well positioned to compete for that volume. Ultimately, competitive pressure, vendor concentration, and the ongoing decline of traditional retail diminish our confidence that Best Buy’s returns will extend beyond the 10-year horizon implied by our narrow rating. Nonetheless, the firm’s value-added in-store experience, proximity to customers, and indexation toward categories that can generate immediacy of need should position the company to effectively compete in a hyper-competitive industry, despite offering a standardized product suite with almost complete price transparency.

Narrow

Economic Moat

Best Buy

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MegaPath

Pacific Sales is a wholly owned subsidiary of Best Buy. They were originally opened with one store in Torrance, California. They offer high to mid range appliances as well as an assortment of home electronics and other home improvement products. When the company was purchased by Best Buy in 2006, the decision was made to keep the brand and company intact, unlike other companies such as Magnolia who was absorbed into the Best Buy brand. Since then, the company has opened over 35 stores in California, Nevada and Arizona, and had opened stores within existing Best Buy stores in Texas and Hawaii as well as California, Nevada and Arizona to offer higher end appliances than are currently available in Best Buy.

Pacific Sales

Geek Squad is a subsidiary of American multinational consumer electronics corporation Best Buy, headquartered in Richfield, Minnesota. The subsidiary was originally an independent company founded by "Chief Inspector" Robert Stephens on June 16, 1994, and offers various computer-related services and accessories for residential and commercial clients. In 2002, they merged with Best Buy, retaining Stephens as the primary corporate leadership for the subsidiary. The Geek Squad provides services in-store, on-site, and over the Internet via remote access, and also provides 24-hour telephone and emergency on-site support. Geek Squad no longer works solely on computer-related devices. It now diagnoses issues in and repairs all consumer electronics, as well as appliances, continually expanding its services to keep pace with ever-changing technology.

Geek Squad

Best Buy Co., Inc. engages in the provision of consumer technology products and services. It operates through two business segments: Domestic and International. The Domestic segment includes operations in all states, districts, and territories of the U.S., operating under various brand names, including Best Buy, Best Buy Mobile, Geek Squad, Magnolia Audio Video, Napster, and Pacific Sales. The International segment is made up of all operations outside the U.S. and its territories, including Canada, Europe, China, Mexico, and Turkey. It also markets its products under the brand names: Best Buy, bestbuy.com, Best Buy Direct, Best Buy Express, Best Buy Mobile, Geek Squad, GreatCall, Magnolia and Pacific Kitchen and Home. The company was founded by Richard M. Schulze in 1966 and is headquartered in Richfield, MN.

Earnings data Q4 2023

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