Don’t Fight Trends – So Don’t Invest in Best Buy

Don’t Fight Trends – So Don’t Invest in Best Buy

Best Buy, the venerable electronics retailer, is hitting 52 week highs.  Coming off a low of $24 in April, 2014 the current price of about $40 is a 67% increase in just 10 months.  Analysts are now cheering investors to own the stock, with Marketwatch pronouncing that the last bearish analyst has thrown in the towel.

If you are a trader, perhaps you want to consider this stock.  But if you aren’t an investment professional, and you buy and hold stocks for years, then Best Buy is not a stock you should own.

eCommerce

The bullish case for owning Best Buy is based on recovering sales per store, and recovering earnings, after a reduction in the number of stores, and employees, lowered costs.  Further, with Radio Shack now in bankruptcy sales are showing an uptick as customers swing over. And that is expected to continue as Sears closes more stores on its marches toward bankruptcy.  Additionally, it is hoped that lower gasoline prices will allow consumers to spend more on electronics and appliances at Best Buy.

But, this completely ignores the trend toward on-line retail sales, and the long-term deleterious impact this trend will have on Best Buy.  According to the U.S. Census Bureau, on-line sales as a percent of all retail have grown from less than 2.4% in 2005 to over 7.6% by end of 2014 – more than tripling! But more critical to this discussion, all retail sales includes automobiles, lumber, groceries – lots of things where there is little or no online volume.

As most folks know, the number one category for online sales is computers and consumer electronics, which consistently accounts for about 20% of ALL online retail.  In fact, about 25% of all consumer electronics are sold online.  So the growth in online retail is disproportionately in the Best Buy wheelhouse.  The segment where Best Buy competes against streamlined online retailers such as NewEgg.com, ThinkGeek.com and the ever-dominant Amazon.com.

So while in the short term some traditional retail customers will now shift demand to Best Buy, this is not unlike the revenue “bounce” Best Buy received when Circuit City failed.  Short term up, but the long term trend continued hammering away at Best Buy’s core market.

This is a big deal because the marginal economic impact of this shift is horrific to Best Buy.  In traditional retail most costs are “fixed,” meaning they can’t be changed much month to month.  The cost of real estate, store maintenance, utilities and staff cannot be easily adjusted – unless there is a decision to close a gob of stores.  Thus losing even a few sales, what economists call “marginal” sales, wreaks havoc on earnings.

Back in 2010 and 2011 Best Buy made a net income (’12 and ’13 were losses) of about 2.6% – or about $2.60 on every $100 revenue.  Cost of Goods sold is about 75% of revenue.  So on $100 of revenue, $25 is available to cover fixed costs.  If revenue falls by just $10, Best Buy loses $2.50 of margin to cover fixed costs.  Remember, however, that the net income is only $2.60.  So losing 10% of revenue ($10 out of the $100) means Best Buy loses $2.50 of contribution to fixed costs, and that is deducted from net income of $2.60, leaving Best Buy with a meager 10cents of profitability.  A 10% loss of revenue wipes out 96% of profits!

Now you know why retailers who lose even a small part of their sales are suddenly closing stores right and left.

Looking forward, online retail sales are forecast to grow by another 57%, reaching 11% of total retail by 2018.  But, as we know, this is disproportionately going to be driven by consumer electronics.  Which means that while sales for Best Buy stores are up short term, long term they will plummet.  That means there will be more store closings, and layoffs as sales shrink.  And, increasingly Best Buy will have to compete head-to-head online against entrenched, leading competitors who have been stealing market share for 10+ years.

If you want to trade on the short-term uptick in revenue, and return to slight profitability, then hold your breath and see if you can outsmart the market by picking the right time, and price, for buying and selling Best Buy.  But, if you like to invest in strong companies you expect to grow for another 5 years without having to be a market timer, then avoid Best Buy.

Quite simply, it is never a good idea to bet against a long term trend.  Short term aberrations will happen, and it may look like the trend has changed.  But the trend to online commerce is picking up steam, not reducing.  If you want to invest in retail, you want to invest in those companies that demonstrate they can capture the customer’s revenue in the growing, online marketplace.

Why Microsoft is Still Speculative

Why Microsoft is Still Speculative

Hope springs eternal in the human breast” (Alexander Pope)

As it does for most investors.  People do not like to accept the notion that a business will lose relevancy, and its value will fall.  Especially really big companies that are household brand names.  Investors, like customers, prefer to think large, established companies will continue to be around, and even do well.  It makes everyone feel better to have a optimistic attitude about large, entrenched organizations.

And with such optimism investors have cheered Microsoft for the last 15 months.  After a decade of trading up and down around $26/share, Microsoft stock has made a significant upward move to $41 – a new decade-long high. This price has people excited Microsoft will reach the dot.com/internet boom high of $60 in 2000.

After discovering that Windows 8, and the Surface tablet, were nowhere near reaching sales expectations after Christmas 2012 – and that PC sales were declining faster than expected – investors were cheered in 2013 to hear that CEO Steve Ballmer would resign.  After much speculation, insider Satya Nadella was named CEO, and he quickly made it clear he was refocusing the company on mobile and cloud.  This started the analysts, and investors, on their recent optimistic bent.

CEO Nadella has cut the price of Windows by 70% in order to keep hardware manufacturers on Windows for lower cost machines, and he announced the company’s #1 sales and profit product – Office – was being released on iOS for iPad users.  Investors are happy to see this action, as they hope that it will keep PC sales humming. Or at least slow the decline in sales while keeping manufacturers (like HP) in the Microsoft Windows fold.  And investors are likewise hopeful that the long awaited Office announcement will mean booming sales of Office 365 for all those Apple products in the installed base.

But, there’s a lot more needed for Microsoft to succeed than these announcements.  While Microsoft is the world’s #1 software company, it is still under considerable threat and its long-term viability remains unsure.

Windows is in a tough spot.  After this price decline, Microsoft will need to increase sales volume by 2.5X to recoup lost profits.  Meanwhile, Chrome laptops are considerably cheaper for customers and more profitable for manufacturers.  And whether this price cut will have any impact on the decline in PC sales is unclear, as users are switching to mobile products for ease-of-use reasons that go far beyond price.  Microsoft has taken an action to defend and extend its installed base of manufacturers who have been threatening to move, but the impact on profits is still likely to be negative and PC sales are still going to decline.

Meanwhile, the move to offer Office on iOS is clearly another offer to defend the installed Office marketplace, and unlikely to create a lot of incremental revenue and profit growth.  The PC market has long been much bigger than tablets, and almost every PC had Office installed.  Shrinking at 12-14% means a lot less Windows Office is being sold. And, In tablets iOS is not 100% of the market, as Android has substantial share.  Offering Office on iOS reaches a lot of potential machines, but certainly not 100% as has been the case with PCs.

Further, while there are folks who look forward to running Office on an iOS device, Office is not without competition.  Both Apple and Google offer competitive products to Office, and the price is free.  For price sensitive users, both individuals and corporations, after 4 years of using competitive products it is by no means a given they all are ready to pay $60-$100 per device per year.  Yes, there will be Office sales Microsoft did not previously have, but whether it will be large enough to cover the declining sales of Office on the PC is far from clear.  And whether current pricing is viable is far, far from certain.

While these Microsoft products are the easiest for consumers to understand, Nadella’s move to make Microsoft successful in the mobile/cloud world requires succeeding with cloud products sold to corporations and software-as-service providers.  Here Microsoft is late, and facing substantial competition as well.

Just last week Google cut the price of its Compute Engine cloud infrastructure (IaaS) platform and App Engine cloud app platform (PaaS) products 30-32%.  Google cut the price of its Cloud Storage and BigQuery (big data analytics) services by 68% and 85% as it competes headlong for customers with Amazon.  Amazon, which has the first-mover position and large customers including the U.S. federal government, cut prices within 24 hours for its EC2 cloud computing service by 30%, and for its S3 storage service by over 50%. Amazon also reduced prices on its RDS database service approximately 28%, and its Elasticache caching service by over 33%.

To remain competitive, Microsoft had to react this week by chopping prices on its Azure cloud computing products 27%-35%, reducing cloud storage pricing 44%-65%, and whacking prices on its Windows and Linux memory-intensive computing products 27%-35%.  While these products have allowed the networking division formerly run by now CEO Nadella to be profitable, it will be increasingly difficult to maintain old profit levels on existing customers, and even a tougher problem to profitably steal share from the early cloud leaders – even as the market grows.

While optimism has grown for Microsoft fans, and the share price has moved distinctly higher, it is smart to look at other market leaders who obtained investor favorability, only to quickly lose it.

Blackberry was known as RIM (Research in Motion) in June, 2007 when the iPhone was launched.  RIM was the market leader, a near monopoly in smart phones, and its stock was riding high at $70.  In August, 2007, on the back of its dominant status, the stock split – and moved on to a split adjusted $140 by end of 2008.  But by 2010, as competition with iOS and Android took its toll RIM was back to $80 (and below.)  Today the rechristened company trades for $8.

Sears was once the country’s largest and most successful retailer.  By 2004 much of the luster was coming off when KMart purchased the company and took its name, trading at only $20/share.  Following great enthusiasm for a new CEO (Ed Lampert) investors flocked to the stock, sure it would take advantage of historical brands such as DieHard, Kenmore and Craftsman, plus leverage its substantial real estate asset base.  By 2007 the stock had risen to $180 (a 9x gain.) But competition was taking its toll on Sears, despite its great legacy, and sales/store started to decline, total sales started declining and profits turned to losses which began to stretch into 20 straight quarters of negative numbers.  Meanwhile, demand for retail space declined, and prices declined, cutting the value of those historical assets. By 2009 the stock had dropped back to $40, and still trades around that value today — as some wonder if Sears can avoid bankruptcy.

Best Buy was a tremendous success in its early years, grew quickly and built a loyal customer base as the #1 retail electronics purveyor.  But streaming video and music decimated CD and DVD sales.  On-line retailers took a huge bite out of consumer electronic sales.  By January, 2013 the stock traded at $13.  A change of CEO, and promises of new formats and store revitalization propped up optimism amongst investors and by November, 2014 the stock was at $44.  However, market trends – which had been in place for several years – did not change and as store sales lagged the stock dropped, today trading at only $25.

Microsoft has a great legacy.  It’s products were market leaders.  But the market has shifted – substantially.  So far new management has only shown incremental efforts to defend its historical business with product extensions – which are up against tremendous competition that in these new markets have a tremendous lead.  Microsoft so far is still losing money in on-line and gaming (xBox) where it has lost almost all its top leadership since 2014 began and has been forced to re-organize.   Nadella has yet to show any new products that will create new markets in order to “turn the tide” of sales and profits that are under threat of eventual extinction by ever-more-capable mobile products.

While optimism springs eternal long-term investors would be smart to be skeptical about this recent improvement in the stock price.  Things could easily go from mediocre to worse in these extremely competitive global tech markets, leaving Microsoft optimists with broken dreams, broken hearts and broken portfolios.

Update: On April 2 Microsoft announced it is providing Windows for free to all manufacturers with a 9″ or smaller display.  This is an action to help keep Microsoft competitive in the mobile marketplace – but it does little for Microsoft profitability.  Android from Google may be free, but Google’s business is built on ad sales – not software sales – and that’s dramatically different from Microsoft that relies almost entirely on Windows and Office for its profitability

Update: April 3 CRN (Computer Reseller News) reviewed Office products for iOS – “We predict that once the novelty of “Office for iPad” wears off, companies will go back to relying on the humble, hard-working third parties building apps that are as stable, as handsome and far more capable than those of Redmond. It’s not that hard to do.”

 

 

Who to follow in 2010? – Amazon, WalMart

Happy New Year!

As we start 2010 the plan, according to The Financial Times, "WalMart aims to cut supply chain costs."  Imagine that.  Cost cutting has been the biggest Success Formula component for WalMart for its entire career.  And now, the company that is already the low cost retailer – and famous for beating its suppliers down on price to almost no profitability – is planning to focus on purchasing for the next 5 years in order to hopefully take another 5% out of purchased product cost.  How'd you like to hear that if Wal-Mart is one of your big customers?  What do you suppose the discussion will be like when you go to Target or KMart (match WalMart pricing?)

Will this make WalMart more admired, or more successful?  This is the epitome of "more of the same."  Even though WalMart is huge, it has done nothing for shareholders for years.  And employees have been filing lawsuits due to unpaid overtime. And some markets have no WalMart stores because the company refuses to allow any employees to be unionized.  This announcement will not make WalMart a more valuable company, because it simply is an attempt to Defend the Success Formula.

On the other hand according to Newsweek, in "The Customer is Always Right," Amazon intends to keep moving harder into new products and markets in 2010.  Amazon has added enormous value to its shareholders, including gains in 2009, as it has moved from bookselling to general merchandise retailing to link retailing to consumer electronics with the Kindle and revolutionizing publishing with the Kindle store.  Amazon isn't trying to do more of the same, it's using innovation to drive growth

And the CEO, Jeff Bezos freely admits that his success today is due to scenario development and plans laid 4 years ago – as Amazon keeps its planning focused on the future.  With the advent of many new products coming out in 2010 – including the Apple Tablet – Amazon will have to keep up its focus on new products and markets to maintain growth.  Good thing the company is headed that direction.

So which company would you rather work for?  Invest in?  Supply? 

Which will you emulate?

PS – "Create Marketplace Disruption:  How To Stay Ahead of the Competition" was selected last week to be on the list of "Top 25 Books to read in 2010" by PCWorld and InfoWorld.  Don't miss getting your copy soon if you haven't yet read the book.