Best Buy reported better-than-expected numbers this past week and the stock spiked as short-term sentiment improved. While this certainly is a ray of sunshine for this beleaguered retail stock, Best Buy in the long-run, will not be able to overcome the headwinds of agile competitors with lower cost structures.
Toys R Us, a dominant brand, was crushed by the online presence of distributors combined with the scale of Wal-Mart . Egghead Software made a proactive decision to eliminate brick-and-mortar stores and move towards online sales. Circuit City, Good Guys and CompUSA all were crushed as margins compressed based on increasing online competition. Best Buy was the beneficiary of the problems that each of these companies faced which allowed it to carve off significant brick-and-mortar market share. Still, despite market gains, there is no disputing the erosion of profit that occurs when just-in-time delivery web access solutions provide the same product at lower cost.
Even Wal-Mart, with its purchase of Jet.com, recognizes that in order to compete with Amazon and other online retailers, it must have a significant presence in the online space. This is Walmart we are talking about which has the most scale of virtually any company in the United States and even THEY needed to take drastic action to blunt the impact of online stores.
Best Buy is a popular choice when you wish to test out an item, see it live and in person, need it same day, and are looking for some degree of human interaction. But despite the brick-and-mortar advantage, how many times have you noticed someone at Best Buy on their smart phone looking to see whether or not Best Buy is charging the lowest price? And given that Best Buy has a price match guarantee for any web retailer, doesn't it make sense that their margins will be crushed given they have much higher overhead costs then online retailers?
There are 4 basic reasons Best Buy faces major headwinds despite its valiant efforts to remain relevant in today's web-enabled marketplace:
- Margin compression: As Best Buy matches prices and attempts to be competitive with a higher cost structure, there is simply no way it can stem the erosion of profit as online retailers have a significantly leaner cost structure.
- Service revenue won't fix the problem: The service business promoted by Best Buy is a higher profit center enterprise but we do not see its potential to be significant enough to offset the erosion of profit margins as it continues to operate as a brick-and-mortar chain.
- Online retailers are moving downstream: Online competitors are beginning to develop brick-and-mortar solutions for product delivery. Amazon, for example, already has a network of delivery lockers for consumers looking for same-day delivery, purchasers of products without permanent addresses, buyers of goods traveling out of town. Online will be the core with modified brick-and-mortar solutions available to compete on a local basis. This is a much different cost structure than brick-and-mortar as the core and online as an add on.
- Same-day delivery services will continue to increase as Amazon and other online retailers work to increase the efficiency of their distribution network. Already in some communities Amazon offers same-day delivery. We expect an increase in delivery efficiency through the use of logistics and other technology solutions.
This is not to say that Best Buy is ultimately moving in the direction of Good Guys or Circuit City; there needs to be a competitor in the marketplace for those wishing to touch and feel a device prior to purchase. But as a lesson to be learned, investors should look and see what happened to the book space: Borders is out of business and Barnes & Noble has been closing stores. There is no reason to believe that Best Buy will avoid the same fate that bookstores fell prey to over the course of the last 10 years. I'm not saying Best Buy will declare bankruptcy but it's going to have a smaller footprint with less retail impact.
One last thought to consider. When Webvan emerged in the spring of 1999, pundits talked about grocery as the next great conquest for online sales. Obviously with the demise of Webvan that turned out not to be the case as consumers wanted to touch and feel the product. But I would contend that buying groceries is far different than buying a computer. The book seller comparison is much more appropriate.
The stock investment game is really one of time horizon. On the short-term there were some positive signs for Best Buy and that is why the stock popped. But if one looks below the surface to look at trend lines and the oncoming march of online retailers towards becoming the alternative to brick-and-mortar solutions, it's hard to see why Best Buy should be a part of one's core long-term portfolio strategy. The competition is fierce and the world is moving online.
While there will be a need for a smaller scale Best Buy footprint, the future for this company will likely look much different that today's current market position. The reasonable inevitable conclusion for this company will be that this enterprise will be smaller and less profitable; I just don't see any other outcome.
Disclosure: Michael Yoshikami does not own shares of Best Buy or other stocks mentioned and has no investment-banking relationships with the company. But Destination Wealth Management may buy shares for clients.
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