Tuesday, August 26, 2008

Screen Result No. 1: Best Buy

The first company that met the criteria of my recent screen is electronics retailer Best Buy, which trades under the ticker BBY on the New York Stock Exchange. The chain's trademark yellow tag hangs on about 770 U.S. stores and 44 international outlets. It also has about 270 other electronics stores under other brands.

I can do without most big-retailers, but I'm an unabashed fan of this store: There's always something at Best Buy I want, from wicked sweet flat-screen TVs and sound equipment to nifty computer stuff. Plus it is usually cheaper than the competition. Consumer electronics account for about 40% of Best Buy's sales. Home-office products -- I presume this is mostly printer cartridges -- bring in 28%, games are 20%, appliances and services each add 6%. All told, it moves about $40 billion worth of merchandise a year -- fully a third of which comes from Sony, HP, Gateway, Toshiba and, of course, Apple. It boasts a 21% market share.

Here are some things I like about this company:

Directors and officers own 20% of the stock. That's huge to me. The only truly immutable law of economics is that people will always act in their own self-interest. You can be sure that owner/managers are far more likely to make the best decisions for the organization's long-term success than even very well compensated hired help. Best Buy also is buying back its own shares -- and not just a little. The presentation its execs gave at the shareholders meeting noted $4.1 billion in buybacks. That's a big statement. The statement is: "Our stock is cheap. Buying shares is the best way we could find to spend this money."

The looming deadline for digital TV. One of the things I've learned from the marketing staff at my company is that consumers always wait until the last possible minute to make a buying decision. The deadline for digital TV is looming. I think we'll see a stampede to electronic stores for new sets that can receive digital signals and for the set-top boxes that can process them in analog models. That deadline is Feb. 17, 2009. This will bring in millions of consumers who haven't been in the store before.

Services are where the money is. In fact, services account for 78.5% of the U.S. economy. At Best Buy, that's Geek Squad, which contributes 6% of sales. I think that unit will see a huge upturn in business when people start trying to hook up all their fancy-schmancy digital TV stuff. Some may see this jump in revenue as a flash in the pan for Best Buy, perhaps juicing earnings a little for a couple of quarters. I agree with that, but only to a point. I think it will expose this service to millions of people who might never before have considered using it. In fact, I wouldn't be surprised to see Best Buy eventually spin off this unit. (Just as competitor Circuit City did with its CarMax division.)

All of this makes me predisposed to like these shares, which, by the way, are down 14% year-to-date and are trading at about 14 times earnings. This is the lowest earnings multiple since 1997.

Let's consider the questions I posed in Monday's post:

How have earnings per share fared over time?
For the past five years, earnings per share have increased an average of 17.7% a year.

Is that likely to continue?
I think so. People like the gizmos Best Buy sells. It has the iPhone, the hottest video games and gaming systems, flat-screen TVs, laptops and BlackBerries. It has navigational devices, cellphones and stainless-steel appliances. It just hit $40 billion in revenue -- twice what it did in 2003. Its target for 2013 is $80 billion. Revenue is increasing at a 15% compound annual growth rate; earnings are growing even faster, at a 23% CAGR.

Where does that put per-share results in two years? What do analysts forecast?
The last fiscal year saw earnings of $3.12 a share. Analysts predict a 5.5% gain to $3.29. I think this estimate is light. I'm not willing to discount their 17.7% average growth too much -- the stores have done well in a faltering economy, and the first thing a lot of consumers are going to do when they feel things have turned around is to splurge. Plus Best Buy opened more than 200 stores last year. I see earnings at $3.50 for this year (fiscal 2009) and $4.00 in 2010. That is still pretty conservative: Its 15% historical annual growth rate puts earnings at $4.13

What is the current earnings multiple?

How close is the PE to its historical average? To benchmarks?
It's low. Last year's average annual PE was only 15; but Best Buy shares hovered around 18-19 times earnings for the four years before that. The S&P 500 is trading at 26 times earnings, both of which make Best Buy look worthy of its name. Some say investors only reward fast-growing companies with high PEs. Well, fine. Doubling your revenue between now and 2013 is a high-growth strategy.

Where will the multiple be in two years?
I think its PE will trend upward, to 18-20. If it hits its revenue target, 22-25 may not be out of line.

Given the earnings estimates and PE predictions, what will the fair market value of the stock be in two years?
20 times $4 in EPS is $80 a share. That's a gain of $34.84, or 77.4%. We'll call that 38% a year, far better than the S&P's recent performance and superior even to its long-term average. In fact, the S&P hasn't posted a gain like that since 1995. And Best Buy also pays a little 1.5% dividend along the way.

Am I willing to accept the risk/reward this potential return represents?
Absolutely. I like Best Buy shares. It's a category leader with a strong earnings history and good prospects to continue it. It has $625 million in long-term debt -- roughly half last year's bottom line. Management has proven capable -- returning more than 20% on equity for the past decade -- and executives have a vested interest in ensuring the(ir) company's continued success.

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