Brick-and-Mortar Retail Done Right, Done Wrong -- but Not Done for

Markets Motley Fool

On this Market Foolery podcast, Mac Greer is joined by David Kretzmann and Aaron Bush of Supernova and Rule Breakers, and their focus is on traditional retail, where at least two niche players took a beating in the market.

Continue Reading Below

Bed Bath & Beyond (NASDAQ: BBBY) is in trouble, but it's not just the broad retail malaise that's causing it. Best Buy (NYSE: BBY), by contrast, irked investors because it's playing the long game. And speaking of the long game, the CEO of FedEx made waves with his relatively upbeat comments about the future of brick-and-mortar retail.

On the tech side of the world, the gang weigh the potential of augmented reality glasses from Amazon (NASDAQ: AMZN), and the value of Nintendo's newly inked partnership with Tencent. And of course, like everyone else in media, they give their two cents on Chipotle's (NYSE: CMG) queso.

A full transcript follows the video.

10 stocks we like better than Amazon
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and Amazon wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Continue Reading Below

Click here to learn about these picks!

*Stock Advisor returns as of September 5, 2017

This video was recorded on Sept. 20, 2017.

Mac Greer: It's Wednesday, Sept. 20. Welcome to Market Foolery. I'm Mac Greer, and I'm joined by Aaron Bush and David Kretzmann from Motley Fool Supernova and Rule Breakers. Guys, welcome! We've got lots to talk about, a lot going on in the world. We've got some retail news, we've got a big deal that Nintendo announced, a big partnership in China. Aaron, I know you have some thoughts on that. We may talk a little Chipotle, because they're still taking a beating over their queso.

David Kretzmann: So brutal.

Greer: I know, I want to get an update there. But let's begin with, frankly, a retailer that I have pretty much forgotten is still around -- Bed Bath & Beyond. Wow, Bed Bath & Beyond taking a bath on Wednesday. Shares down more than 14% after the company lowered its earnings outlook and reported weaker-than-expected earnings. David Kretzmann, I go to you, is Bed Bath & Beyond beyond repair? Is there anything you can do to save this?

Kretzmann: What hurts here is, the stores aren't performing that well, but on the financial side of things, management has done more to add gasoline to that bad fire overall. If you go back to 2014, from a financial perspective, the company looked like it was in decent shape. It was producing over $1 billion in free cash flow annually, had $850 million in net cash on the balance sheet, so they had cash in the bank, they were producing a lot more cash to add to that tally. But that year, they decided to issue $1.5 billion in new debt just to buy back stock. They essentially went into more debt, bought back a lot of stock, and now a few years later the company has over $1 billion in net debt, and their free cash flow production has almost been cut in half to about $570 million. So, that's a bleak direction to be going within just a few years. They've really been focusing on buying back stock, they haven't done a whole lot to improve the actual in-store experience, and what they have done has been very slow. They are making some progress with their digital sales, which now make up about 15% of total revenue. They say that their "differentiated products," which they consider their exclusive products, personalizable products, makes up about half of sales, so I think that's probably an area where they really need to double down and find some way to differentiate what they're offering and how they offer it from Amazon and other retailers that are still out there. They've also made some acquisitions into new brick-and-mortar retail concepts. They bought a website, personalizationmall.com, late last year, where you can buy and personalize a lot of different items. Going that route makes the most sense to me. It's not a stock I would buy, even though it looks very cheap-looking at these trailing metrics. But I think management has made some very poor cash management decisions over the past few years, and in the meantime, the actual performance of the stores leaves a lot to be desired.

Aaron Bush: Yeah, one tidbit that I keep on coming back to for Bed Bath & Beyond and for other struggling retailers is, when a brick-and-mortar store tries to add a quality e-commerce operation, not only does it tend to cause its physical stores to struggle more, but it makes the company increasingly expensive to run, because they have to duplicate the cost just to serve that same customer. So, you do see them making really dumb decisions with debt, and adding new retail concepts, which feels more like a distraction than anything. But, just the fundamental structure of how the economics work, and managing an in-store presence and an online presence isn't very friendly. And they've been really slow to do this. But now that they are invested in it, it's another reason that's adding a margin drag and keeping earnings lower.

Greer: Do you think, in terms of those traditional retailers adding that online piece, I see why you would want to do it. Everyone's trying to fend off Amazon. You have to try anything. So, you have Wal-Mart with the Jet acquisition, do you think that's going to work for Wal-Mart? Or, to take your logic even further, if you're Wal-Mart, do you stick to your knitting, which is just bread-and-butter traditional retailers?

Bush: I think for Wal-Mart and Jet, I think it was smart to acquire Jet, not for Jet itself, but more for the talent that is in that management team. And I know, I'm blanking on his name ... Marc Lore, who was the head of Jet, now runs Wal-Mart's e-commerce operations. So, I think that was smart. What Wal-Mart really needs to do is continue to acquire things and really build up a big suite of an online presence. When it comes to e-commerce, aggregation is increasingly important, so you either have to dominate a niche, or you have to be someone that you can go to for anything and everything. So, it's tough. Wal-Mart might be able to pull it off, Amazon is definitely pulling it off, but for someone like Bed Bath & Beyond it's a hard spot.

Kretzmann: I think what Aaron mentioned highlights why it's so difficult for these brick-and-mortar retailers to pivot more to online or omnichannel sales because it tends to be more expensive to operate both rather than one or the other. But there is some value to the omnichannel experience. You see Amazon clearly showing a lot of interest in opening up their own brick-and-mortar stores, acquiring Whole Foods. So, there is value there. But for a lot of these companies, I think it will be a short-term ding, but it's probably what they need to do to stay relevant, and figure out some way to hopefully improve the economics over time, one way or another, whether it's offering more personalized services or some sort of consultation. We're going to talk about Best Buy today, they're trying to do something along those lines. But in the short term, the company needs to stomach those short-term dings if they want to stay relevant with competitors like Amazon.

Greer: So, Bed Bath & Beyond shares a lot cheaper today than they were yesterday, but you're still not interested?

Kretzmann: Based on management's track record, both managing the stores and how they've been trying to pivot those stores, I think they've been lackluster there. And they've also really jeopardized the company's financial position, because you're not going to go bankrupt if you don't have debt, and they completely pivoted the whole balance sheet a few years ago to buy back stock which, in hindsight, looks like a very dumb move. Shares have continued dropping since then, so that was a poor investment, and a very poor reason to go into debt. So, from a financial position now, the company's future is in a lot more jeopardy now. So, I would stay on the sidelines here.

Greer: So, five years from now, are they still a going concern? Are they still around?

Kretzmann: I think they're still around but they're probably getting pretty close to bankruptcy, at the rate they're going now.

Greer: OK, guys. Other bricks-and-mortar news. On Tuesday, FedEx CEO Fred Smith said that e-commerce is not going to eliminate the retailing sector of the country. An interesting quote here by Smith. He said, "It's about 10% now, it's certainly going to grow as a percentage. But will it be half? I doubt it." Let's talk about that quote. Fred Smith on the future of e-commerce, is he right that it may not even get to half? And if he is right, what does that mean for investors?

Bush: Even if they got to half, that would make me very happy. That's still huge. But I suspect that he's wrong, but it's going to take a very long time for that to play out. I think there still are very good reasons for there to be physical stores. There's showrooming, concepts like grocery stores and convenience stores, those aren't going to go away at all. So, I think there are a lot of smaller concepts that will stick around, and it doesn't make sense to go completely online.

Kretzmann: Yeah, I think, the lines will be blurring between the physical experience than the online experience, like we talked about. What classifies as an online sale, what classifies as in-store sale. But, I still think there's a lot of room for e-commerce to grow, as Aaron was mentioning. Right now in the U.S., about 9%-10% of sales are online, like you mentioned. And that's doubled since 2010. Even in countries like Korea, where e-commerce is closer to 17%-18%, which is the highest in terms of countries' adoption of e-commerce, they're still below 20%, less than a fifth of their retail sales are happening online. So I think there's still a lot of room to run with this transition, and I would expect that down the road, it gets to 30%-50%. How long that takes is anyone's guess. I would expect it to accelerate in the coming years, but in general, I think there's still a huge opportunity, whether it's 40% or 50% or 80%, there's still a big room to run.

Greer: And how about in that traditional retail space, that other 50%, do you have a favorite name? I know we like Amazon when it comes to online as being a company that continues to dominate and take market share. How about traditional retailers that may be Amazon-proof, what comes to mind?

Kretzmann: I'll throw out a couple. There's Tractor Supply Company, which I know, Mac, you and I know and love.

Greer: Yes.

Kretzmann: Just because they cater to people who are doing gardening, they might have livestock, the type of items that you buy in a Tractor Supply, like a 50 pound bag of feed or these heavy items, those are things you're probably going to want some in-store service, and it's just not necessarily a logistically reasonable or feasible to ship a 50 pound bag of feed. Another one would be Camping World, which is a nationwide RV retailer. They're selling RVs, trailers, and they're also getting into boats and other outdoor gear and stuff like that. Those are items that I don't see being sold online anytime soon, so I think they have a nice little niche there as well.

Bush: I like to look for really strong brands. The No. 1 company that strikes me as more Amazon-resistant would be someone like Nike, which isn't really known for being a retailer, but they play in that playing field quite a bit with their own stores, as well as partnering, and they've even partnered with Amazon. I think what's most interesting to me isn't as much looking for the companies that are Amazon-resistant, but just looking for the companies that can stand on their own and partner with most anyone.

Greer: Guys, I notice that neither of you said Best Buy. A rough day for Best Buy on Tuesday. The stock was down after the company outlined a new set of financial targets. David Kretzmann, we were talking before the show here, really surprising that Best Buy over the last one, three, and five years has beaten the stock market. The stock has really had a nice comeback over the last five years. The CEO Hubert Joly says that Best Buy is now focused on growth. Are you buying that, Best Buy as a growth story going forward?

Kretzmann: I think they're in an interesting position here. I would expect them to continue beating the market over the next five years. What he mentioned in this presentation, looking back over the last few years, how has Best Buy stuck around? Because a lot of people, including just about everyone at the Fool, was basically writing them off. Like, they're selling commodity products, they're not going to be able to compete on price, Amazon is a very convenient option. So, Best Buy was essentially a showroom for Amazon. You go to the Best Buy store, figure out what you're going to order, and buy it on Amazon for $10 cheaper. But, he basically said, no, we were able to compete on price, and where we were able to differentiate ourselves with Amazon was an extra level of service, so really doubling down on that service aspect, saying, we're not going to try to sell these items at a higher margin compared to Amazon or other competitors. And so far, that's worked really well. They haven't really grown financially a whole lot over the last few years, but they also haven't slipped a whole lot, either. They've managed to stay relevant in a time when a lot of people had written them off.

And now, what they're doing, they're essentially taking that same strategy but really focusing on this in-home consultation strategy. They're offering the services, they'll have people go to your home for free and help give you this consultation if you're trying to install, maybe, a smart speaker or a TV or all these other smart home devices. And I think that strategy makes sense as electronics become more complex, more expensive, more integrated with one another. They're really taking that same strategy, competing on price, they're not trying to charge people more for the same product that they can get on Amazon, they're adding that extra level of service. In the short term, that will be expensive for the company. So, they're rolling that out nationally, so they will take a hit there, but Amazon is also testing a similar consultation strategy in a few cities. It's clearly, to me, the direction that they're going, I think that's a way that they can stay relevant, even though in the short term it will probably hurt a little bit.

Bush: Yeah, I think it's interesting, looking at Best Buy and the amazing performance of the stock. It makes me think of The Tortoise and the Hare a bit, and how everyone underestimated the tortoise, which is Best Buy, but here it is, it's kind of won the race. And now I feel like it has a little bit of an ego. So, when it says it's going into growth mode, if you look at what they're forecasting for 2020, it isn't that fantastic. Revenue is still poised to maybe be up 10%-15% from now until then. EPS is higher. But that's more from buybacks and cost-cutting. I still think they have a lot going for them. I think David nailed it on the head, services is their differentiation, and that is increasingly going to be their source of competitive advantage. Making the Geek Squad a much bigger thing than it is, and going along with this home assistant, integrated home, smart home trends, I think that's something that will be more important to them. That said, I tend to think that trend might be a little overrated. I still think that smart homes in general, they're not going to need a ton of help to install everything. With the Echo alone, you just plug that in. 

Kretzmann: You're making that sound really simple, Aaron. Some of us aren't as technically adept. [laughs] 

Greer: That's true.

Bush: Well, I just think the smart home trend isn't going to arrive as quickly as people think it will. And, they're also trying to get into elderly care along with that as well. And there are so many others trying to do the same. It just makes me question if Best Buy is going to be the one to do it. I really admire that they're trying to be a great service here for everyone, but I don't know, I'm still a little skeptical and paranoid, maybe.

Greer: OK, I will call you cautiously pessimistic.

Kretzmann: I think that's a diplomatic way to put it. A couple of things the CEO mentioned of why this strategy has worked -- because when you think about it, you're selling something that you can buy online, how are you going to do that and offer more service and make money doing it? He basically said that there's more margin at the high end, and people who are using those services are probably buying the more expensive products. And he was also saying that multichannel or omnichannel is a real asset, customers value having that complete experience, being able to have that hands-on time with a product and have that consultation. And he also said it's not a zero-sum game. Best Buy is still the leader in consumer electronics market share in the U.S., and they've been growing market share along with Amazon. So, he's basically saying, if anything, it's a competition between Amazon, Best Buy and everyone else, not Amazon and Best Buy. And just looking at the financial picture of the company, it's a very stark contrast to Bed Bath & Beyond, which we talked about earlier. Strong balance sheet -- $2.3 billion in net cash, they're producing $1.3 billion in free cash flow annually, so they're in a very solid position as long as they don't jeopardize it and do some dumb buybacks and go into debt to buy back stock like Bed Bath & Beyond. And the valuation is still reasonable, P/E ratio of 14, so they don't have to do a lot to beat the market from here, I don't think.

Greer: And David, you were just mentioning Amazon, so I want to get your quick take. Amazon working on its first wearable device, a pair of smart glasses. The device will allow the wearer to summon Alexa, Amazon's digital assistant, and you can also hear Alexa without the headphones. Now, I will remember when Google Glass and Google Glasses were the thing, and then they retired them, and then they brought them back. What's Amazon doing here?

Kretzmann: This is toward the top of my list of, OK, maybe this is the next thing that flops like the Fire Phone. I think there's some cool technology here, but I think for smart glasses or whatever you call them, for some sort of glasses product to work, the camera has to be the focal point, and I think there would be some AR tie-in there. And Amazon might have that, but I think Apple and Google have a bigger lead, at least from what they've released thus far. But, I don't know. At first glance, looking at this story, I'm skeptical. I think this might be a flop. But that's the way Amazon goes. They're going to have their failures, and that's just how they operate and they continue to learn each time. Aaron might be more optimistic.

Bush: No, I totally think it's going to be a flop. But, I do think it's fascinating for a couple of reasons. One, I think that Amazon jumping in and trying to create the smart glasses product reinforces that this is something that's going to be relevant in technology in the future in general. I think it helps clarify that. And it's important enough that even if Amazon can't come out with something impressive, they're still trying. They don't have a mobile phone operating system. So, the more that they can get literally on people, the better it is for them. The second thing that's interesting, also because they don't have a mobile operating system, it means that Alexa and the Echo are increasingly more important to them. And the more hardware places that they can make that software shine through, the more that reinforces their own ecosystem. And I think this is just one step toward more that we'll see from them in the future.

Greer: So, a longer play.

Bush: Oh, definitely. They're playing the long game.

Greer: OK, guys, before we get to our final story, I want to do a quick queso update. David, we talked about queso last week, as in Chipotle unveiling its queso. I think a lot of us were excited about that. Aaron, you're from the great state of Texas, as I am, so I think we have some pretty high standards for our queso.

Bush: Absolutely.

Greer: And I have to tell you, the more I read about Chipotle's queso, the more I see one word that I don't want to see, and the word is "gritty." I want to be characterized as gritty. I want my kids to be characterized as gritty. Do you know what I don't want to be characterized as gritty? Queso. In related news, Chipotle's stock is having kind of a rough week. So, Aaron, you have since tasted the queso.

Bush: I have.

Greer: Give me your take.

Bush: I went and tasted it right after last week's taping.

Kretzmann: Research.

Bush: Yes. The important stuff. I mean, I think gritty is a strong word. I understand where they're coming from. It's not the smoothest queso you'll ever taste. I gave it a 7 out of 10. So, it's passable. It's definitely edible. I don't think anybody should be screaming in horror after dipping a chip into it.

Greer: But it's not your Velveeta style. I mean, I'm a sucker for just Velveeta and butter and whatever else you put in there. I don't need grit.

Bush: Yeah, I wouldn't walk five miles through the snow to get this queso.

Kretzmann: I'm wondering, I haven't had it since I tried it last week, but I do want to try putting it on a burrito bowl, because then I feel like the texture isn't the issue, you're focusing more on the taste. And based on some of these reviews, you would think people just had such high expectations that this was going to change their entire life. It's like no, it's queso, it's not meant to change your life, it's meant to be another add-on that you buy with your chips, or something you add on to your tacos. Come on, people, be realistic. But yeah, it's unfortunate, because I think Chipotle... because, they had tested this in a couple markets, and the early reviews from that test kitchen that they have in New York where they're testing the new ingredients like salad dressings and margaritas and queso, it seemed like the initial reviews there were positive. But, I don't know, hopefully they can bounce back from this somehow. They said that they are still looking at tweaking the recipe.

Greer: I was going to say, change the recipe.

Kretzmann: Yeah. They clearly need to do something. But at least people are talking about Chipotle, and not referencing norovirus or rats. So, to me, maybe that's a small win.

Greer: I like that. Forgotten already. What I would do is, for the queso, I would get away from the whole food with integrity thing, because people don't care about that. They want good queso. And I would just brand this as a guilty pleasure. And they could even have their whole guilty pleasure menu, and I would bring in the Velveeta. That's what I would do if I'm Chipotle. I don't want grit. I don't want all-natural ingredients. I want good, yummy queso that doesn't run out.

Kretzmann: You could have them side-by-side, guilty queso, food with integrity queso.

Greer: Perfect!

Kretzmann: That way, the consumer chooses.

Bush: But they would have to take something else away. What would they take away?

Kretzmann: Apparently, now all these people are also complaining that chorizo is gone, but management said that only 2% of customers were actually choosing chorizo. So, at some point I'm wondering, are people just looking for a reason to complain about Chipotle?

Bush: Oh, absolutely.

Greer: Yes.

Kretzmann: So, it's like, they can't do anything right right now.

Greer: No, that's true, I think that's totally true. Well, on a more upbeat, positive note, shares of Nintendo hitting a nine-year high on Tuesday on the news that Nintendo will be partnering with the Chinese internet giant Tencent. Aaron, for those of us who are not familiar with Tencent, why is this such a big deal?

Bush: Tencent is the largest gaming company in the world. I think it's larger than Activision and EA combined, if that gives any --

Greer: That's big.

Bush: Yeah. It's very big. And this is extra important to Nintendo, because they've been on a roll. Probably about a year ago is when they launched Pokemon Go, that was overhyped.

Greer: I've heard that.

Bush: But they've since launched the Switch, and launched a new mobile strategy and such. And so far, it's working out fine. But, one thing that they're missing still is third-party publishers to put their own games on the Switch. Nintendo really just publishes their own games on it, but if others would add their own content, it would be a bigger deal, reach a larger audience. So, that's part of why this is a big deal, because Tencent, largest gaming company in the world, is looking to put at least one of their top games on the Switch. Which is good for Tencent, because it helps them reach a new market, but it's good for Nintendo because it's a new game. But, also, this is a great partnership because it can help Nintendo launch in China, and Nintendo has never launched in China, which is so fascinating, because a few years ago, consoles were banned because the Chinese government said it interfered with education. They have since changed.

Greer: And it does. As a father, I would like to say, that's a true fact.

Kretzmann: [laughs] No disputing that.

Bush: [laughs] But, that's changed, so Nintendo is contemplating ways to get in. So, this Tencent partnership might be a key cornerstone of that.

Kretzmann: And my understanding from looking at this story is, there isn't actually a guarantee that Nintendo will be selling the Switch or any of their devices in China, but I guess the theory is, this partnership helps get them closer, hopefully, to that point within the next couple of years.

Bush: I guess there's a win either way. Either they win and get into China, or they win and content that's in China helps bolster their presence outside of China. 

Kretzmann: Yeah, can't argue with that.

Greer: OK, guys. Before we wrap up, I want to remind everyone that the third edition of The Motley Fool Investment Guide is now available. It has been updated and revised since the classic first edition came out back in 1996. Hot off the presses, so if you're a new investor, if you're a veteran investor, if you're somewhere in between, this is a great book for you. You can find out more at book.fool.com. David, Aaron, thanks for joining me today!

Kretzmann: Thanks, Mac!

Bush: Thank you!

Greer: As always, people on the show may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's it for this edition of Market Foolery. This show is mixed by Dan Boyd. I'm Mac Greer. Thanks for listening! And we'll see you tomorrow!

Aaron Bush owns shares of ATVI, Amazon, and Chipotle Mexican Grill. David Kretzmann owns shares of ATVI, Amazon, CWH, Chipotle Mexican Grill, EA, NKE, and TSCO. Mac Greer owns shares of ATVI, Amazon, Chipotle Mexican Grill, and TSCO. The Motley Fool owns shares of and recommends ATVI, Amazon, Chipotle Mexican Grill, and NKE. The Motley Fool recommends CWH, EA, FDX, and TSCO. The Motley Fool has a disclosure policy.