Shares of consumer electronics retailer Best Buy have more than tripled since late 2012, when fears of bankruptcy drove the stock down to decade lows. Those fears turned out to be overly pessimistic, and under the leadership of CEO Hubert Joly, Best Buy has slashed costs, sold off underperforming international businesses, and invested heavily in e-commerce.
Best Buy's latest earnings report shows how far the company has come in the past few years. Comparable-store sales rose, margins expanded, and the company announced its first share buybacks since 2012, in addition to a 21% increase in the quarterly dividend and a one-time special dividend.
Despite the massive rise in the stock price over the past few years, Best Buy remains undervalued.
Slashing costs and rising profitsSince the beginning of Best Buy's turnaround, the company has removed $1.02 billion in annualized costs from the business. Most of this hasn't flowed through to the bottom line, as Best Buy lowered prices to become more competitive and made various investments, particularly in e-commerce. But Best Buy is a far leaner operation than it was a few years ago.
Source: Best Buy
This cost cutting has been necessary, because a combination of more competitive prices and growth in the e-commerce business has led Best Buy's gross margin to fall considerably over the past few years.
Source: Best Buy
Best Buy's operating margin in 2014 was 3.6%. While this was lower than the company managed before the recession, it was a significant improvement compared to 2013, rising from 2.8% in that year. The fourth quarter was particularly solid, with Best Buy posting a 5.7% operating margin, thanks to both lower costs and a higher gross margin.
Best Buy expects its margins to be pressured during the first half of this year, and the consumer electronics industry as a whole is still contracting, with the NPD Group reporting a 3.2% decline during the 13 weeks ending on Jan. 31. Despite this environment, Best Buy has managed to not only remain profitable, but grow its earnings considerably.
The company expects to achieve an additional $400 million in cost reductions over the next three years, driven by reducing losses involved in returns, replacements, and damages, as well as by streamlining processes. This should help bring gross margins up and further reduce SG&A expenses, boosting the bottom line in the process.
A fortress balance sheetOver the past few years, Best Buy has been strengthening its balance sheet. At the end of January, the company had $3.9 billion in cash and investments and about $1.6 billion in debt. This compares to just $1.2 billion in cash and $2.2 billion in debt at the end of 2011.
Halting share buybacks, which Best Buy spent a total of $2.7 billion on from 2010-2011, along with selling its European business, have allowed Best Buy to build up quite a bit of cash.
I argued last year that Best Buy was ready to start repurchasing shares again, and the company has now done exactly that. Best Buy will repurchase $1 billion worth of shares over the next three years, good for about 7% of the company based on the current market capitalization. It will also pay a one-time special dividend of $0.51 per share, or about $180 million, on top of a 21% increase in its regular quarterly dividend.
Even with all of this cash going back to shareholders, the balance sheet should remain strong. Best Buy recorded about $1.4 billion in free cash flow during 2014, more than enough to cover the $333 million in annual buybacks and roughly $325 million in annual dividend payments.
How much is Best Buy worth?In the fiscal year ending in January, Best Buy recorded EPS of $3.53. An item related to the sale of Best Buy's European business is responsible for $1 per share of these earnings, so non-GAAP earnings of $2.60 per share better reflects the performance of the business. This represents 25% growth compared to 2013.
Best Buy currently trades for about $40 per share, putting the P/E ratio at about 15.4 based on this non-GAAP figure. Best Buy certainly isn't cheap based on current earnings, but the operating margin is still well below historical levels.
This is what Best Buy's EPS would be for different operating margins, assuming that revenue remains flat and the tax rate is 35%:
Source: Author's calculations
Getting to a 5% operating margin certainly isn't out of the question: Wal-Mart typically manages operating margins of 5.5%-6%. Along with buying back shares and reducing the share count, it's not hard to imagine EPS approaching $4 per share within a few years.
It's also not hard to imagine margins staying depressed. Best Buy is still facing declining demand for consumer electronics, and while its e-commerce business is growing, margins there will likely be lower compared to in-store sales.
Best Buy's success in bringing up margins is going to depend on its ability to continue to take costs out of the business. Over the past couple of years, the original plan to slash costs by $1 billion has been a complete success, and there's every reason to believe that management will be able to follow through on its new $400 million cost cutting plan. To compete with online retailers, Best Buy needs to be as efficient as possible.
It's hard to put a value on Best Buy, but if it continues what it's been doing over the past couple of years, cutting costs and becoming more efficient while defending or even growing its market share, I think it could be worth a lot more than $40 per share.
The article Why Best Buy Stock is Still a Buy originally appeared on Fool.com.
Timothy Green owns shares of Best Buy. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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