Competition Means Best Buy May No Longer Be the Best Bet

The electronics retailer faces a sharp challenge as electronics goods become commoditized.
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It's shaping up to be the Christmas of consumer electronics. But

Best Buy

(BBY) - Get Report

, one of the largest retailers of things digital, may not be the live wire investors had hoped.

Best Buy, which has profited greatly from consumers' growing penchant for surround sound, has trained investors to expect sales and earnings to exceed analysts' estimates. And investors have rewarded it, giving the stock a forward price-to-earnings ratio of 38, well above the average of 26 for other consumer-electronics retailers.

But as electronic goods become commodities and competitors rush in to offer the lowest possible prices, investors face the possibility that Best Buy's amplified performance will be unplugged by slowing sales growth and profit-margin growth.

Loud and Clear
Best Buy shares sharply outperform those of Tandy, Circuit City over two years

Peter Caruso, a

Merrill Lynch

analyst whose 12-month price target on Best Buy is $95, says investors would make a mistake to bet against the 356-store chain. "Long term, people who are negative on Best Buy will be wrong," says Caruso, whose firm hasn't done underwriting for the company. "They will be shorting the place where a lot of technology will be sold to consumers." Best Buy shares recently traded around 59.

But David Strasser, a

Salomon Smith Barney

analyst who downgraded Best Buy to neutral from buy in September after second-quarter sales failed to live up to his estimates, thinks the stock's outperformance (see chart above) can't last. Since September, Best Buy's stock has tumbled around 20%. Strasser's 12-month price target is $55.

"We are concerned that the competitive environment this Christmas could impact the company's ability to achieve sales and earnings that justify current valuations," Strasser wrote in a recent research note. (He declined to be interviewed for this story. His firm has no underwriting relationship with Best Buy.)

Best Buy spokeswoman Susan Hoff says the Eden Prairie, Minn., company already goes head-to-head with discount chains on items such as VCRs. Best Buy's niche is in higher-tech products like home theaters, where people need more assistance than a cashier at the local

Wal-Mart

(WMT) - Get Report

can provide, Hoff says. However, she declines to specify how much of Best Buy's sales are derived from these more expensive items. In the latest year, $2.7 billion of Best Buy's $10.1 billion in sales came from consumer electronics, making the sector its second-biggest after that of home-office.

Fighting the Holiday Crowds

Fueled by a healthy economy and new products, retail sales of consumer electronics jumped 11% last year to $61 billion, compared with a 5% year-over-year gain for total retail sales, according to the

Census Bureau

. Also on the rise: the number of retail outlets that sell DVD players, digital cameras and home theaters.

Hot new technology products have long been the province of specialty chains such as Best Buy. But a shortening technology cycle, which has compressed the time it takes for products such as DVD players to go from luxury to mass market, is allowing just about anyone to sell these products at cut-rate prices.

"People consider consumer electronics commodities, and they will increasingly go to a mass merchant to purchase them," says Lisa Fasold, a spokeswoman for the

Consumer Electronics Manufacturers Association

.

Wal-Mart has told analysts that sales of DVD players will increase 30-fold this year. And the discount chain recently added consumer electronics to its Web site.

Target

, a division of

Dayton Hudson

(DH)

, made similarly enthusiastic comments to analysts regarding sales of digital products. And

Sears

(S) - Get Report

is expected to expand its offerings, analysts say.

Then there are online retailers such as

Amazon.com

(AMZN) - Get Report

, which sells some 26 different types of home theater systems, ranging in price from $79.99 to $1,199.99.

Tangled Web

Meanwhile, Best Buy, which started selling CDs online in 1998, has lost its early e-commerce lead. Its expanded Web site won't launch until next year, later than analysts had expected. For the all-important holiday season, Best Buy online, in addition to CDs, is only offering DVD players and music that consumers can download for free. This despite the fact that its nearest competitor,

Circuit City

(CC) - Get Report

, has a Web site that's fully integrated with its stores and offers a vast array of products.

"We'd like to have a new Web site functional for the holidays, but we didn't want to rush it and risk not being perfect," says Hoff, the Best Buy spokeswoman. Four months ago, Best Buy hired John Walden as its e-commerce division president. He's pursuing strategies like integrating the Web site with retail stores so customers can check inventory in nearby locations, Hoff says.

While external competition heats up, Best Buy also faces internal hurdles. The easy sales and margin gains that made Best Buy stock such a winner the past two years are largely behind the company. Since fiscal 1997, Best Buy has examined everything from how the placement of, say, digital cameras near computers can induce customers to spend more money in Best Buy stores to calculating the return on advertising to ensure that newspaper circulars translate into higher sales. The result: Best Buy's gross margin is approaching 19% of sales for the current fiscal year, compared with 13.5% in fiscal 1997. Likewise, sales at stores open at least a year averaged double-digit increases for the past year.

Now, even by the company's own admission, those gains will slow. Hoff, the spokeswoman, says that margin growth will be less rapid than it has been in the past. And she adds that last year's third- and fourth-quarter same-store sales gains of 17% and 24%, respectively, "will be difficult to match." Best Buy expects sales growth in the mid-to-high single digits for the remainder of the year.

The competitive threat, however, remains the real wild card. Despite Merrill analyst Caruso's insistence that Best Buy continues to have a lock on higher-end products such as satellite TVs, at least one Best Buy shareholder remains concerned.

"The competitive landscape is what I'm worried about," the money manager says. "Who will make these sales? If it's Wal-Mart, it will kill me as a Best Buy shareholder."