Though it has improved its competitive position more than many retailers, the firm will continue to face pressure from Amazon on many of its product and service initiatives, limiting growth and margin expansion potential.
Best Buy Co
offered a rare bright spot in a disappointing first-quarter reporting season for retailers, with its top and bottom lines coming in ahead of market expectations and management guidance. Comps rose 1.6% (1.4% domestic, 4% international), aided by new gaming hardware (Nintendo Switch), mobile category strength due to unlimited data plans and Android preorders, and tax refund checks. Online sales were also encouraging, growing 22.5% or just a hair below Amazon's North America growth of 23.5%, implying strong traffic/conversion trends versus other retailers. Adjusted operating margins grew 60 basis points to 3.5%, with a 50-basis-point increase in gross margins stemming from promotional discipline and merchandise margin growth and 10 basis points from selling, general, and administrative cost containment.
R.J. Hottovy, CFA, is a consumer strategist for Morningstar.
We are placing the shares under review and plan to raise our $37 fair value estimate about 15%-20%, with half the increase based on more optimistic near-term revenue growth and margin expansion and the other half chalked up to lower U.S. tax rate assumptions. We view management's second-quarter guidance (1.5%-2.5% comps, revenue of $8.6 billion-$8.7 billion, adjusted EPS of $0.57-$0.62) and updated full-year outlook (revenue growth of 2.5%, adjusted operating income growth of 3.5%-8.5%) as realistic based on its smart home/in-home advisory, tech support, inventory management and gross margin and SG&A optimization plans, as well as competitors exiting the market the next several quarters. But even with favorable near-term product cycle tailwinds, we believe the market may be getting ahead of itself, with current prices implying mid-single-digit growth and 5%-6% operating margins longer term. While Best Buy has improved its competitive position more than many retailers, we still view it as a no-moat firm that will continue to face pressure from Amazon on many of its product and service initiatives, limiting growth and margin expansion potential.
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