Best Buy‘s (NYSE:BBY) stock has suffered by adverse industry trends which are increasingly squeezing its legacy business model. The stock had slumped since mid-August when the company announced that it would no longer provide profit outlooks for the year. The reasons cited were industry factors and insufficient clarity on introduction of new products by companies. The stock price declined from about $21 to around $17. It has, however, recovered in the last couple of days. The recovery has not come due to any shift in fundamental factors, but on expectations that the firm’s founder Richard Schulze is preparing to propose a $11 billion takeover. This implies a valuation of $24-$26 per share. 
According to Reuters, Apollo Global Management LLC, Cerberus Capital Management LP, TPG Capital LP and Leonard Green & Partners LP are among firms that are conducting due diligence on Best Buy, as are Schulze and his financial advisers at Credit Suisse Group AG.
We have a price estimate of around $25 for Best Buy which is at a premium to the market price.
Increasing Focus On Growing Online Sales
Best Buy has been struggling to keep pace with the rapidly changing nature of the consumer electronics retail industry. Retailers like Wal-Mart and Amazon are taking business away from pure-play consumer electronics stores by offering huge discounts. Customers are still using physical stores to check out products and gain hands-on experience with gadgets. However, a large number of them then proceed to buy these from online stores like Amazon at cheaper prices. This phenomenon of showrooming has hit business hard for companies like Best Buy. The trend has been accelerated by changing consumer spending habits, which are shifting from high discretionary spending and debt taking to higher savings. 
To counter it, Best Buy is trying hard to sell its products online and investing in building a strong internal IT team over the course of next 12 months. It plans to hire 200 professionals. Best Buy has also hired a new e-commerce chief, former Expedia Inc. President Scott Durchslag to lead this effort which shows its seriousness towards building capability in this space. The company is considering lowering its online prices to compete with rivals like Amazon. Right now, online sales contribute to 6% of its sales but are expected to constitute a much bigger share in future. 
Changing Product Mix And Store Formats
TV’s constitute a major portion of its sales but average selling price has been falling even though number of units sold are rising. This is due to higher contribution of small and mid-sized TV’s to the product mix. PC sales have been declining due to increasing preference for tablets and mobile devices. TV’s and PC’s come with high-margin yielding warranty and service attachments so lower sales hurt margins.
To compensate, Best Buy is selling tablets and smartphones which provide opportunities for high margins on warranties, service contracts, and accessories. This strategy is being pursued in tandem with opening smaller-sized mobile stand-alone stores which increase average revenue per square feet, a key performance measure for this industry. It will also result in lower operating costs, enabling Best Buy to better compete with online retailers on prices. Further, many of these stores will be opened in strip malls which have lower rentals and higher visibility. 
Catching Up With Today’s Technology
In November 2011, Best Buy acquired mindSHIFT, a Massachusetts-based cloud service provider, to get access to the $40 billion managed service provider (MSP) market for small and mid-size companies. This acquisition is expected to have synergies with the Best Buy Geek Squad. In June 2012, it acquired White Glove Technologies, a Texas-based managed IT services provider (MSP), in an effort to strengthen its presence in the cloud services industry and expand its managed IT services in Texas. Best Buy has also launched a third-party market place to offer online products from other sellers in exchange for a cut from the proceeds. Third-party sellers including Buy.com, Mambate, SF Planet, ANT Online, BeachAudio.com and Wayfair have signed up for the platform. 
There are potential risks to our outlook for the company.
Its missteps with inventory in the last holiday season in the U.S. resulted in Best Buy losing some of its market share. Recently, the company informed customers that their pre-orders for iPhone 5 might be delayed by up to 28 days. In all fairness, this wasn’t Best Buy’s fault as Apple didn’t supply enough of those, but a customer is unlikely to trust Best Buy again and may go through an alternate channel.
If Best Buy is unable to seamlessly integrate its online and physical stores to deliver a superior customer experience, it may be unable to differentiate itself from the competition. Along with technology, this needs investment in employee training to make them smarter. It needs to provide product information and be visible when a customer is engaging in price comparison. 
If it is unable to either shift from the big-box retail format to smaller stores, or optimize store space by sub-leasing to other businesses, operating costs will not come down. This will continue to eat into margins and reduce pricing flexibility.Notes:
- Exclusive – Best Buy founder presses forward on possible $11 billion buyout plan, Reuters [↩]
- Understanding U.S. Consumer Electronics Retailing, Cognizant Whitepaper [↩]
- Best Buy May Reduce Online Prices to Compete With Amazon, Bloomberg [↩]
- Best Buy Looks To Steamroll RadioShack With Small Store Shift, Trefis [↩]
- Best Buy Company Overview, Trefis [↩]
- Best Buy CEO Says Employee Training Key to Reviving Stores, Bloomberg [↩]