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The bargain-basement appeal of Best Buy shares

Is the leading consumer electronics retailer in North America the best of buys or the worst of buys?

Over the last six months, it has been the latter. Best Buy once a darling growth story among retailers, shed about 20 per cent of its value last December after an earnings miss and guidance reduction; it has since slid further, to 52-week lows, in advance of Tuesday's first-quarter earnings report.

What's gone wrong? Expectations for an endless cycle of new-TV purchases were too sunny, and the iPad ate into notebook computer sales more than expected. Online sellers have provided sharp price competition, while other mass retailers are carrying the newest, flashiest products.

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But the pessimism on Best Buy - which operates more than 200 stores in Canada under the Best Buy and Future Shop banners - has grown too great. The stock is so cheap it's as if the market believes no one will ever walk into a physical store to buy electronics again.

"We believe that many investors in the market are of the opinion that Best Buy's business model is simply outdated and that the company is on an inevitable journey toward zero," says analyst Scot Ciccarelli of Royal Bank of Canada's U.S. investment arm.

Mr. Ciccarelli disagrees with that assessment- and investors willing to weather what may be a bumpy few quarters for Best Buy may profit from betting on the last of the old-line consumer electronics retailers.

To be sure, there's a bear case for Best Buy. Analyst Christopher Horvers of J.P. Morgan Securities notes Best Buy benefited from an extraordinary explosion of U.S. television sales in recent years, thanks to the growing popularity of flat screens. Mr. Horvers figures television shipments averaged around 22 million units per year from 1988 to 2003, but bumped up to 28 million per year from 2004 to 2010, topping out at 34.3 million last year.

Sets are also selling at a huge premium to historical prices, Mr. Horvers notes. If all the unit and price figures revert back to their historical trend lines, the revenue from television sales in the United States will fall 3 per cent to 4 per cent annually in each of the next five years, he notes. That's a big issue for Best Buy, which gets around 35 per cent to 40 per cent of its revenue from television and computer sales. (Mr. Horvers has a "neutral" rating and a $35 (U.S.) price target on Best Buy.)

At the same time, mass-market retailers such as Wal-Mart and Costco have improved their product selection, and online retailers like Amazon, which collects no sales tax in most states, have expanded their offerings.

Best Buy's management, to its credit, has responded to recent woes rather than claiming that TV sales are just going through a temporary blip. The company is reducing the average size of the selling floor at its stores, which average just under 40,000 square feet. Mr. Ciccarelli says Best Buy is currently testing a 20-per-cent reduction in square footage in 30 of its stores and finding "total sales have remained flattish despite the decline in store size."

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The expansion instead will come at new, smaller Best Buy Mobile locations devoted to cellphone sales. From about 200 today, Best Buy Mobile is slated to grow to 325 locations by next February's fiscal year end, to 600 to 800 in five years, Mr. Ciccarelli said. (Best Buy is an RBC "top pick" with a target price of $38.)

BB&T's Anthony Chukumba - another bull with a "buy" and a $40 price target - says that not only can Best Buy offer phones and service from multiple wireless carriers, it can also activate new wireless subscriptions "significantly faster" than carrier stores and other retailers.

Mobile phones, with their continuing growth and high gross margins, offer a partial solution to the incredible disappearing TV sales. But the market sees more disappointment ahead, based on its valuation: Best Buy trades just over eight times forward earnings, and its enterprise value - market cap plus net debt - is less than four times its EBITDA.

In the near term, Best Buy still runs the risk of disappointing even the low current expectations. Unlike televisions, however, Best Buy is cheaper than at any time since the pre-Internet days - a good buy for a retailer that isn't disappearing any time soon.

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About the Author
Business and investing reporter and columnist

A business journalist since 1994, David Milstead began writing for The Globe and Mail in 2009. During eight years at the Rocky Mountain News in Denver, Colo., he individually or jointly won nine national awards from SABEW, the Society of American Business Editors and Writers. He has also worked at the Wall Street Journal. More

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