How to Fix Best Buy

Best Buy Co. shareholders are lucky that CEO Brian Dunn pulled a “Mark Hurd” and resigned as a result of allegations of an inappropriate relationship with a staffer. Dunn was not the right person to lead Best Buy into battle against online-only competitors that use the company’s spacious stores as showrooms for their products. Dunn…

Best Buy Co. shareholders are lucky that CEO Brian Dunn pulled a “Mark Hurd” and resigned as a result of allegations of an inappropriate relationship with a staffer. Dunn was not the right person to lead Best Buy into battle against online-only competitors that use the company’s spacious stores as showrooms for their products. Dunn and the current management team were going about their business as if they were still competing against Circuit City Stores and Wal-Mart Stores. They did not wake up to two paramount realities: Best Buy cannot have lower prices than its online competitors, and its stores lack the breadth of selection of, putting it at a permanent competitive cost disadvantage.

The new strategy Dunn announced a few weeks before his resignation — of closing big stores and opening a lot of smaller stores — made little sense. It was basically turning Best Buy into RadioShack Corp. It would have been great if this approach had worked for RadioShack, but it hadn’t.

Best Buy’s strategy for the brave new world requires thinking that cannot be delivered by somebody who spent 28 years in the Best Buy box. It requires the strategy of an Amazon or Netflix, where management was willing to bring forward and execute a disruptive new approach that undermined its current cash-cow business. Amazon did this by bringing electronic readers to the masses. Netflix did it by streaming movies and TV shows.

The new plan for Best Buy must involve a much tighter collaboration of physical stores and the company’s Internet presence — the stores need to be turned from a liability into an asset. Maybe Best Buy should become the intentional showroom for electronics manufacturers. Yes, you read it right. It should take a page from drug distributors’ playbook.

A decade ago McKesson Corp. and Cardinal Health found themselves with a broken business model. For a long time they’d bought drugs from manufacturers ahead of planned price increases, held them for a few months and then sold them to retailers at the higher prices. Drug companies started to stuff distribution channels to “make” their quarterly numbers, Bristol-Myers Squibb Co. got into trouble with the Securities and Exchange Commission, and this practice was banned. Distributors had to figure out a new way to make money. Lacking the scale to deliver their own products, pharmaceuticals companies needed distributors, and therefore a new model was created: fee for service. Drug companies started to pay distributors a volume-based fee for handling their products.

Back to Best Buy. Manufacturers like Dell, Hewlett-­Packard Co., LG Electronics and Toshiba Corp. need the company to showcase and educate consumers about their products. With the exception of a few regional chains, Best Buy is the last place in the U.S. where you can play with electronics — then, yes, go buy them on Amazon. Target Corp. and Wal-Mart are still around, but their salespeople know even less about TVs, PCs and printers than they know about the location of toilet paper and motor oil in their stores.

If Best Buy ceased to exist, electronics manufacturers would be forced to start opening their own stores — think Apple — and I seriously doubt they want to do that. They lack retail expertise, and they’ll face the same structural problem Best Buy is battling today. So an outside-the-box model for Best Buy would be to carry very little or no inventory in its stores but increase the variety of products. In other words, expand from carrying 30 TVs to 100, but only have display models, and when a customer wants to buy a TV or PC, offer free same- or next-day delivery. I know “next day” goes against the instant gratification embedded so deeply in American DNA, but Americans have overcome bigger obstacles in the past.

Here is the key: Manufacturers would need to subsidize the cost of running Best Buy stores — a fee-for-service type of arrangement that would make Best Buy’s cost structure comparable to Amazon’s. This would turn Best Buy stores into showrooms for Best Buy warehouses. In addition, the company could take its relationship with manufacturers further and become a servicing hub, the place you go to repair a product that is still under warranty.

I am a value investor, so when I see a stock dangling at 6 times earnings, I’d be lying if I told you I didn’t have a temptation to seriously consider Best Buy for our portfolios. But Best Buy is not a retailer that missed a fad — those sorts of situations often present great buying opportunities, as the problems are easily fixed. It is a retailer that has missed a structural change that will make its business obsolete. Best Buy is only cheap if the earnings projected for next year will be there. So far, the market is betting that they won’t, and I have no insight that encourages me to disagree with the market.  •  •

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of The Little Book of Sideways Markets (Wiley, December 2010). 

Investment Management Associates Inc. is a value investing firm based in Denver, Colorado.  Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy Katsenelson’s Active Value Investing (Wiley, 2007) book.

Please read the following important disclosure here.

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