Is Traditional Retail Structurally Challenged?

One of the key secular growth trends set to dominate retail over the next few years is the transition from bricks and mortar sales to online sales.  Another, more cyclical, theme relates to the unequal nature of the economic recovery.  Put simply, emerging market demand is pushing up the price of those goods that the lower income groups spend a larger part of their discretionary income on.  So with higher food and energy prices there will be less spend on consumer discretionary for lower income groups.

Putting these two themes together, it is not hard to see that businesses like Best Buy $BBY, Family Dollar $FDO and Dollar General $DG should be structurally challenged. Indeed, Best Buy gave Q4 results recently and it disappointed the market with its outlook and guidance. However, the likes of Nordstrom $JWN and Coach $COH (Japan aside) have been demonstrating good growth.  Moreover, companies like Amazon $AMZN and Walmart $WMT are key beneficiaries because they both can grab market share from the likes of Best Buy.

What Best Buy Earnings are Telling the Market

Best Buy gave numbers and guidance

• Full Year Guidance of $3.30-$3.55 vs. $3.56 estimates
• Q4 revenue decline by 2%
• Same stores sales decline of 4.6% partially offset by new store growth!
• Gross Margin expansion

Clearly, Best Buy has some issues to deal with and the company was quick to cite disappointing sales of higher margin TV sets and net book sales. Moreover, declining sales has had an effect on inventory and analysts were quick to focus on the rising inventory plus working capital requirements. High inventory is a problem because it implies a reduction in future margins (to shift slow moving stock) and it also raises question about the structure of the business.

 

($m)	2008	2009	2010	2011
Revenue	40,023	45,015	49,694	50,272
Inventory	4,708	4,753	5,486	5,897
Revenue/Inventory	8.50	9.47	9.06	8.53

So we see that the revenue/inventory ratio is rising. This is not usually a good sign.

The Case for Making Best Buy a Best Buy?

The positive case for Best Buy is best made with reference to its evaluation and restructuring program. The decline in sales could be seen as a result of an unfavourable product sales mix (TVs, net books, lack of new upgrade cycles for windows) and the difficulty of beating tough comparable sales. There is no doubt that Best Buy is generating huge amounts of free cash flow and it is capable of using this cash to generate EPS growth via share buy backs. Indeed, current analyst (and company) estimates do not account for buy backs. More importantly, Best Buy is generating the cash in order to restructure the business.

The restructuring program centres on shifting sales towards things like Best Buy Mobile, tablets and gaming. In addition, Best Buy is reducing the size of stores in the US so the possibility exists for an increase in sales per square foot as well as learning how to maximise sales in new stores.  Gross Margins rose in these results and the company has been aggressively controlling SG & A costs. Initiatives like ‘buy online pick-up in store’ are intended to differentiate Best Buy from online only competition and are reflective of how Best Buy is competing.

We can see these issues reflected in gross margin growth which has been in sequential decline.

($m)	2008	2009	2010	May-10	Aug-10	Nov-10	Feb-10	2011
Revenue	40,023	45,015	49,694	10,787	11,339	11,890	16,256	50,272
Gross Profit	9,546	10,998	12,160	2,793	2,918	2,983	3,943	12,367
Gross Margin	23.9%	24.4%	24.5%	25.9%	25.7%	25.1%	24.3%	24.6%

However, on a yearly comparison Q4 gross margins were actually up.  

Best Buy a Structurally Challenged Stock?

The negative case centres on the argument that-despite the cheap evaluation-Best Buy is structurally challenged and these issues will see a future decline in earnings and cash flow generation. For example, a comparable retailer in the UK is HMV (cds, dvds, games etc) and this company looked very cheap for a long time on traditional evaluation metrics. However, the share price continued to decline with ongoing structurally challenges. This is a significant point because Best reported that European sales growth and gross margins were negative.  As HMV went, so could Best Buy.   Indeed, many of Best Buy’s initiatives are focused on restructuring to face the online threat, but is the company capable of meeting these challenges?

For example, reducing store size is wonderful, but it implies reduced sales of ‘bulky’ products and these products tend to be those sold in store.  Retailers tend to buy IP based purchases online and it is this type of purchases  (mobile, tablet, gaming etc) that Best Buy think it can expand into. Furthermore, opening new stores when existing sales are in decline is usually a bad move in retail. It suggests that the company will be implementing more of a failing business model or sales mix.

Similarly, new technological developments like customers being able to scan barcodes and search online for cheaper alternatives will challenge Best Buy margins and sales growth. Moreover, online retailers specialise in ‘long tail’ provision, so if Best Buy wants to compete with them they will have to hold larger inventory and that will eat into cash flow generation.

Essentially, new technologies and ‘convergence cannibalisation’ (ex cameras, computers, phones, ipods merging into a single device) from companies like Research in Motion $RIM and Apple $AAPL are challenging retailers like Best Buy. Unfortunately, this comes at a time when discretionary spending in middle income America is being pressured by high food and energy costs.

Whilst Best Buy Mobile sales growth is good, this could be seen as being driven by a cyclical uptake of things like smart phones of which Best Buy is not particularly well positioned to take advantage of for follow up sales.

Is Best Buy a Stock to Buy?

On balance, I think not. The stock trades at $29.22 and has an EV of $13.45bn.  I think that history shows us that despite the superficial attractions of a high free cash flow yield (above 10%) and low P/E ratio of 8.8x  the structural trends against this business are significant. I would look for a fall in comparable sales to revenues ratios before considering a long term purchase of this stock. For short term investors, I suspect that given improved macro-economic fundamentals there is some upside here because investors will like the evaluation-after all every stock has a price- but I think the challenges for Best Buy will accelerate and, I place little confidence in the forecast estimates.

Ixia and Spirent, Two Great Stocks Set to Benefit from Internet Growth

 

Ixia $XXIA and Spirent Communications represent two great ways to play the roll out of next generation wireless technologies. These companies primary activity is to stress test the load bearing capacity of telecommunications network equipment manufacturers and large service providers.  In particular, both stocks are exposed to the upgrade cycle in 4G ad LTE spending, which should see them expanding margins and cash flow as their customers appear to be in the early stages of a sustained capital expenditure cycle. They are two great stocks to play the growth in internet and broadband expansion.

Growth Drivers

The argument here is relatively simple. From the consumer side, there is an explosion in bandwidth demand which is being driven by social applications (facebook, twitter etc) and a concomitant technological revolution in smart phones and internet based devices. On the business side, there is a huge increase in demand for ‘anytime, anywhere’ internet access utilising increasing usage of data.

Furthermore, the service providers are moving beyond purely providing bandwidth, by increasingly selling cloud services and helping large enterprises to outsource their IT. All of which, is placing increasing demands on Spirent & Ixia end customers and, it is inevitable that an upgrade cycle will follow.

In addition, as internet traffic grows more complex there is an increasing demand for large enterprises (financials etc) to invest in stress testing equipment. Financials are seen as a key growth market because their end demand is mission critical and quite frequently involves dealing with unusual patterns in network usage.

Ixia and Spirent Solutions

These companies are strong rivals and compete in many of the same markets. Whilst wireless attracts most attention due to its growth, it should be emphasised that this produces a backload which is then dealt with by wire line. In other words, both these markets will see sustained growth.

A quick look at the geographic mix of revenues reveals a marked similarity.

 

Geographic Share	Spirent	Ixia
US	52%	51%
Emea	16%	15%
APAC/RoW	32%	34%

Both companies offer convergence performance testing and are seeing strong growth in Ethernet based infrastructure. In particular, the move towards 10GbE infrastructure should see continued demand growth. Within 3G/4G there is a strong trend (particularly in emerging markets) towards a deployment roll out as data centers and service providers.

Spirent provides ‘TestCenter’, which is its main network testing platform which assesses the vulnerability of traffic application load. Capacity and performance are tested via ‘Avalanche’ which operates on the ‘TestCenter’ platform

By way of comparison, Ixia offers IxLoad which tests converged services and application delivery platforms. IxLoad has been enhanced via the incorporation of IxDefend which was previously a separate vulnerability assessment solution.

Ixia does have Cisco as a major client and this could cause concern as Cisco have been disappointing the market recently. However, strong growth elsewhere has seen Cisco sales fall to less than 10% of Ixia’s revenues.

Spirent or Ixia?

Essentially, both look set for strong growth. Spirent has lower gross margins because it offers service assurance and has a oddly fitting division (Systems) which manufactures electronic control systems for electrically powered systems. This division is lower margin but nevertheless contributes 12.3% of revenues and 7.8% of operating revenues to Spirent.

Spirent looks to be cheaper on current evaluations..

Evaluation ($m)	Spirent	Ixia
Market Cap	1561	1120
EV	1338	1100
Gross Margin	66.60%	78%
EV/Rev	2.8	4
FCF/EV	6.20%	3.23%
Current P/E	19.8	34.1

...but Ixia has the edge on growth prospects

Analyst Forecasts	Spirent	Ixia
Forecast Rev Growth	9% , 6.7%	20.5% , 16%
Forecast EPS growth	10.7% , 9.4%	36.7% , 29.8%
P/E 1 year	18	30
P/E 2 year	16.5	19.2
Price/Rev 1 year	2.5	3.4
Price/Rev 2 year	2.4	2.9

It looks, assuming current pricing, like it will take Ixia a couple of years to reach the levels of cash flow yield that Spirent is at now. Moreover, Spirent has $223m in cash and could possibly sell the 'Systems' division, so the possibility exists for EPS enhancement. Indeed, the company recently made some share buy backs with its cash and this can be expected to continue.

Spirent was added to the portfolio.