Amazon Stock Holders Should Aware of This From UPS and FedEx Earnings

What's Amazon (NASDAQ:AMZN) planning with its delivery and logistics network? It's well known that the e-commerce company is expanding its delivery services -- but is it merely to complement the existing services it gets from FedEx Corporation (NYSE:FDX) and United Parcel Service (NYSE:UPS), or will Amazon end up directly competing with the package delivery giants? The question of the threat from Amazon comes up on almost every investor presentation given by FedEx and UPS.

However, what's less discussed is that e-commerce growth is creating challenges for both companies. If Jeff Bezos thinks Amazon could compete with FedEx and UPS, the evidence from their latest results suggests he might be in for a rude awakening. Here's why.

READ THE FULL ARTICLE LINKED 

Amazon.Com Isn't Really a Threat to UPS and FedEx

First it was Amazon.com (NASDAQ:AMZN) drones that were set to destroy the businesses of FedEx Corporation (NYSE:FDX) and United Parcel Service, Inc (NYSE:UPS). Now it's the online retailer's expansion of its air-cargo network. It all sounds dramatic, but in reality Amazon's moves don't present a significant threat to the two mega-logistics players. Here are five reasons why.

READ THE FULL EQUITY RESEARCH ARTICLE LINKED

More Trouble for Rackspace

Life just got a bit harder for cloud computing services company Rackspace Hosting. Google  aggressively reduced prices across its range of cloud services recently, while deep-pocketed competitors like Amazon, Microsoft, and Oracle are committed to offering infrastructure as a service, or IaaS, at highly competitive rates. In addition, Cisco Systems is planning to invest heavily in offering IaaS. While much of this is known to investors, it's sometimes easy to lose site of the fundamental reasons why these companies are doing this and why competition is only going to get more intense.

Why companies are investing in IaaSSimply put, it works. The companies that have transitioned to offering their services and applications on a software as a service, or SaaS, basis have seen a transformational improvement in their prospects. The three leading examples of this change are Adobe, Autodesk, and Intuit. Investing Fools already know how and why these companies are outperforming the markets.

 

READ THE FULL ARTICLE LINKED HERE

Why Oracle is Still Good Value

When a technology company misses analyst estimates and disappoints based on its own guidance, the stock usually gets punished severely. However, in the case of Oracle  the market was much more forgiving, with the stock down barely a percentage point on the day. Investors' reaction to the news is telling you a lot of what you need to know about the stock: Oracle remains one of the most attractive investing ideas in technology.

Oracle disappoints, again
First things first, aside from its hardware product sales, it wasn't a great set of results:

 

READ THE FULL ARTICLE LINKED HERE

How Oracle is Making the Right Changes

The market's valuation of Oracle continues to suggest doubt over its future direction. It's traditional on-premise on-license sales are being threatened by pure-play software as a service, or SaaS, companies like Workday and Salesforce.com. Meanwhile, analysts are also questioning its future margins, given that management declared an intent to be "price competitive" with Amazon Web Services and Microsoft's Azure. Are the skeptics right about Oracle, or is the stock a good value?

Oracle reports a good second quarter
After disappointments from IBM and Cisco, investors have approached Oracle's recent results with caution, despite the fact that the numbers came in slightly better than expected.

• New software licenses and cloud software subscriptions (26% of revenue) grew 1% constant currency growth vs. internal guidance of -4%-6% growth.

• Hardware systems product sales declined 2% in constant currency vs. internal guidance of  -9%-1% growth.

• Non-GAAP earnings were $0.69 vs. internal guidance of $0.65-$0.69.

Although new software licenses and cloud subscription growth appears weak, Foolish investors should note that the company came up against some very strong numbers from last year's second quarter.

Source: company presentations.

Oracle's management articulated that its mix of software sales had a larger share of renewals and annuity deals versus new license deals. This kind of shift usually involves trading off some upfront revenue for an income stream over time. Indeed, Oracle's management argued, "you would think it would take you a couple to three years to get to that full productivity of the equivalent of a recurring stream of revenue to what you would have typically seen in license."

In other words, Oracle's revenue is likely to be negatively affected in the short term with this shift toward subscription-based sales.

The geographical breakdown confirmed Oracle's strength in the Americas, with sales up 5%, along with "good growth" in China. However, the real talking point is how aggressively Oracle is seeking to expand its cloud infrastructure services.

Oracle takes on Microsoft, Amazon, and Rackspace
As you would expect from a megacap tech company, Oracle's cloud offerings include SaaS, applications, and infrastructure. However, on its recent conference call, Oracle's CEO, Larry Ellison, explained that his company's plans involve being "price competitive" with Amazon, Microsoft's Azure, and Rackspace. Ellison also plans to make Oracle "highly differentiated at both the platform level and the application level."

The plan can easily be criticized for potentially sacrificing infrastructure margins at the expense of chasing future revenue. The market is competitive enough already, as Microsoft has already promised to match Amazon on pricing and features.

Oracle needs to address the threat that pure-play SaaS companies like Salesforce and Workday will grab market share within their respective niches of customer relation management and human capital management. Therefore, a strategy like this will help efforts to retain leadership with long-term recurring revenue from cloud applications.

Similarly, Microsoft and Amazon have their own services that will benefit from selling cloud infrastructure at less-than-optimal prices. The important strategic issue for Oracle is to remain relevant as SaaS solutions become more important.

Oracle's financial firepower and marginsOracle has the financial firepower to make these moves. It's trailing twelve month free cash flow generation of $14.6 billion represents approximately 9.6% of its enterprise value. Furthermore, Oracle is investing in dedicated sales teams to compete for business against Workday and Salesforce. Sales and marketing expenses increased 12% in constant currency during the quarter, as Oracle built out sales capacity to win future business in the cloud.

All told, these initiatives may trim margins, but Oracle has a lot of financial leeway, and so does its valuation. Despite a 20% rise in the last six months, the stock still trades on just 12.5 times forward earnings to May 2014. Operating income margins fell to 36% in the first half, versus 37% last year, but 80% of the increase in operating expenses came from investments in sales and marketing.

The bottom line
Investors can be quick to criticize management for failing to adjust to structural changes, but Oracle is making significant efforts to manage the transition of software into the cloud. Investments in sales capacity, infrastructure services, cloud-based acquisitions, and efforts to respond directly to the threat posed by Salesforce and Workday are all demonstrations of intent.

Oracle is responding to structural changes in its marketplace, and it will take time to come to fruition. However, the stock's valuation suggests it can withstand some margin erosion along the way.

Rackspace's Business Model is Being Challenged

There is a difference between saying that a company is good, and saying that it is a good investment. In the case of Rackspace , its current business trajectory is suggesting that it's not a good investment even though that doesn't mean it’s not a great company. Unfortunately, increasing competition within the cloud computing provision market from the likes of Amazon Web Services  and Microsoft's   Azure is threatening Rackspace, even as the company improves its already high level of service.

Rackspace's margin
It's difficult competing with Microsoft and Amazon in the best of times, but it's a lot harder when they are both cutting prices in order to win market share in a fast-growing business. Throw Google into the mix and its almost unfair. The fact is that those three tech giants can easily subsidize lowering prices (and therefore margins) because they have add-on advantages to winning new business.

Indeed, AWS is reported to have recently cut prices by 10% across all its regions, and it's hard not to think that its response to Microsoft's aggressive discounting actions. The two companies have seemingly been locked in a price battle, the effects of which are starting to show in Rackspace's margins.

While its revenue was up 15.6% in the third quarter, Rackspace's operating income margins fell to 9.4% for the first nine months compared to 12.9% last year. Moreover, the third quarter saw operating income margins come in at just 7.1%.

Rackspace invests in order to grow
In defense of the company, it's currently investing to support growth created by customers adopting its OpenStack public cloud options. In addition, its management has long claimed that its "Fanatical Support" is its unique selling point within a competitive industry. Unfortunately, a high level of support usually implies a high level of investment, and Rackspace appears to be running hard in order to stand still on that front.

At the start of the year, Rackspace had forecast full-year capital expenditures of $375 million--$445 million and customer gear expenditures of $235 million-$275 million. Fast forward to the latest results and capital expenditures are now forecast to come at $460 million--$510 million. While "north of $10 million" of the increase is due to buying land for a datacenter, the rest is because it is investing in its cloud infrastructure and customer gear. In fact, customer gear expenditures have already hit $233 million this year. It's safe to assume that they will come in higher than the forecast at the start of the year.

These facts play to the heart of the questions with Rackspace. Can it leverage up its investments and start to generate meaningful cash flow in future? Alternatively, is it forced to invest in continually buying customer gear so that its customers can benefit from outsourcing IT expenditures in order to generate growth?

The following chart shows operating cash flow, capital expenditures, and customer gear expenditures as a share of income over its last four quarters. The hope is that Rackspace will be able to generate free cash flow (operating cash flow minus capital expenditures) over time.

Source: company presentations, author's analysis.

Unfortunately, it looks like Rackspace is finding it difficult to generate meaningful cash flows. As 2013 has gone on, its customer gear requirements have gone up. Consequently, customer gear now makes up nearly 67% of capital expenditures. Its one thing to provide fanatical support to generate revenue growth, but it's another thing to generate cash to be returned to shareholders.

Rackspace's bottom line
All told, conditions look like they are getting tougher for Rackspace. Competition from Microsoft and Amazon appears to be pressuring prices, while it's having to increase expenditures in order to service clients.

Rackspace has generated just $18.7 million generated in adjusted free-cash flow (its own figures) so far in 2013, but sits on a current market cap of $5.9 billion. Meanwhile, it still hasn't demonstrated that its business model can generate the kind of cash flows that could justify its valuation in future. It doesn't look like a good value to me.

Digital Realty Trust Signals Problems in the Data Centres

One week after datacenter services company Equinix (NASDAQ: EQIX  ) disappointed the market with a lackluster set of results, it was datacenter REIT Digital Realty Trust's (NYSE: DLR  ) turn to indicate that industry conditions are getting tougher. But is this a short-term growth hiccup or a longer-term problem? And with behemoths like Google (NASDAQ: GOOG  ) and Amazon's Web Services, or AWS, rolling out their own datacenters, are Equinix and Digital Realty headed for more difficulty?

Digital Realty reality
Digital Realty reported funds from operations, or FFO, of just $1.10 in the third quarter compared to analyst consensus of $1.20. FFO is just a metric that REITs use to equate to EPS. Although $0.07 of the "miss" is due to a rent expense adjustment, its core FFO still only came in at $1.16.

Moreover, its guidance for 2014 was disappointing. Quoting from its conference call:

We are revising our 2013 FFO per share guidance to $4.60 to $4.62, down from $4.73 to $4.82 previously, and revising guidance for 2013 core FFO per share to $4.65 to $4.67, down from the prior range of $4.74 to $4.83

This adjustment is a reduction of 3.5% or $0.17 of EPS at the mid-point of guidance, but to be fair to Digital Realty, $0.07 is due to the aforementioned rent adjustment and $0.03 is due to a joint venture with Prudential.

However, the worrying bit is the $0.06 that is due to "delayed lease commitments." In other words, customers are not utilizing the datacenter space—that they signed up for—as quickly as Digital Realty had anticipated. This is a sign of a maturing industry, or at least, one in which the customers have the upper hand with regard to pricing negotiations. Moreover, in its earnings release, Digital Realty gave preliminary guidance for 2014, and informed investors that rental rates on renewal leases are expected to be roughly flat on a cash basis, along with operating margins "approximately 25-75 basis points lower than the historical run rate."

In other words, Digital Realty is finding it harder push through price increases. Another sign of a maturing industry.

Equinix deals with reality
These industry trends are confirmed when looking at Equinix's recent results. There is a more detailed analysis of them linked here.

Equinix had lowered earnings guidance already this year, and its third quarter results also contained some negative nuances. Its deal sizes are getting smaller, while its sales cycles are lengthening. However, Equinix's management argued that it was primarily a consequence of delays caused by enterprises planning more complex hybrid cloud deployments:

I don't believe they are really just driven per se by macroeconomic uncertainty or a broader enterprise anxiety or anything like that... ...just driven by the fact that the decisions of CIOs to move to sort of hybrid cloud infrastructures

Partially in response to these developments, Equinix strengthened its relationships with Microsoft's (NASDAQ: MSFT  ) cloud platform, Azure/and also with AWS. The idea being that Equinix's customers will find it easier to build out their hybrid clouds from within its [Equinix] infrastructure. In fact, Equinix sees the development of cloud services from the likes of Google, Amazon and Microsoft as a net positive in the long-term.

The bottom line
Essentially, the evidence is that the datacenter market is maturing and pricing power appears to be moving away from the datacenter providers and toward the buyers. Meanwhile, its incumbents are still investing in new capacity. Investors in datacenter providers InterXion, Telecity and DuPont Fabros should take note.

Whether the issue is going to be prove relatively short term (as is implied by Equinix's arguments over the hybrid cloud deployment issue), or if it's simply a function of oversupply, the near-term outcome is likely to be similar. The industry is facing some pressures and cautious investors should wait until there are signs of pricing power returning.

Equinix Investors Should Brace Themselves

What do you do with a stock with which you fear near-term risk, but are confident in its long-term prospects? That's pretty much the problem that investors in data-center provider Equinix (NASDAQ: EQIX  ) are faced with right now. While its third-quarter results didn't bring lower full-year estimates again, they were accompanied by the sort of commentary that suggests the company is still facing headwinds.

Equinix responds to a changing market
In its previous quarter, Equinix had lowered its expectations for growth in the second half due to a combination of weaker conditions in Germany, a longer sales cycle within its enterprise markets, and a reduction in average deal size. Unfortunately, the narrative around the last two issues continued in the third quarter. Fortunately, Equinix is responding to these changing market conditions.

On its conference call, Equinix outlined that deal sizes continued to be smaller this year, and its intention was to do "more transactions every quarter" as it refuses to take on board larger scale work at unattractive price points. This is fine, but it increases the pressure on its sales team to find suitable deals in a market that is changing.

While there is little that Equinix can do about lengthening sales cycles, per se, its measures to extend contracts for 70% of its top 50 customers helps to secure long-term revenue streams. Moreover, it insulates Equinix from some future pricing competition and frees up management resources in order to chase other deals.

And finally, it's strengthening its relationships with partners like Amazon (NASDAQ: AMZN  ) Web Services, or AWS, and Microsoft's (NASDAQ: MSFT  ) cloud platform, Windows Azure. Both measures are intended to offer Equinix's customers more flexibility to build out their hybrid cloud infrastructure.

What is lengthening sales cycles?
The relationships with Amazon and Microsoft are important, because they help address what Equinix believes is the reason why the environment has gotten tougher. On its conference call, management outlined that more of its customers were seeking to build out more complex infrastructures, such as the hybrid cloud.

In plain English, the hybrid cloud just means an infrastructure where private and public clouds are working in combination. As a network-neutral data center, this shouldn't be a problem for Equinix. In fact, its co-location data centers benefit from these trends because customers can connect with various cloud service providers from within Equinix's data centers. However, the snag is that the increased sophistication of the hybrid cloud is lengthening sales cycles. Speaking on the issue on the conference call, management had this to say:

I don't believe they are really just driven per se by macroeconomic uncertainty or a broader enterprise anxiety or anything like that...just driven by the fact that the decisions of CIOs to move to sort of hybrid cloud infrastructures...And there are sales cycles that need substantive technical support.

In this context, the agreement with Microsoft to extend the strategic relationship by enabling connectivity to Windows Azure through Equinix's data centers makes a lot of sense. Similarly, Equinix has a deal with Amazon which allows Equinix customers to connect their IT infrastructure directly with AWS.

If customers are taking longer to define their hybrid cloud architectural needs, then these sorts of deals with Amazon and Microsoft will surely help them by granting them more flexibility. In addition, Amazon and Microsoft will benefit too.

What to do with Equinix?
In the long-term, Equinix looks set to be a net beneficiary of these changes. However, the problem is that it could come under near-term pressure. Moreover, it's a competitive industry in a high-growth expansionary phase. Indeed, rivals such as Telecity and InterXion haven't been slow in building out capacity. If sales cycles continue to lengthen, then pricing pressure could appear as the leading players start to fight to fill their growing capacity.

The current enterprise value is around $11.8 billion, and with a 2013 forecast of around $620 million-$640 million in adjusted discretionary free cash flow -- a useful measure that Equinix uses to demonstrate its underlying performance -- the stock looks like a good value. The potential for REIT conversion should turn this stock into a dividend favorite, and long-term demand conditions look good. However, the near-term uncertainty means investors should be aware that conditions could get worse before they get better.

Why I'm Still Not in Love with Rackspace

It’s been a difficult year so far for investors in Rackspace Hosting (NYSE: RAX). While it is not alone in having delivered disappointing results in the tech world the latest earnings raise more questions than answers as to how to best evaluate this company.

In summary, an investment decision here requires a certain amount of confidence in the future of its OpenStack public cloud project.It also requires an expectation that it is about to demonstrate the kind of scalability in its cash flow generation that it has hitherto not been seen.  No one said investing is easy! But I’m saying you don’t have to invest when it isn’t.

Just another tech disappointment or is it?

In a sense the results were the usual story of tech weakness in the first quarter. Okay Rackspace had the excuse that it is engaging in managing a product cycle transition to its OpenStack public cloud offering. In this kind of environment enterprises are taking any excuse to delay spending decisions. In this case it seems that its customers are holding off investing in Rackspace’s legacy and hybrid solutions while they assess its OpenStack offerings. It does look like a mix of macro and company specific issues but both create uncertainty.

I discussed its strategic move in more detail in an earlier article linked here.  Essentially Amazon (NASDAQ: AMZN) is offering a public cloud approach and VMware (NYSE: VMW) has a private cloud focus while Rackspace wants to do something different by offering its customers the benefit of not being tied to one customer. The  benefit being that the the customer will not ultimately be locked into one provider. This makes sense for VMware because it is in line with its unique selling point of offering ‘Fanatical Support’ to its customers.

Unfortunately in a weak environment the competition tends to get tougher. Amazon Web Services (AWS) has cut prices in order to attract market share and customer growth. Of course it can take some potential margin loss because it is part of a highly cash generative e-commerce monolith. Google has also lowered its cloud storage costs and even though AWS reported 21% in its international operations this came in below what some may have hoped. AWS claimed to still be in 'investment mode' so we can expect a heightening of competition in the industry.

As for VMware, the market was disappointed with the recent results, but the stock has come back strongly since then as investors appreciate its long-term potential.

So will Rackspace’s share price see a similar bounce back? Frankly I’m not sure and here is why.

Same old Scene

Put quite simply VMware generated $599 million in free cash flow in the quarter while Rackspace generated adjusted free cash flow of ($1 million). If we look at the reported free cash flow (operating cash flow less capital expenditures) it was ($11 million) in the quarter.

Moreover expenditures on customer gear are being ramped up at a time when revenue is disappointing. In fact Rackspace stated, in the conference call, that revenue per server declined to $1.308 from $1,310 in the quarter, although in mitigation it had opened a new data center in Australia replete with investment in new servers.

Nonetheless the question mark over its long term ability to leverage its capital expenditures will get even more relevant after this report. Here is a graphical depiction of what I am talking about.

It is one thing to laud offering ‘fanatical support’ and argue (positively) that capex only increases with future growth, but the fact is that the gap between operating cash flow and capex isn’t expanding much at present. Where is the scalability?

Moreover I note that –despite revenue disappointing- there was no downward adjustment to the full-year capex forecast of $375-445 million. The bulk of which being focused on customer growth. Rackspace is going to continue investing because it believes in its strategy. That is fair enough but to follow it you need to share this belief.

Where next for Rackspace?

Clearly the question marks over its business model are not going to be answered definitively anytime soon so investors will have to live with this uncertainty. In addition investors will have to deal with the general macro uncertainty around tech spending. Naturally this also provides some upside potential as well. If enterprise spending picks up then it could appreciate strongly but I would argue that there are better ways to get exposure to it than by buying Rackspace.

Competition is also an issue here with Amazon and VMware determined not to cede market share meanwhile investors need to appreciate that VMware is generating huge amounts of cash while Amazon Web Servces can be supported. In other words they can deal with some margin erosion from price cutting. Can Rackspace do the same while it has significant outlays planned for capital gear this year?

Throw in the overlying uncertainty over the transition to its OpenStack public cloud model and proposition gets even harder. It’s not a stock for widows, orphans or for me.

GameStop Set to Disappoint the Market in 2011?

GameStop $GME is a business that has been aggressively shorted over the last few years, but is it now becoming a contrarian play? Investors have been quick to sound the death knell for GameStop due to the ‘oncoming’ onslaught of online gaming sales, and according to Yahoo Finance the short percentage of the float was around 24% However, the recent results were superficially quite good and the stock rallied. Is it time to buy?

GameStop Earnings and Margins

A quick look at revenues over the years (year end to Feb)...

Sales ($m)	2007	2008	2009	2010	2011
New Video Game Hardware	1,073.7	1,668.9	1860.2	1,756.5	1,720.0
New Video Game Software	2,012.5	2,800.7	3685	3,730.9	3,968.7
Used Video Game Software	1,316.0	1,586.7	2026.6	2,394.1	2,469.8
Other	916.7	1,037.7	1234.1	1,196.5	1,315.2
Total	5,318.9	7,094.0	8,805.9	9,078.0	9,473.7

...reveals that growth in the Used Video Game Software segment appears to be slowing. The importance of this can be demonstrated by a look at gross margins.

Gross Profit ($m)	2007	2008	2009	2010	2011
New Video Game Hardware	77	108.2	112.6	113.5	124.9
gross margin	7.2%	6.5%	6.1%	6.5%	7.3%
New Video Game Software	427.3	581.7	768.4	795	819.6
gross margin	21.2%	20.8%	20.9%	21.3%	20.7%
Used Video Game Software	651.9	772.6	974.5	1121.2	1140.6
gross margin	49.5%	48.7%	48.1%	46.8%	46.2%
Other	315.2	351.6	414.6	405	452.6
gross margin	34.4%	33.9%	33.6%	33.8%	34.4%
Total	1471.4	1814.1	2270.1	2434.7	2537.7

Over the years, the used game segment has made up the bulk of profits but growth appears to be slowing.  I think this is an understandable issue and I would like to explore the reasons why.

GameStop Structurally Challenged?

There are four main challenges to GameStop and I think all of them are significant.

1. Best Buy and Walmart are encroaching on their market share
2. Online merchants are grabbing market share from in-store sales
3. Software manufacturers are shifting to delivering the games online (avoiding piracy and protecting IP is a key driver here)
4. They are being forced into the 'long tail' of retail (superstores are selling the blockbuster titles) which is an area that is not their forte

The likes of Best Buy $BBY and Wal-mart $WMT, as indicated in an earlier article, are seeing some of their traditional markets erode to online competition. Therefore, they are seeking new ways to sell to their captive audience of shoppers. Naturally, selling new and used gaming software fits perfectly into the sales demographic of kids making trips to their outlets. This competition is significant for GameStop.

Similarly, online competitors like Amazon are continuing to grab competition from GameStop. The advent of smart phones that can read bar codes and immediately compare prices will pressure margins for ‘bricks and mortar’ retailers. GameStop will still be able to offer the ‘retail experience’ of kids checking out new releases but as the tables indicate hardware sales are low margin, and new software sales do not make up the bulk of GameStop’s profits.

However, the key challenge for GameStop will come from how the gaming companies deliver files. With the advent of 4G and other ‘fat bandwidth’ provision, it will become feasible for games to be sold online. This has great advantages to the gaming industry because they will be able to insure against piracy by selling gaming upgrades and licences to the original purchaser. This helps avoid the kind of piracy that is rife in this form of Intellectual Property. This will be a significant problem for GameStop and I think will hurt them sooner rather than later.

A Value Trap?

I think there is a value trap here. GameStop are talking about closing 200 stores and opening 200 others in an attempt to restructure the business, but I think the decline and structural challenges are already showing in the numbers. Let’s look at sequential numbers...

Gross Profit ($m)	Jan-10	May-10	Jul-10	Oct-10	Jan-11
New Video Game Hardware	40.9	21.2	25.9	21.7	56.2
gross margin	5.5%	6.1%	8.2%	7.9%	7.2%
New Video Game Software	322.2	174.5	141.7	182.4	321
gross margin	20.6%	20.0%	21.4%	21.7%	20.1%
Used Video Game Software	360.7	274.4	260	250.2	355.8
gross margin	46.4%	48.1%	46.0%	47.4%	44.2%
Other	150.3	100.7	89.2	92	170.7
gross margin	33.6%	34.7%	34.8%	35.9%	33.3%
Total	874.1	570.8	516.8	546.3	903.7

..and margins are clearly falling in the used games category. However sales are doing ok (on a like for like comparison)

The reason for this is that I suspect Sales for the used game segment will do well for a while due to the hardware upgrading cycle causing lots of new inventory to become available. Unfortunately, for GameStop this will be sold off a lower margin and is likely to get lower still, as games shift to being delivered online. All of which creates a value trap for GameStop, they could be reporting good sales growth but I would keep an eye on used game software margins. I think they are set to fall aggressively.

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.