Best Buy Downgrade Highlights New 2019 and 2020 Concerns, and It’s Not Just Apple

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It was not all that long ago for long-term investors that Best Buy Co., Inc. (NYSE: BBY) was being treated like it was victim to the death march. It turns out that Best Buy figured out how to avoid just being the showroom for, and from 2013 to 2018 its shares rose from almost a low of $10 to over $80. Unfortunately, its slide has resumed and the stock has headed back down to almost $50.

On Monday, Merrill Lynch downgraded Best Buy to Underperform from Neutral and slashed its price objective to $50 from $70. The closing price was $55.37 on Friday, and the shares had traded down to about $52.00 early Monday. This downgrade has ties to Amazon and even to the broader concerns around Apple Inc. (NASDAQ: AAPL), but broader industry issues and valuation concerns also were brought up.

The reason for the downgrade may spook some of the retail climate out there. Merrill Lynch’s Curtis Nagle indicated that Best Buy’s valuation discount is warranted on a continued industry slowdown. The report talks about a continued deceleration in industry growth trends and a continued caution on the key categories of TVs, Apple products and gaming.

Nagle’s downgrade should stand out as a larger than normal one. An Underperform rating is the equivalent of a Sell rating elsewhere. And note that Best Buy was just downgraded from Buy to Neutral in November. Nagle’s report said:

We downgraded Best Buy to Neutral in November on our view that slowing industry growth, tough comparison in key products and cost inflation will make upside less likely. We are turning more negative as we now see a higher possibility that Best Buy may see an outright comp (comparabales) miss in the fourth quarter and we believe Street 2019/20 EPS estimates are too high. We continue to see Best Buy as a very high quality company with an very strong management team but a continued softening in industry trends will make it difficult to grow operating earnings and thus a discount multiple is warranted. We also believe that lower comps will weigh on valuation given a close relationship historically in our view.

The report also mentions several pockets of product headwinds on the horizon. Nagle is cautious on the TVs category, and he noted that this is roughly 25% of Best Buy’s total sales. This had been a very strong category as consumers traded up to larger screens and more expensive screen sizes, but a growing market share of non-premium TVs and increased competition from mass retailers is said to be stifling growth for Best Buy. He even noted that Best Buy lost market share in the second and third quarters.

Gaming is another area of concern, and that is shown to be 8% of sales. Gaming had been a strong business for Best Buy in 2017 and 2018, but now there is a waning hardware cycle and a lapping of strong accessories growth that is expected to drive declines starting in the fourth quarter.

Other analysts have taken down numbers on Apple in recent weeks. Merrill Lynch estimates that 10% of Best Buy sales come from Apple products. Curtis Nagle sees headwinds related to the iPhone, noting that Merrill Lynch’s Wamsi Mohan recently downgraded Apple, and the likely pressure from a new Apple and Amazon partnership.

Merrill Lynch’s investment rationale sums up the quality versus headwinds as follows:

Best Buy has executed one of the best retail turnarounds in many years and is in a significantly stronger competitive position than only a few years ago. After several years of outsized earnings and more recently comp growth, we see risk from slowing industry growth and continued cost pressure. We believe BBY can still grow EPS but at a much slower rate than in years past and EBIT dollars are likely to decline. As such we do not believe a multiple inline with the historic average is warranted.

Best Buy shares traded down at $53.50 shortly after Monday’s opening bell. In fact, the new 52-week low is now $52.07 on Monday morning. Best Buy previously had a 52-week trading range of $55.06 to $84.37 and a consensus analyst target price of $73.79.

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