A Strong Investor Day Underscores That Best Buy Stock Is Undervalued

Best Buy stock should trade above $80, not below $70

From 2012 to 2017, Best Buy (NYSE:BBY) was busy staging one of the biggest turnarounds the retail world has ever seen, with Best Buy stock moving from the low $20s to the high $60s.

A Strong Investor Day Underscores That Best Buy Stock Is Undervalued
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The consumer electronics (CE) retailer, which was being pressured by eCommerce competition and a wave of bankruptcies across the CE sector, focused on creating a multi-channel retail strategy, improving its direct operations, and pulling costs out of the system.

Those initiatives worked wonders. Best Buy went from struggling CE retailer with declining sales, margins, and profits, to a thriving CE retailer with rising sales, margins, and profits.

This big rally in BBY stock has run into some friction over the past 22 months. The company’s revenue growth momentum has slowed. Margins have started to flatten out. There have been some macroeconomic growth concerns, as well as multiple geopolitical risks. Valuation risks have also factored in, as BBY stock is no longer as cheap as it once was.

Net-net, Best Buy stock has rallied and dropped plenty over the past 22 months, but at the end of the day, has a net gain of essentially zero since January 2018.

The big questions now – will Best Buy stay stuck in neutral? Or will it get back to rally mode soon?

I think the latter. Best Buy just hosted an Investor Day, wherein the company outlined an aggressive yet very achievable multi-year growth strategy.

That growth strategy ultimately makes Best Buy stock look dramatically undervalued at current levels. Management will begin to execute against this growth strategy over the next few quarters. As they do, investors will increasingly adopt a long-term constructive stance on Best Buy, and shares will move higher.

Best Buy’s Impressive Investor Day

Best Buy hosted an Investor Day meeting in late September, and it was very impressive.

Long story short, management gave aggressive five-year financial targets that were well above Street estimates. Management expects revenue to hit $50 billion by FY25, representing a 2.9% compounded annual growth rate. Street consensus estimates call or 1-2% revenue growth in each of the next few years.

At the same time, management expects operating margins to expand from 4.6% today, to 5% by FY25, when Street estimates are calling for flat margins over the next few years.

In a nutshell, then, management told the Street they are dead wrong about Best Buy. This isn’t a 1-2% growth company with flat margins. It’s a 3% growth company with upside margin drivers.

Who is right here? The Street or Best Buy management? I’m inclined to say management.

First, it’s worth mentioning that management has a strong track record. Back in 2017, they gave what the Street perceived then as aggressive FY21 revenue and margin targets. Best Buy has already hit those targets, and it’s only FY19.

Second, the fundamentals support an optimistic outlook. The CE sector is a stable growth industry with secular demand drivers from the IoT, AI, and AR/VR markets. Innovation in those markets is ramping.

Think cloud gaming, streaming players, 8K TVs, 5G smartphones, smart appliances, connected health products, etc. Broadly, the CE sector projects as a healthy growth industry over the next several years.

In that healthy growth industry, Best Buy is king. That won’t change anytime soon. This company is doing everything right from a customer experience and convenience standpoint to widen its moat, fend off competitors, and keep customers in its ecosystem.

Consequently, as goes the secular growth CE industry over the next few years, so will go Best Buy. Margins will ramp higher, too, because management is pulling $1 billion in costs out of the system by FY25.

Big picture – Best Buy does reasonably project as a healthy growth company over the next few years, with upside margin drivers.

Best Buy Stock Is Undervalued

If Best Buy does grow revenues at a 3% clip over the next five years and expands operating margins by 40 basis points, then Best Buy is dramatically undervalued at current levels.

Here’s the math. Revenues hit $50 billion by FY25. Operating margins rise to 5%. That pegs FY25 operating profits at $2.5 billion. Pull out about $100 million for interest expense. Take out 24% for taxes. You’re left with about $1.8 billion in net profits. Buybacks will continue over that stretch, and the diluted share count will likely measure around 215 million by then.

Thus, assuming management hits its FY25 targets, Best Buy could report about $8.50 in EPS by FY25. Historically speaking, Best Buy normally trades around 13- to 14-times forward earnings. Taking the midpoint of that range (13.5) and applying it to $8.50 in FY25 EPS, we arrive at an FY24 price target for Best Buy of about $115.

Discounted back by 7% per year (3 points below 10% to account for the yield), that equates to a FY19 price target of over $85. Best Buy trades below $70 today.

Bottom Line on BBY Stock

Best Buy is dramatically undervalued below $70. This undervaluation is a result of the Street thinking this is a 1-2% growth company with flat margins. It’s not.

As management emphasized at Investor Day, thanks to secular growth tailwinds in the CE industry and continued cost gouging at the company, Best Buy is a 3% growth company with upside margin drivers.

In that world, Best Buy stock should trade above $80 today, not below $70. This disconnect won’t last forever. Over the next few quarters, management will execute against its multi-year growth targets and increasingly convince the Street (and investors) that this is a growing company with expanding margins.

The more investors are convinced of this, the higher BBY stock will go.

As of this writing, Luke Lango was long BBY.

Article printed from InvestorPlace Media, https://investorplace.com/2019/10/strong-investor-day-best-buy-stock-undervalued/.

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