Best Buy Stock: Buy The Dip On This Free Cash Flow Machine (NYSE:BBY)

Investment Thesis

Shares of Best Buy (NYSE:BBY) have pulled back sharply over the past year. Electronics demand has fallen further than expected as consumers shift their spending habits. But I still think that Best Buy’s strong balance sheet and cheap valuation make its shares undervalued at the current price.

The Environment Is Deteriorating

The fundamental environment for consumer electronics is deteriorating. The US Census Bureau reported that electronics and appliance store sales declined 5.3% year over year. This is the worst of any reported category. Adjusted sales from the category declined month over month.

Best Buy has been hit quite hard by the highly volatile demand environment. The company expects sales to decline 11% year over year. Management formally withdrew their 2025 guidance targets. They said that they’re seeing evidence of consumers spending less and trading down.

The company reported a 16.6% year over year decline in its computing and smartphone segment. The consumer electronics segment was also hit hard, down 14.7% year over year. Yet there are some signs of resilience. All the company’s segments are still reporting sales above prepandemic levels.

Best Buy’s forward sales and earnings outlook is unclear. Even the company’s own management is having difficulty predicting future results. These results are going to be dependent on the uncertain macro environment. The consumer electronics industry currently has a major surplus of inventory. Best Buy has mostly avoided these headwinds. But these dynamics may fuel an increased promotional environment. We’re already seeing an increase in sales events, such as Amazon (AMZN) introducing a second Prime Day. This could depress margins throughout the category.

Why I Think Best Buy’s Fundamentals Are Still Solid

The fundamental environment is clearly deteriorating. But I think that Best Buy is still a strong company.

I believe that physical stores are a competitive advantage in the consumer electronics space. A physical presence is especially useful in categories without strong brand loyalty. Examples of these products are televisions and appliances. Best Buy has also developed a service component to their business. This and the company’s geographic footprint make up a sustainable moat. This is why brands such as Samsung use Best Buy for repairs and customer support.

The company is also expanding its Best Buy Outlet brand. This segment focuses on open box and refurbished items. This is a segment that online retailers may have more difficulty competing in. It may also let the company benefit from customers trading down. Clearance sales through this segment can recover twice as much cash as alternative channels.

But I think that Best Buy’s strong financial profile is the most compelling part of this investment.

The company has a relatively healthy inventory, down 6% year over year. Right now, many other retailers are dealing with a severe inventory surplus. But looking at raw inventory numbers can be misleading. There are still inventory shortages in some high demand categories. Demand has fallen heavily in other areas. On their last earnings call, management provided some details on their inventory position.

Overall, our inventory is healthy and reflects an evolving mix of product in our network, including more high ASP appliances and larger-screen televisions, which also have longer lead times and a slower inventory turn. While we took more inventory markdowns than last year, the level reflected a normalization to pre-pandemic activity.

Within our inventory numbers, there are categories where we have ample inventory supply and still pockets where we are constrained. In our industry, it’s not as simple as we have inventory or we don’t. It can be incredibly variable by product and even brands within a particular product. For example, we are also still experiencing inventory constraints in key models and brands across computing and gaming… While it is important to manage inventory against current demand, we also want to ensure we are well positioned to react to the ever-changing consumer needs.

Management thinks that the promotional environment is back to normal prepandemic levels. It’s promising that Best Buy isn’t forecasting a drastic increase in markdowns. Even if sales pull back, I think that the company should still generate a decent profit.

The company also has a healthy net debt position. Its balance sheet has $1 billion in long-term debt, only about 5% of its enterprise value. All of their debt is low interest, and none of it matures until 2028. I think this is a healthy financial position. The company is able to survive a pullback and could come out stronger on the other side.

Overall, I believe that Best Buy is well-positioned to ride out the current economic pullback. Its balance sheet is solid, and the company is in a good spot to grow its market share.

Best Buy’s High Dividend And Cheap Valuation

Best Buy is trading at a cheap valuation. Using analyst estimates, the company is trading at a forward P/E of 11 and an EV/EBITDA of 6.8. I think that this inexpensive valuation should cover some of the downside potential. However, Best Buy’s stock has also enjoyed a decent multiple expansion for several years. If this trend reverts, the company could have more downside in the near term. I still think that the company is more stable than the market is predicting.

The business has the ability to return a lot of cash to shareholders. It has a long track record of generating free cash flow well above GAAP net income. Even in the worst quarter since May 2020, the company still generated solid free cash flow. During the last quarter alone, the company generated a 3% free cash flow yield.

Best Buy pays out a steady dividend at a 5.4% yield. It’s unlikely to increase by a lot in the near future. Management said that this year’s payout ratio may fall outside of the target range of 35% to 45%. But the dividend is still well covered by the company’s free cash flow. I think that it may even have room to grow as the environment stabilizes.

Share repurchases are also strong. The company repurchased over a quarter of its shares in the past five years. Management has paused buybacks for the time being. But they’ve shown a willingness to use buybacks to generate high shareholder returns.

Final Verdict

I’m surprised by Best Buy’s robust fundamentals. The company has a solid moat and its balance sheet is very healthy. The cheap valuation should provide some margin of safety.

Due to the high uncertainty, I think there could be further downside. It may not be the right time to buy shares. But with the current free cash flow yield, I think that it makes sense to start a small position.