Best Buy Can't Afford a Holiday-Season Victory

Best Buy Can't Afford a Holiday-Season Victory

Best Buy shares plunged more than 10% on Tuesday after the company warned that the competitive retail environment could impact profits in the critical holiday quarter.

Best Buy's management team believes it is essential to be price-competitive with other major retailers like Wal-Mart and Target . However, Best Buy differs from these companies in that it earns the majority of its annual profit during the holiday season. Additionally, consumer electronics is Best Buy's main business, but a small part of the mix at Wal-Mart and Target, and is often used as a loss leader for those companies.

Best Buy's drive to "win" the holiday season could end in a Pyrrhic victory. An all-out consumer electronics price war will hurt Best Buy a lot more than it will hurt Wal-Mart or Target. Best Buy may be able to improve upon its recent sales trends, but only by taking a big hit to the bottom line.

Desperate for business
Wal-Mart has become increasingly desperate to drive store traffic recently, as comparable-store sales have declined every quarter this year. Its "Black Friday" doorbusters (which will actually be available beginning at 6 p.m. on Thanksgiving) include a $98 LCD TV, and a $100 gift card with the purchase of a first-generation iPad mini.

Most important, Wal-Mart is providing a "1-Hour In-Stock Guarantee" on these doorbusters: If you are in the store by 7 p.m. and request one, Wal-Mart is guaranteeing that you will get that item. If the store runs out of stock on that day, customers will be able to buy a guarantee card that reserves the item for pickup before Christmas. This stands in stark contrast to typical Black Friday limited-quantity doorbusters.

Despite carrying low margins for retailers, Apple products are seeing heavy promotion this year. Aside from Wal-Mart's iPad mini offer, Wal-Mart and Target are providing gift cards with iPhone purchases. Target is also offering $20 off the iPad Air and a $100 gift card.

So far, Best Buy's Black Friday deals don't seem quite as impressive as anything Wal-Mart and Target have rolled out -- although Best Buy is offering $100 off the older iPad 2 and some pretty good TV deals. However, Best Buy is holding back some "mystery" deals until Thanksgiving Day, presumably to avoid being preempted by competitors.

Based on comments made by Best Buy CEO Hubert Joly on the company's conference call yesterday, these "mystery" deals could be very competitive. Best Buy is committed to being a low-price leader during the holiday season. Given the lengths to which Wal-Mart and Target seem willing to go to drive customer traffic, this could put significant pressure on Best Buy's gross margin.

Disproportionate effect
Heavy price competition in consumer electronics during the holiday season will hurt everybody from a gross margin perspective. However, Best Buy is likely to feel a disproportionate impact.

Wal-Mart executives have stated bluntly that they are using consumer electronics products as Black Friday loss leaders that will drive traffic into the stores. The company can then -- hopefully -- make up for those losses through higher sales in other categories. Target's strategy is similar. However, Best Buy doesn't have the same general merchandise offerings as either one of those competitors.

Additionally, analysts estimate that Best Buy will earn more than two-thirds of its annual profit during the fourth quarter. By contrast, while that period is also the most profitable quarter for Wal-Mart and Target, it represents well under half of the annual profit for both companies.

While a consumer electronics price war would depress gross margin for all three companies, Best Buy would be by far the worst off.

Best Buy loses by winning
Simply put, Best Buy makes most of its money by selling consumer electronics for the holiday season. By contrast, most of its major competitors have more balanced profitability across the calendar year and across different categories.

The holiday season is shaping up to be highly competitive this year, especially in consumer electronics. This is bad news for Best Buy, because a significant drop in gross margin would have a disproportionate effect on its full-year profitability. Even if Best Buy wins in market share this holiday season, it's likely to lose in terms of profit.

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Fool contributor Adam Levine-Weinberg owns shares of Apple and is long January 2015 $390 calls on Apple. The Motley Fool recommends and owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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