How This Retailer Actually Makes Money

Best Buy makes more than half of its profits from selling extended warranties, based on company data and my estimates. If you've been in a store recently, that might not surprise you. This dependence on warranty profits suggests that Best Buy's business model might not be sustainable over the long term.

Let's take a closer look.

Would you like a warranty for that?
Ever wonder why the friendly blue-shirts at Best Buy push extended warranties so hard? It's become a huge profit stream for the company -- potentially even more lucrative than the actual business of selling electronics and appliances. If you check out the footnotes on Best Buy's most recent 10-K (page 74, if you're looking), you'll see that the company's "revenues earned from the sale of extended warranties represented 2.8%, 2.7%, and 2.6% of revenue in fiscal 2013 (11-month), 2012, and 2011, respectively." That might not seem like a lot, but the margins on extended warranties are very high. Best Buy doesn't disclose its profitability on warranties, but they are estimated to be 50% or higher. In the past year, Best Buy had revenues of $48 billion and operating profits of $1.2 billion. If you assume that 2.8% of revenue came from warranties with a 50% operating margin, then that's approximately $670 million in operating profit. In other words, more than half of operating profits came from warranties.

So what's the problem? Warranties are just smart business.
The money spends the same, regardless of how the company generated it. Lots of respected retailers make money outside their core operations of selling merchandise. Costco generates most of its profits from membership fees. CarMax generates a good chunk of its profits from financing and service plans. New-car dealers such as Penske Automotive Group depend on parts and service, not the sale of new cars, for profitability. Savvy gas-station operators such as Wawa and Sheetz make most of their profits on convenience store sales, not gasoline sales. The clever operators in retail look for creative new ways to make money, beyond just selling goods.

It might not be sustainable, and it's unfair to customers
While others might not penalize Best Buy for being largely dependent on warranty sales, it does bother me. It's another indication that Best Buy's core business isn't viable -- I'm not sure Best Buy would even exist without the profit stream from warranties. Second, it's my opinion that extended warranties aren't worth the cost (Consumer Reports agrees), and I'm skeptical of a long-term business model that depends on such a consumer-unfriendly tactic.

Foolish bottom line
Obviously, you can decide for yourself whether Best Buy's dependence on warranty profits matters. I don't like the idea of investing in a showroom for warranties. It doesn't seem like a sustainable business model over the long-term.

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The article How This Retailer Actually Makes Money originally appeared on Fool.com.

Brendan Mathews owns shares of CarMax and is short shares of Best Buy. The Motley Fool recommends CarMax and Costco Wholesale and owns shares of Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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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