Best Buy: Beware of Relief Rallies

 | Jan 07, 2014 | 2:00 PM EST  | Comments
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Twenty years in the interbank currency markets around the world taught me many things, some more useful than others. I can curse fluently in multiple languages, I can shrug off big losses and big profits alike, and I can smash a phone handset with one blow -- all useful skills in the world of forex, but of limited use outside it. But some things that I learned have universal relevance.

One has to be suspicious of relief rallies, such as the one in the last few months in Best Buy (BBY). At the start of last year, the stock was languishing below $12 and the vultures were circling. The conventional wisdom was that it was only a matter of time before BBY went the way of Circuit City, beaten into submission by online retailers and the mobile revolution. Then, on March 1, a minor miracle happened: BBY not only declared a profit, but beat expectations. As the year progressed, it continued with beats, including a 166% positive surprise in August, and the stock went on a tear.

Best Buy making money and beating expectations is not unlike seeing a dog walking on its hind legs. As Samuel Johnson put it, "It is not done well; but you are surprised to find it done at all." The same applies to a brick-and-mortar electronics retailer making money in an e-commerce space dominated by Amazon.com (AMZN).

Once the amazement subsides over BBY beating estimates at all, however, one should ask the question, is it doing it well? The answer, I'm afraid, is probably not. After spending all of 2012 with a negative Return On Equity (ROE), Best Buy edged back into positive territory in 2013, and each quarter saw that metric increase to a high of 6.7% in the third quarter, ending Oct. 31. There is no doubt that that number is better than expected, but compared to an average ROE of 18.4% in the hard lines retail sector, it probably doesn't justify a forward price-to-earnings ratio of 16.84, higher than the industry average.

To some extent, the spectacular beats in 2013 were down to lowered expectations, but as disaster has been averted, analysts have begun to adjust forecasts for 2014 upward, making continued positive surprises less likely. In that event, traders and investors are left with a company whose best days are behind it. But it is priced with an assumption of growth in earnings. I know turnarounds happen, but so do false dawns.

Reaction to the third-quarter earnings report was negative despite another beat as traders focused on disappointing same-store sales. That, too, is a worry. Almost all earnings reports contain a mix of positive and negative news if you look hard enough, and what the market chooses to emphasize can say a lot about underlying sentiment. The longs, it seems, are getting nervous.

BBY had a great 2013 as it became evident that reports of the company's demise were exaggerated and that it would survive. This year will most likely be marked by a focus on fundamentals and a realization that, while survival was remarkable, it doesn't mean that all is well. Best Buy has survived and stopped the bleeding, but the market's natural tendency to overreact has left the stock priced for growth in a shrinking industry. It doesn't take a genius to deduce that that is a recipe for underperformance.

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