2HRS2GO: Best Buy hits the expectations wall

Best Buy Co. Inc. (NYSE: BBY) has finally been caught by expectations.

Plenty of observers (including me, which should be reason enough for skepticism) have lauded the electronics retailer for its performance, which included stronger-than-expected growth for the last several quarters. Unfortunately, that streak ended last Thursday when Best Buy announced second quarter results slightly less than analysts predicted.

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Not that things are bad in an absolute sense. Most physical store retailers would be pleased with Best Buy's same store sales increase of 11 percent year-over-year. But since the stock market is a relative world, Best Buy suffers when compared to the analyst forecasts of growth near the mid-teens.

The suffering can be compounded when you make an analyst look bad. Just three days prior to Best Buy's announcement, Salomon Smith Barney's David Strasser actually increased his estimates. Strasser expected Best Buy to post overall growth as much as 15 percent for stores open at least a year.

His reaction to the disappoinment isn't surprising. Strasser today cut Best Buy to "neutral" from a "buy" rating.

"We believe that the company will continue to produce quality sales and earnings growth," Strasser writes in today's research note. "Just not enough to justify current valuation levels."

Even after last week's rout, Best Buy was trading at 39 times Strasser's earnings estimates for fiscal 2000 and 32 times 2001 forecasts. Today's downgrade may have helped alleviate the situation a bit -- Best Buy shares were down more than 5 percent in early afternoon trading.

Strasser notes a few concerns:

• Competition. The holiday season will see discount stores, office supply shops and other electronics specialty retailers pushing hard to sell digital products. Gateway has jumped on the sub-$700 PC wagon, which will push prices down further, as well as the ISP rebate phenomenon. "We do not believe that any one of these competitors with the exception of Wal-Mart could have a large impact on the company, but all of them combined could adversely impact ... relative to expectations."
• Tough year-over-year comparisons. Best Buy boosted same store sales 13 percent in last year's third quarter, and 17 percent in the fourth quarter. "Success for the past two holiday seasons could make this holiday season difficult to attain double digit comps, a necessity ... to justify current valuations."
• Less advertising from DVD producers. Last year Time Warner and Circuit City waged the Divx/DVD war. Divx is gone, Time Warner won't feel compelled to carry out as much of a media blitz any more, so this year's sales may not be as robust.
• Margin improvement. Best Buy has done an amazing job of becoming more efficient in the last few years, with gross margins of 18.8 percent now expected for fiscal 2000, compared to 13.5 percent three years earlier. But the company recently told analysts that about two-thirds of margin enhancement moves have been completed, meaning there's not as much room for growth in that area. And price pressures are just going to get worse as e-tailers and large discounters continue to move into the electronics market.

The Salomon analyst also worries Best Buy will have a harder time boosting sales of its high margin service plans. And as with all retailing stocks, investors might be sensitive to interest rate hikes, declines in consumer confidence indices and other macroeconomic events.

Best Buy remains one of the stronger members of its group. Its comparable store sales growth continues to outpace rivals such as Circuit City, which recently reported 6 percent year-over-year improvement in that category. And Best Buy looks like a the 50-karat diamond compared to a coal lump like CompUSA.

But Circuit City and Tandy Corp. -- for which Strasser maintains "buy" ratings -- trade at lower levels, while Best Buy until recently was screaming higher. Judging by the last few sessions, Best Buy investors are starting to adjust.

Other issues:

Red Hat Inc.

(Nasdaq: RHAT) Speaking of overvalued stocks, Red Hat is shooting higher today. But the end of the SEC-required quiet period doesn't change the story, which involves a company with an intriguing model, strong grassroots interest, growing momentum among OEMs such as Gateway -- and a market exceeding $6.4 billion as traders continue to play with the stock. Investors would do well to stay away until hype fades and wait for the impression of reality, which says that the Linux market remains wide open. In fact, given the structure of the Linux community, you have to wonder if there will ever be one dominant consolidator of the field.

V-One Corp.

(Nasdaq: VONE) Another beneficiary of Linux, as the stock climbs today after announcing a VPN security product for Linux systems. Linux is seeing some momentum in the corporate sector, but it's still a long way away; in the meantime, traders are playing with this one too, just as they did recently with Corel, Applix and others. Those stocks deflated quickly, so don't be surprised if this one does too.

Market indices drifted in mildly positive or slightly negative territory today. With two hours left in regular trading, the Nasdaq Composite Index was up 12.58 to 2855.69, the S&P 500 down 0.39 to 1356.85, and the Dow Jones Industrial Average lower by 10.76 to 11067.69. 22GO>