Best Buy Margin Compression Leads to One Unhappy Conclusion

No one with access to Google Finance could have missed the news from Best Buy Co. last week, news bad enough to leave the stock price down by about 35 percent from its high close last week.

The company said comparable store sales in the U.S. were down in the nine-week holiday selling season about 0.9 percent from the year-earlier period, which wasn't great, but what crushed the stock was talk of a far skinnier gross margin due to aggressive price discounting.

When business people talk about "margins" they usually mean gross margin, the ratio of gross profit to revenue, with gross profit being the money left over from the sale after subtracting just the cost of the product. For a retailer the cost includes what it paid to the supplier for a product as well as some costs for overhead such as freight and warehousing.

The gross profit pot of money is what pays all of the other bills, the sales expense and well as the general and administrative expenses that come from just being in business. In its most recent reported quarter, Best Buy's gross profit dollars came to just less than $2.2 billion, or 23.2 percent of revenue.

The sales, general and administrative expenses came to a little over $2 billion, or about 21.9 percent of revenue.

Based on what Best Buy said last week, analysts in the investment committee now expect Best Buy's gross margin to decline significantly in the company's fourth quarter, which still has a couple of weeks left to go, to about 19 percent.

In a research note, the analyst Aram Rubinson of Wolfe Research pointed out that the gross margin for Best Buy is now in the neighborhood of the gross margin of its principal competitor, Amazon.com.

The higher total sales of the holiday selling season compared to the third quarter should help the sales, general and administrative expenses of Best Buy to be lower as a percentage of revenue than they were in the third quarter, but the fundamental problem here is pretty easy to see.

If the gross profit margin is 20 percent and the sales, general and administrative expenses equal 20 percent of revenue, then that means the operating income line will be zero.

And if the gross profit margin is something that Best Buy has difficulty controlling, with the apparent need to aggressively reduce selling prices to defend market share against Amazon.com and all others, then management's attention has to focus on what it can control. That means ratcheting down the sales, general and administrative expenses.

It has no choice.