Best Buy: The Insurance Company

Yesterday, Best Buy - the symbol for the last 5 years of leveraged American Consumer excess - revealed its true colors.  They eliminated 2008 guidance and said that their high margin businesses have fallen off.  They contend that consumers are not buying the right stuff (Bad, Bad Consumers!!!  Don't you know that Best Buy needs to maintain their margins). 

In college I had a buddy who worked at Best Buy and got us stuff with his employee discount at wholesale (minus markup).  This gave me insight into what types of margins these companies worked with.  The items we got the best deals on were TV's (the bigger the TV, the bigger the discount), digital cameras, and some bigger ticket computer and audio equipment.  We didn't get a big (if any) discount on CD's, video games, and software.  They were essentially making nothing off of these items.  Everything else was somewhere in the middle.

Besides these items, we got a great discount on one other "item" that Best Buy sold - insurance.  We could get an extended warranty on anything for FREE, yes FREE.  This seemed odd, and basically implied that they were making so much money off of these things that their cost to supply them are essentially zero.  Since then I have never bought another extended warranty - EVER. 

Yesterday the company said, "its profit margins fell due to a drop in domestic sales of extended warranties and on increased sales of lower-margin personal computers."   I believe these extended warranties are the reason.  If you think about the useful life of consumer electronic goods, given it is not a lemon, it usually falls off pretty quickly.  Most computers are relatively obsolete in a few years, and so are most iPods, video game systems, car stereos.  Other items such as TV's, and stereo systems have some staying power, but in 3 years, there is usually something better out.  Most well made consumer electronics should not break in the first year, or second year, and in the third year may have some problems - but for the most part unless they are abused they should hold up.  There are also very few products that if they break that quickly someone would WANT another one of those items.  The one item is a $2000 stereo or computer.  Therefore Best Buy's margins for a particular product group came from the actual markup plus warranty.  Since they operate in such a highly competitive marketplace, their earnings are very dependent on selling warranties.  Therefore to grow earnings they need to grow sales from a lot of products that people would want to replace (ie TV's, iPods, video game systems, car stereos), and keep sales of other items steady. 

Best Buy is essentially an insurance company.  To undercut competition they would give away the products and then sell insurance on it at outrageous rates.  Since there are no competitors in consumer electronics insurance, they can get away with it.  Think about the emotion involved with such a purchase.  You have just spent an money on an iPod.  They are ringing you up for an item that you got "cheap" - you can't find it at this price anywhere else.  You have just laid out a significant amount of money - or financed the purchase with money you don't have.  No matter what the probability of the object breaking (last time I checked Apple made quality goods), you don't want to take the chance that this big purchase that you can't wait to use will break and you will have to buy another one.  So you buy a policy to protect this for 3 years. 

Let's look at the math.  The policy on a $350 ipod is $60.  This is 17% of the cost.  If they don't mark up iPods - which they don't really do, then their margins on iPods are 17%*(the % of iPod sales who buy protection).  For a $2300 50 inch plasma TV, the 4 year service policy is $350, approximately 15%.  After looking across most products an policy is about 10% - 20%.  Best Buy's profit margins are small - approximately 4%, so it needs about 25% of its consumers to buy insurance on their products to keep prices low, and maintain margins.  If consumers are starting to become strapped but still want to consume this number will go down.  If they stop buying things that they would want to replace, this number will go down.  No wonder they really pressure you on buying their insurance.

This will be interesting on a few accounts.  One, if they begin raising prices to maintain margins - we will start to see inflation start to possibly creep up in an area it has not - consumer electronics.  If the cost at which they have to import Japanese goods increases, we will also see this phenomenon occur.  Either way, they are between a rock and a hard place.  It has been about 3 years since they really started pushing this and many consumers never used their insurance - they didn't have to and paid way to much to do it.  So, they are not selling as many of these policies nor are they selling as many products.  If they raise prices, they will not sell as much and not as many insurance policies. If they slash prices, they will lose money on their inventory, and still may not sell as many policies.  Therefore, no wonder they did not issue guidance - they have no idea what may happen as they are in the hands of the consumer. 

Comments

[David Merkel]

If you are into warranties, the company to look at is Assurant, who is #1 in the US on warranties by a wide margin, and probably the world leader as well. I don't know if they do the warranties for Best Buy; I think the answer to that is no, but that they did do the warranties for BBY's Canadian subsidiary as late as 2004.

Assurant is one of the best run firms in the insurance industry, and the valuation is modest compared to the ROE.

Disclosure: I own a decent amount of AIZ

[Bond investor]

David and ZeroBeta, I am also long Assurant. AIZ's presentation at a Merrill conference in February '07 had logos of their customers. FutureShop (BBY's Canadian unit) was on the list, as well as CC, RSH, HD, SHLD and CompUSA. I like the extended warranty business, but am more excited about the creditor-placed homeowner's insurance unit.

More on-topic: ZB, I think you should distinguish between the free extended warranties employees get and the warranties that customers pay for. They appear to be buying them in fewer numbers, or with a lower margin for BBY. The key is which cause is more important:

Lower-margin warranties may be made up with higher volumes in the long run.
Fewer warranties sold in general is probably the scarier cause. Customers are buying cheaper goods that last longer, on average, so are more willing to bear replacement-cost risk.

Flat-panel TVs and continued purchasing of "cocooning" technology make BBY a long-term buy, in my opinion.

[Zero Beta]

David and Bond Investor,

Thanks for the comments. I appreciate both your insight. I would not think that Best Buy would go through someone like Assurant. Not that you implied that they did. I used to work in reinsurance in the Cat area structuring deals between insurance and reinsurance companies and the capital markets.
Every now and then, however, we would get a large corporation that would want to try to go straight to the market. After Katrina, most large refiners had to go to the market to buy insurance for their refineries and drillers because their shareholders made them, although it would be cheaper for them to just keep the risk on the books. Shareholders did not want to sit on that fat tail risk. Since Best Buy is essentially the market for consumer electronics risk, and Circuit City as well as some larger names - if times got tough, would they possibly come to a point at which they basically insure themselves and capture whatever profits that Assurant makes off of them? It seems to me someone like Best Buy, Sears, Circuit City, who sell a variety of products from a variety of companies don't have that much risk tied up in one single product - or enough to justify ceding some or all to Assurant. I am not too familiar with the underlying distribution of the risk. Or, do you think in a soft market for this insurance (consumers not buying warranties), a Best Buy wouldn't want to keep this risk at such a low price and just cede it to Assurant? I don't know as much about AIZ as you do but those are my thoughts. Let me know what you think.