Best Buy (BBY) is the largest U.S. retailer of consumer electronics, with roughly 19% of the domestic and 5% of the global market. In addition to over 1,000 "big box" Best Buy locations in the U.S., the company also has over 400 smaller Best Buy Mobile locations that sell cell phones and other mobile devices. Internationally, Best Buy has about 2,400 smaller locations in Europe, 300 locations in Canada (including the Future Shop brand), and 200 stores in China (mainly the Five Star brand). Best Buy's product categories are: consumer electronics (TVs, digital cameras, etc. - about 31% of sales), computing and mobile phones (laptops, desktops, smartphones, tablets, etc. - 46%), entertainment (gaming consoles, video games, movies and music - 8%), appliances (about 8%), and services (7%).
Once a fast-growing and highly praised retailer, Best Buy has fallen on hard times. Consumer electronics has been one of the fastest growing segments of the U.S. retail market. While this seems like a tailwind, the reality is that it has attracted a lot of competition. General retailers like Wal-Mart (WMT) and Costco (COST) expanded their electronics offerings and have pushed aggressive discounts to drive store traffic.
But the bigger blow has been the trend towards buying electronics and entertainment online. During the "Black Friday" weekend this year, consumer electronics were the 4th fastest growing online product category, up 17% from last year. Right behind it was video game consoles, up 16%. The #1 grower, digital content and subscriptions (up 25%), also hurts Best Buy as it represents people purchasing digitally-delivered movies, music, and video games, instead of the physical Blu-ray and game console disks sold in Best Buy's stores. In fact, digital format entertainment increased to 31% of category spend last year, up from 20% in 2009, and is forecast to add another several percentage points in 2012. Simply put, trends are moving quickly away from Best Buy's business model.
These trends are plainly visible in the results. Last quarter, Best Buy reported an 18% drop in entertainment sales, along with a 10% drop in consumer electronics. Overall, the company reported yet another 4% decline in same-store sales, and without taking out any costs, operating profit declined to a minuscule 0.4% of sales, compared to the company's historical 4.5-5% margin.
There are two things to consider when analyzing Best Buy as a potential Magic Formula (MFI) investment. One, what is Best Buy worth as an ongoing company? And two, can and will founder Richard Schultze make good on his offer to take the company private, and if so, what is a likely buyout timing and price?
Let's tackle the first question. I'm not so worried about the general retailers. In fact, Wal-Mart has already begun to reduce electronics space. Online sales, though, are a bigger concern. To combat these, Best Buy has outlined several initiatives, including a 10% reduction in store footage, an increased focus on mobile devices and salesman knowledge, $400 million in SG&A cost reductions, and capturing more of e-commerce spend. The last one is particularly important. Best Buy is already the world's 11th largest online retailer, and has some advantages with special financing offers and in-store pickup.
I believe the company is focusing on the right things and can eventually (over a few years) right the ship on margins. However, entertainment is a lost cause here - the company cannot compete with Netflix (NFLX), or Amazon (AMZN), or Apple (AAPL) in this space. Overall, I see about an 8% annualized decline in operating income over the next 5 years. This, combined with already-suspended share buybacks and a likely-to-be suspended dividend, makes the ongoing value of the stock about $15, in my opinion.
Now, what about founder Richard Schultze's ongoing takeover saga? Schulze already owns about 20% of the company, and in August agreed with the company to present a takeover bid expected to be worth $24-26 per share. It was extended once, and then extended again last Friday. Just a day before, reports emerged that Schulze was prepared to bid $15-18! Now, it is unlikely that any activity on the bid will come before late February.
So, what is going on here? Schulze clearly doesn't need more time for due diligence - he founded Best Buy in 1966, was its CEO until 2002, and sat as chairman until stepping down in June of this year. It seems to me that one of two things are delaying this bid. One is that his financial backers - reportedly TPG Capital, Leonard Green & Partners, and Cerberus Capital - are getting cold feet considering the firm's poor recent performance. The other is that those partners may want to wait for an even better price if fourth quarter results are similarly poor. After all, the expected takeover bid has already been trimmed nearly in half since August!
Frankly, I'm worried that it is more of the former than the latter. For one, I think Best Buy is likely nearing its operational nadir. The year 2012 was filled with management and board turmoil, which probably slowed down operational action to improve results. With things calming down and turnaround specialist Hubert Joly now in charge, I think the numbers should start stabilizing. It may have been in the best interests of the private equity to firms to strike while the stock is cheap.
Given this, I'm more inclined to go with $15 as a reasonable valuation for Best Buy. While that represents a decent 30% upside, I'm not real enthusiastic about it being one of the best MFI picks at present, given the risks. We'll slap a tentative "positive" outlook on the stock, but it is not Top Buy material.