Benefits of a Best Buy - RadioShack Merger Would Be Tremendous

Includes: BBY, GME, RSH
by: Clumsy Rick, CFA

Seems like every time retail sells off, you hear about Best Buy (NYSE:BBY) being interested in buying some retailer. Best Buy needs to buy RadioShack (NYSE:RSH), I mean buy GameStop (NYSE:GME), I mean Musicland. While the last one of these companies dates me, it is also a reminder that not all of Best Buy's acquisitions have turned out as planned. However, the relative success of the Carphone Warehouse deal and now Best Buy Mobile stores, at least show that Best Buy can operate a small box format successfully, something that had eluded the company previously.

To be clear upfront, I don't think Best Buy NEEDS to buy any company. With the exception of international expansion where local expertise around culture and well-established brands can be invaluable to a retailer, "greenfielding" a store concept generally seems to make more sense than buying. Best Buy has a much stronger hand with landlords today then it did a few years ago and there is something to be said for steady square footage growth versus swallowing a concept whole. Having said this, would an acquisition of RadioShack make sound financial sense?

If private equity can make money on retailer acquisitions in this market, one would think a strategic buyer could do even better. In fact, I'm not so sure that Best Buy themselves aren't a good target for PE firms, as I wrote about in early September (The Case for a $20 Billion Retail Takeover). With RSH trading at 3.8x EBITDA, I think the idea of a BBY/RSH merger is at least worthy of consideration.

Upon acquiring RadioShack, Best Buy would have the option to either re-brand the stores under the Best Buy Mobile brand or leave them "RadioShack" and run with two small format store brands similar to its approach when Best Buy acquired Future Shop in Canada. I suspect the latter makes more financial sense even after RadioShack spent millions in advertising recently to re-brand itself "the Shack", but can see arguments in favor of both.

The benefits of a merger with Best Buy for RadioShack stores would be tremendous:

1) Better buying power: This would be particularly true with wireless handsets, where the combined entity would be the largest US buyer of mobile phones, controlling an estimated 15%-20% of retail distribution. This leverage would work both ways (both BB stores and RSH stores would benefit). Additionally, RadioShack would benefit from a significant increase in its buying power in consumer electronics and home office categories, including mobile computing.

2) Better negotiating power with wireless service providers: The combined entity would be a very powerful force in wireless distribution and likely continue to gain share from smaller one-service outlets. BBY/RSH would have a significantly better negotiating position with carriers.

3) Verizon back at Shack: The entire wireless service provider offerings would likely undergo contractual negotiations at RadioShack and perhaps BBY. Given the importance of the combined entity and Best Buy's relationship with Verizon (NYSE:VZ), it would appear highly likely Best Buy would bring in Verizon particularly if it were to re-brand RadioShack stores to Best Buy Mobile. This would be an important factor if the iPhone launches on Verizon's network at some point (rumored to be 1Q11).

4) Access to more exclusive offerings and hot products: Best Buy uses its leverage to get many exclusive product offerings in wireless handsets and other product categories, such as the Nexus phone it is now offering. Best Buy is also able to get a good supply of hot products early in their introduction versus RadioShack which has historically been far behind the curve. Current examples of this include the iPad and a full selection of eBook readers and a good historical example would be the iPhone. Best Buy's relationship with Apple (NASDAQ:AAPL) would certainly help RadioShack in this area (again, assuming a re-branding to BB Mobile), although would be no guarantee. Best Buy's ability to get product from other vendors would greatly enhance RadioShack.

5) Re-merchandising RadioShack: Re-branding would allow Best Buy to take a new approach with RadioShack's merchandising that could be as subtle as placing more emphasis on certain categories over others (i.e., mobile computing over traditional consumer electronics), introducing new categories (i.e., used games) or as radical as a complete restructuring of the concept (i.e., selling mobile and games only). The beauty of RadioShack is that it is highly profitable as it stands and Best Buy could take its time experimenting across 5,000 stores to figure out what works best.

6) Short term lease flexibility: the vast majority of RSH stores are leased for five year terms with options to renew. Even its corporate headquarters is well positioned to be exited in short notice. While the vast number of store leases coming up each year is allowing RSH to renegotiate better terms in a softer rental market, it would also be very helpful to BBY as it would need to relocate or close some stores.

7) International expansion: RSH already has a presence in Mexico with over 200 stores which would help jump start BB Mobile's efforts. Best Buy could also leverage its international experience to eventually expand a small box format in other international markets, including China.

8) Reduced competition: This would be a stretch in any category EXCEPT wireless, where BB Mobile are direct competitors now with stores in the same vicinity and competing advertisements.

9) Improved internet and mobile access: Best Buy owns and operates its own websites while RadioShack uses a third party. BBY's website is, in my opinion, a vastly superior experience to RSH's as well. RSH could leverage BBY's technology investments for it internet capabilities, as well as mobile commerce initiatives.

10) Corporate cost savings: Last, but certainly an important part of any buyout equation is cost savings. Getting rid of the board of directors, certain duplicate professional fees and the most senior management would save about $10 million in expenses alone (20 bps of margin). Clearly there would be lots of other duplicate corporate employees (estimating 2,000 employees at corp.) that could be reduced. Additionally, there would be consolidation in repair facilities, buying and importing and other operations. In total, I would roughly estimate total net savings to RSH at at least $75-$100 million (1.7%-2.25% of sales), or $0.40-$0.53 per share (22%-29% accretion) before one-time charges for severance. For comparison purposes, RSH saved $30 million annually when it reduced corporate headcount by 280 positions a couple years back.

Calculating the Deal
Assuming BBY paid $26/share (40% premium from today's price), the total payout to shareholders of RSH would be $3 BN. BBY should end the year with about $2 BN in cash, even after paying down some short term debt. I'll assume BBY has $1.5 BN in cash it can use. Assuming the $330 mm in long term debt RSH, RSH's pays off its short term debt with cash on hand, this would still leave about $350 million in cash BBY could use towards the shareholder payout. Thus, BBY would have to raise $1.15 BN to complete the deal, which I assume it can do at 9% (high yield debt spreads just hit a three year low at 540 bps). Best Buy could also pay part of the cost in stock, but frankly that would be less attractive given how low the valuation currently is.

So what could BBY earn on this $3 BN investment? A relatively conservative assumption would be that BBY simply holds RSH sales and margins flat and there are no synergies. Under in this scenario, BBY's ROIC for the deal works out to about 13%. Not bad and almost certainly above the company's cost of capital, but still below the 15% investment hurdle many company's have. However, if I assume 2% in corporate cost savings, the ROIC goes up to 16%.

This second scenario is probably more realistic than the first and shows that a deal that meets a 15% return thresholds is likely without the multitude of other benefits possible. However, the real decision in my opinion would likely come down to how BBY quantifies all the other benefits I discussed and what are the alternatives uses for its capital.

So my conclusions are that (a) RSH has some real value, both for BBY or a financial buyer, (b) RSH's low price today means there is likely a price/premium that makes sense for both RSH and BBY shareholders and (c) the trigger point for BBY would depend more on its synergy and revenue growth assumptions, as well as its alternative uses of capital right now. I own (and would buy) both RSH and BBY, but on the fundamentals first and foremost, with buyout potential only a side benefit.

Disclosure: I am long RSH, BBY, GME, AAPL.