The anniversary is coming up for an article I wrote on Seeking Alpha on September 2, 2010 entitled “BBY: The Case of the $20 Billion Takeover”. While a lot has changed since then, Best Buy’s (BBY) core business and long term outlook has not. Plus, with the stock haven fallen 20% and the company having bought back 10% of shares outstanding, a deal looks even more compelling now as it would be $5 BN cheaper. Call it: “The Case of the
$20 $15 Billion Takeover”.
I would never recommend buying a stock based solely on takeover potential, but the valuation on Best Buy (BBY) has gotten so low it's worth pointing out that there is significant value for longer term investors, including private equity. I am not alone in this opinion as many analysts I have spoken to and/or read reports from over the past week can’t believe how cheap the stock has gotten (e.g., look for more upgrades soon, but I digress…). Given its low valuation (based on P/E, cash flow, or earnings before interest and taxes- EBITDA), strong brand and cash generating ability, Best Buy looks very attractive.
There haven’t been many buyouts in retail over the last several months, but it has historically been a favorite target for private equity. With valuations very low, balance sheets strong and economic data this week suggesting that a recession is not likely (call it under 25% odds, for argument's sake), we are probably due for some more deals when Wall Street returns from summer vacation. Even with a recession, some companies are so cheap that a buyout makes sense if you can look beyond the current economic cycle. I certainly think that is the case for BBY. As for the size of a deal like BBY, obviously not all private equity shops could handle $15 billion on their own. However, taking on a partner(s), including insiders or an investment firm/hedge fund, makes a deal doable.
Best Buy would be at the top of my shopping list for a retail acquisition. As the largest consumer electronics retailer in the world, Best Buy is the poster boy for consumer discretionary spending and as such has seen its stock decline 48% from its 52 week high on macroeconomic concerns. While there are competitive concerns as well, I believe these would all but be forgotten if it were clear the US economy and CE industry were in full recovery mode.
If someone told you that BBY was trading at 7.5x a year or two ago, you would have thought they meant an EBITDA multiple. Incredibly, that’s the P/E multiple now at its all-time low (6.5x on 2012E earnings!). Best Buy now trades at only 3x TTM EBITDA and 2.7x forecasted 2011 EBITDA. Buyouts in retail over the last year have ranged from 6.8x-8.6x EBITDA, down from 9x-11x EBITDA during 2000-2007.
TTM EBITDA for retail as a whole is arguably depressed now given weak consumer demand. I think that is true for BBY as well. But even assuming flat EBITDA, BBY is cheap enough that a buyer could still make lots of money. A buyer could offer $36-$40, paying a premium of 50%-70% to the current stock price, and still pay only 4.5x-5.0x EBITDA. Some might argue that selling the company at this level understates the long-term prospects for the company. However, I doubt shareholders would out put much of a fuss with this kind of return in today’s market.
So with the price right, the real question is whether EBITDA is sustainable. I think it is more than sustainable and that a buyer could even grow EBITDA substantially over the next few years. I’ve included some ideas in that direction, along with other reasons I think BBY would be a great buy:
- Low risk acquisition - Best Buy is not your fixer-upper. It’s a highly successful company in an industry that is challenging right now, trading at the multiple of a company that won't be around in a few years. A buyer would not need to make aggressive and risky changes to Best Buy's business model to realize the value of its investment. Even if I am wrong and EBITDA were to decline some, multiples are bound to grow over the next few years as growth in the US finally accelerates (all things come to an end, even the great recession). Buying at 4.5x-5x EBITDA and selling/taking public again at 7x-8x EBITDA gives a buyer an awfully nice cushion on earnings.
- Strong brand and a dominant position in consumer electronics - Best Buy has roughly twice the market share of its closest competitor, Wal-Mart (WMT). This is a volatile industry, but over the long term it is one of strong growth averaging in the 5%-6% annually over the last 15 years, by my estimation. While there are concerns about competitive threats from discounters and online retailers, these are not new. In fact, they are same arguments that have been around since I started following the industry a decade ago. Best Buy missed a step this past holiday season, but has been showing improved trends since then.
- Cash and cash generating ability - Best Buy has $6.40 per share in cash ($0.92 net of debt) that an acquirer would have access to and strong free cash flow estimated at $2-$2.5 BN this year ($5.25-$6.60/share) and averaging $1.3 BN over three years.
- Strong management team already in place - Best Buy has a winning corporate culture and deep management team. While not all strategic decisions have worked out as planned, the company has steadily grown its market share, margins and influence in the industry for the last 15 years. This was due in no small part to good stewardship.
- Squeezing profits out of international - Best Buy recently shut down underperforming stores in Turkey and China. It still has profitable chains in China and the UK and a small growth vehicle in Mexico. This is an area a financial buyer might find costs to pare back. This includes the company’s big-box start up venture in the UK. While the long-term benefits of such a venture may be substantial, with the stock trading at 3x EBITDA there is no investment with a higher risk/return than buying back their own stock.
- Moving aggressively to shrink average store size to raise margins - Shrinking packaged media and gaming sales as these businesses shift to digital distribution is a challenge. This doesn’t mean less total revenue, but rather the need to devote more space to other categories such as e-readers, wireless and connected services (i.e., Lightsquared 4G broadband services in 1Q12). However, these businesses require less space. Also, BBYcould reduce its assortment TVs in stores given weaker sales and make better use of the web for slower moving SKUs. Thus, BBY can still grow its revenues while reducing its store size and occupancy costs. The shift out of packaged media and some other categories is an opportunity to drive margins, EPS and ROIC higher. I believe that Best Buy has about 8% of their leases coming up every year in the near term. Given that 51% of its stores are in the 45,000 sq ft or larger format and that these fall disproportionately into the older store category (80% of stores opened the last five years were 30,000 sq. ft. or smaller), the company has a significant ability to transform its store base in a few short years. This could be accelerated if BBY decides to buy out some leases or finds creative ways to sublease (i.e., walling off part of a store to create a space to lease as WMT does). If Best Buy were to reduce its biggest domestic stores by a third over the next several years, this would be a reduction of 10.5 million square feet, or about $950 mm in rent. Assuming the new category sales can replace the old and that labor and other costs remain the same, this action could boost domestic operating margins by 225 bps and raise BBY's EPS by about 50%. This number does not take into account shrinking some smaller stores in mid-sized markets, as well as the potential for shrinking some big box stores in Canada.
- Taking the fight to Amazon on its home turf - Best Buy only gets 5% of its sales from online sites versus 10%-15% for many other retail channels. The company is moving to address this in a few ways. First, BBY is expanding its online assortment with SKUs that it won't carry in stores. BBY has the number one brand in CE and its site attracts high traffic, but shoppers sometimes go elsewhere as they can’t find what they want. There is no reason Best Buy can't carry virtually all major SKUs online. As these products wont be in stores, Best Buy can be as sharp as its competition on pricing.
An expanded online assortment also plays well with more opportunistic end-of-cycle inventory buys. Historically when BBY purchased inventory, it had to be in lots large enough to accommodate its 1,000+ stores. However, if it is selling something online only, BBY can now make special purchases at attractive prices that the company can essentially blow out online at a low price and still make its margin. Some retailers built their business on this, but that business moved online now. For Best Buy, it's another part of the market it doesn’t operate in now.
Best Buy is also launching an online marketplace this fall that will allow vendors and other retailers to sell on BBY.com. Vendors and retailers get to take advantage of BBY's significant website traffic and I expect third party sellers recently dropped by Amazon over tax issues will flock to BBY’s site.
Finally, the playing field is being leveled. As I discussed here, many "Amazon Bills" are being proposed. Driven by the need to increase revenues, states are passing laws to force Amazon (AMZN) and other online retailers with warehouses or affiliates in the states to begin collecting the taxes that consumers were supposed to be paying to the states anyway. A number of states have taken up this issue and now has been taken up by the US Congress. Assistant Senate Majority Leader Dick Durbin recently introduced the Main Street Fairness Act bill, which would set up a framework for online retailers to collect state taxes no matter where the online retailer is located. Given states' dire need for revenue, this bill should have substantial momentum.
In addition to these points, recent concerns about Europe and June sales are misplaced as I discussed here. The latter seems particularly relevant given July sales seem to be trending stronger again, as I discussed here, and comparisons will be easier for BBY in August after a weak back-to-school season last year.
I believe Best Buy is a compelling investment all on its own at the current price. The idea that the stock should make private equity investors drool is just some additional enticement.