Best Buy (BBY) is having some issues. Some consider this an understatement. The purpose of this article is to highlight different aspects that I believe are significant in understanding the firm and determining the value of its stock. Rather than look at a qualitative view based on anecdotes of poor customer service or comparing it to Amazon, this piece focuses solely on Best Buy and its most recent 10-K and proxy statement. Certain spreadsheet programs created by Professor Aswath Damodaran from NYU's Stern Business School were used and are referenced throughout this article.
1. The debt is a lie. The biggest issue with analyzing Best Buy's finances is in its off balance sheet section, more specifically in its operating lease obligations. The firm contains roughly $7.5 billion in lease obligations, not including "real estate taxes and common area maintenance", which create another $2.1 billion in obligations, totaling at $9.6 billion. Leasing is no different from one renting a townhouse, and it is a contractual obligation to pay this amount within the predetermined time span. Therefore, lease obligations should be thought of as debt and reclassified as such.
To properly reclassify these items, the balance sheet and income statement must be altered, while the cash flow statement is technically unaffected. First, the present value of the lease obligations needs to be calculated. In calculating the present value, the $2.1 billion was spread out evenly over 7 years, increasing each year by $300 million, while the other future payment numbers were unchanged. In total, the present value was calculated to be $7.7 billion in debt, assuming a cost of debt of 6%.
Based on this value, the income statement is adjusted, created an operating income of $2.4 billion, compared to an initial operating income of $2.3 billion. Both incomes do not include the goodwill impairment charge of $1.2 billion. Finally, an adjusted return on capital is required to see the effects of this increase in debt. Return on capital is equal to operating income minus taxes divided by the book value of equity and debt. The adjusted ROC came out to be 17.4%, compared to its unadjusted ROC of 37.6%. Details of steps involved in reclassifying debt can be found in this research paper and this spreadsheet program. (The cost of capital will also decrease when this new debt is added to the balance sheet.)
One very important side note needs to be made about this change in debt level. Most firms in the retail and restaurant sectors have large amounts of operating leases because it makes more sense to lease than to own every property in these sectors. For another good example of lease obligations masking true return on capital, see Starbucks (SBUX) in the early 2000s.
2. Silk suits, new ties. George Mikan has replaced Brian Dunn as interim CEO. Based on his description in the most recent 10-K, Mikan has spent most of his career as an accountant or finance-based executive. This implies Mikan will likely be managing the finances first and the marketing and brand second. Also, founder and Chairman Richard Schulze is stepping down and appointing Hatim Tyabji as the new Chairman, while retaining his stake in the firm. Schulze will likely retain influence on corporate decisions, but in a more indirect manner.
3. Blinded by the one-time charges. In the last quarter, BBY had two significant expenses that caused their fiscal year earnings to be negative. The first was a goodwill impairment expense of about $1.2 billion, the other was a payment was Carphone Warehouse Group plc for buyout out the remaining stake in a profit sharing agreement, resulting in an expense of about $1.3 billion.
Regarding the goodwill impairment, there are two important notes to make. First, this is a non-cash charge, i.e. no cash has left the firm and therefore is not a cash flow issue. This will significantly increase the free cash flow to the firm. Also, the operating income appears quite normal when the charge is added back, coming out to be about $2.3 billion compared to $2.4 billion for both fiscal years 2011 and 2010.
For the profit sharing agreement, this was the cause of BBY's negative earnings. However, BBY has paid $1.3 billion in order to end the agreement, making it likely that this will increase their profits in the near future, assuming the segment is profitable. Another peculiar detail with this transaction is the accounting used to report it. Best Buy essentially paid for the present value of the future profits of the segment, making this akin to buying an entire business.
This poses the important question whether this transaction should be thought of as a settlement or as a business acquisition. If it's the latter, this transaction should go under investment activities rather than financing activates in its cash flow statement, and its expense would then be amortized throughout the coming years. This train of thought is not to imply there are accounting shenanigans going on, rather this is an argument on how to think of these types of business activities and how they can influence an investor's perception of the business operations and overall health.
4. A Simple Valuation. The following is a highly conservative valuation of the equity of Best Buy. A single free cash flow value will be used. This value is calculated at about $1 billion. The formula used is:
Free cash flow= net income+ non-cash charges (depreciation, amortization, and goodwill impairment charges)+ one time charges (e.g. the profit sharing agreement mentioned earlier) - capital expenditures-average increase in working capital (in this case, over the last 5 fiscal years)
The resulting free cash flow is the average free cash flow for the last 5 fiscal years.
The goal is to estimate how equity investors would make under normal business operations. For the discount rate, this was calculated based on the current risk-free rate of 1.7% and an equity risk premium of 12% (this is not based on any given formula), giving a discount rate of 13.7%. Based on these numbers, the equity of BBY is calculated at about $7.3 billion, slightly above the current market cap of $6.8 billion.
Value of equity= Free cash flow/Discount rate= $1 billion/0.117= $8.5 billion
There is one important factor that this valuation ignores: the possibility the firm will go bankrupt. Typically, when there is a legitimate probability of the stock price going to $0, one can factor into their valuation by adding the probability of the valuation with the probability of insolvency. For this case, assuming the probability of bankruptcy of 20%, the resulting value of the equity is (0.8)*7.3+(0.2)*0= $5.8 billion.
In the end, I personally would not consider purchasing Best Buy stock regardless of price. However, that is only because of my overtly conservative nature, as I simply don't like debt. Regardless of my opinion, any stock is worth purchasing regardless of business prospects at a low enough price, and Best Buy is no different.
Source for SEC filings is here.