The Case Against A Buy Out For Best Buy

| About: Best Buy (BBY)

On June 8, 2012, Mr. Richard Schulze announced that he had made the decision to resign as chairman and director of Best Buy (NYSE:BBY). This announcement made headlines because the company had previously announced a different timetable for Mr. Schulze's departure. Speculations regarding the Best Buy founder's future plans are running high since the only information Mr. Schulze provided when he announced his resignation was that he would be exploring "all options available" for his ownership stake. Many believe there are two possible reasons and potential outcomes to Mr. Schulze's resignation.

The first possibility is that Mr. Schulze decided that the current path being charted by the existing management team would lead to a further rapid decline in Best Buy's stock price and that it was necessary to exit the company immediately so he could begin selling his stake before the company's stock price begins to fall even further. The likely outcome to this scenario is that there would be additional significant pressure on the current Best Buy stock price, created by the shares Mr. Schulze unloads into the market. Some have opined that this is the likely reason for the resignation and have pointed to Mr. Schulze's uncanny ability to time the sale of his Best Buy stock to maximize his profits. An article discussing this theory can be found here.

The other possibility is that Mr. Schulze made the decision to resign because his future vision for the company is so different than existing management's that the only way for him to save the company would be to take it over by force through a leveraged buy out (LBO). The likely outcome to this scenario would be a dramatic increase in the stock price as Schulze attempts to acquire the remaining number of shares necessary to control the company to take it private. There have been a number of articles discussing why a leveraged buy out of Best Buy would make sense right now. Some of these articles can be found here and here.

This article provides a look at the "other side of the coin" and analyzes the facts which show why the leveraged buy out scenario is not likely. Three reasons why a LBO will not likely occur are outlined below.

1. It's the economy stupid

Most of the arguments in favor of a leveraged buy out point to the fact that Best Buy is unbelievably cheap compared to other retailers, and cheap compared to prior valuations of the company. The problem with this line of thinking is that there are some very good reasons to explain why Best Buy is so cheap right now. Unlike other retailers that Best Buy competes with (e.g. Wal-Mart (NYSE:WMT), Target (NYSE:TGT), Costco (NASDAQ:COST), and Amazon (NASDAQ:AMZN)), BBY is not competitively situated with its current strategy to succeed in today's very crowded and competitive consumer electronics retail business, which is currently rapidly in decline (as discussed by the article here). For a more detailed breakout of all the different headwinds facing the company, the article explaining why Fitch Ratings lowered its outlook for Best Buy is included here. These same headwinds are also currently facing other brick and mortar big box consumer electronics retailers. For example, Google Finance shows that hhgregg, Inc. (NYSE:HGG) is currently trading at a P/E of 4.92, which is right in the same ballpark as Best Buy. Interestingly enough there are no leveraged buyout rumors surrounding HGG.

Most importantly, a leveraged buy out assumes that a current buyer is willing to take on the considerable risk of trying to turn around a company facing some serious problems in a very bad economy. The global economy, including China (where Best Buy has a footprint) is slowing (as discussed here). Another recession looms both here in the US and around the globe (as discussed here). Consumer confidence in the US has reached new lows (as discussed here).

Private equity will be faced with the dilemma of trying to figure out whether Best Buy is currently a value acquisition or a value trap. Unfortunately if Best Buy turns out to be a value trap, the buyer(s) will be left with a multi-billion dollar loss. I find it very unlikely that private equity would be willing to take such a gamble on a company facing so many problems, in today's very difficult economic environment.

2. Size matters!

In today's turbulent economic times, leveraged buy-outs have become rare. A list of the top 10 largest leveraged buy outs since the financial crisis can be found here. As shown by the article in the prior link, there have been very few leveraged buy-outs valued at over $5 billion since 2007. Most valuations of a Best Buy LBO indicate that private equity would have to raise approximately $6 billion in order to take the company private (as discussed here). The $6 billion number is important for two reasons. First, even if private equity was interested in taking Best Buy private, it assumes the company could not be acquired for a lower price. The company and the stock have been in a free fall for the past few months, and a potential private equity buyer would have to be willing to pay $6 billion for a company that could probably be acquired for a significantly lower price tag. The second reason the $6 billion number is important is because there are few entities that have such a large amount of capital readily available. In order to come up with the money necessary to close the deal, lines of credit would probably need to be accessed. Unfortunately credit is not easy to come by right now. While the current estimates show that private equity would need to raise about $6 billion in order to take Best Buy private, it is the size of the valuation in today's very difficult economy that makes the prospect of a leveraged buyout very unlikely, especially when that $6 billion price tag could be much lower in the coming months.

3. But substance is just as important

And while size matters, substance is just as important. One thing that the top 10 largest leveraged buy-outs since the financial crisis have in common is that none of them involved a retailer. Generally leveraged buy-outs work well when a company has large amounts of free cash flow and other assets that can be eventually leveraged to help take the company private. Best Buy has a large pile of cash that could be used to take the company private, but the main assets the company has which could be used for leverage consists of inventory in the form of consumer electronics, which is subject to a high rate of depreciation. This is a problem shared by many LBOs of retail companies. Interestingly, two of the most famous LBOs which resulted in corporate bankruptcies have been the LBO acquisitions of Federated Department Stores and Revco Drug Stores, both of which involved the acquisition of retailers as described here.

Conclusion

In sum, the possibility that Schultze is considering a leveraged buy-out of Best Buy was based on sheer speculation. Even the Wall Street analyst who "interpreted" Schulze's announcement to mean that there was the possibility of a LBO admitted that pulling off such a feat would be "tricky" (as described here). While Mr. Schulze's resignation announcement never excluded the possibility that he was considering a leveraged buy out, it is telling that the individuals who announced the possibility don't even fully believe that it could be possible.

For those who still believe that a LBO is in Best Buy's future, the information presented above helps to confirm that there will be better entry points into the stock, at prices that will make a possible LBO of the company much more likely. For those who don't believe that a LBO is in Best Buy's future, I suspect that the current rumors of the possible LBO give investors (like Richard Schulze) a great exit point from the stock.

Finally and most importantly, if Schulze actually does sell his stake in the company, the free fall that the stock price experienced on the morning of July 7th, 2012, is only a small taste of how quickly the stock price could rapidly decline. A description of that free fall in price is described here. On the other hand, if Schulze is really trying to make a run at the company, it is not likely that the LBO would be consummated immediately, which would give investors plenty of other opportunities to enter back into the stock. A prime example (although not an exact replica) of how such a scenario would likely play out is GlaxoSmithKline's (NYSE:GSK) recent hostile takeover attempt of Human Genome Sciences Incorporated (HGSI). The article here outlines what is going on with that takeover, which to date has still not been consummated.

Of course, regardless of how things play out, one things is certain - Mr. Richard Schulze made it clear that he is not on board with the current Best Buy strategy to turn his company into the next RadioShack. Interestingly enough, it was a message he announced just one day after the article here was published.

Disclosure: I am short BBY.