Best Buy (BBY) has had an eventful August. Company founder Richard Schulze has been pursuing a leveraged buyout of the company. Meanwhile, the company appointed Hubert Joly, an executive with substantial experience leading corporate turnarounds, as its new permanent CEO on August 20. The following day, Best Buy reported poor Q2 earnings, withdrew its full year guidance, and suspended its share repurchase program.
These events have set up something of a "three ring circus" at Best Buy. Investors must weigh the likelihood of a takeout against the company's deteriorating fundamentals and the prospects for a successful turnaround under Joly's leadership. On balance, I would call Best Buy a "speculative buy" at this point in time. The company has been trying to transition from an emphasis on big box stores (great for selling TVs and PCs back in the day!) towards smaller "Best Buy Mobile" stores and an emphasis on services. This creates risk that the transition will be much more costly or less successful than expected. If the buyout does not materialize, shareholders could be stuck with a painful turnaround stock. However, at this point the upside from an LBO or successful turnaround outweighs the downside from continued deterioration in the business.
The LBO Scenario: It took a long round of haggling for Schulze and the Best Buy board to come to terms on an agreement that allows Schulze to do due diligence and submit an orderly bid to the company. If Schulze's bid to take Best Buy private succeeds within the next year, shareholders will get a healthy return on their investment. Schulze has floated a ballpark figure of $24-$26 as the buyout price in recent weeks (a 35% or greater return over the current price). However, when he publicized that figure, Best Buy had not yet released its disappointing Q2 earnings report. With adjusted EPS down by half year-over-year, it's likely that Schulze would now be aiming toward the bottom of that range. Even then, he may have trouble selling $24 a share to potential private equity partners. On the other hand, having put out an initial figure, Schulze would lose credibility with shareholders if he offers a lower bid.
For a combination of these reasons, many market-watchers put the probability of a deal near zero. However, Schulze has a big head start from owning 20% of the company and I think there are PE firms out there that would be intrigued even at $24/share, given that Best Buy expects operating cash flow of $4/share or better for the year. I would put the probability of a deal by early next year at 1 in 5. If the board does not consent to a buyout, Schulze could potentially make a hostile bid for the company late next year. I think the hostile takeover is actually a more likely scenario simply because shareholders are more frustrated with Best Buy's performance than the company's board.
Deteriorating Performance: The claim that Best Buy is on the road to bankruptcy is oft-repeated, so I won't delve too far into the details here. Revenue has stagnated in recent years, as many of Best Buy's bread and butter products have become commoditized. Meanwhile, the company had been aggressively growing its store count until this year. Best Buy finally recognized last year that it had too much big box square footage, and the company closed 50 stores earlier in 2012. Best Buy has been trying to downsize other stores while expanding its Best Buy Mobile concept (which specializes in cell phones and tablets). This business shift is part of a broader cost-cutting campaign, but many observers think revenue will erode faster than Best Buy can slim down.
Many analysts are also worried about "showrooming" eating away at Best Buy's sales. The idea is that consumers will come in to Best Buy (and other stores) to look at products and will then use their smartphones to comparison shop online. The worry is that Amazon (AMZN) will be able to undercut Best Buy's prices, because it does not have to support the overhead of over 1000 big box stores. As I have written before, I think the fear of showrooming is overblown. If you compare Best Buy's and Amazon's earnings statements for last year side by side, it turns out that SG&A for Best Buy was 20.2% of sales, while the comparable figure for Amazon was 20.6% of sales. Simply put, Amazon does not have a lower overall cost structure. Rather, the fact that Amazon does not charge sales tax in most jurisdictions has artificially lowered its prices compared to physical retailers by as much as 10%. But Amazon recently began collecting sales tax in Texas, and it will begin collecting sales tax in Pennsylvania and California in September. This will allow Best Buy to compete with Amazon on price in many of the most populous states in the U.S., going forward.
Thus, I do not expect Best Buy's performance to deteriorate much further unless the economy falls apart. However, macroeconomic weakness is a significant concern in light of high gas prices and stubbornly high unemployment. If U.S. consumers get spooked before the holiday season, Best Buy could suffer along with the rest of the retail sector.
Turnaround Potential: Most analysts agree that Best Buy pulled off a huge coup by hiring Hubert Joly as its next CEO. Joly is seen as a turnaround expert, who led successful restructurings at EDS and Vivendi. Since Joly has not even taken up his position yet, this is the hardest part of Best Buy's valuation to handicap. Given Joly's recent experience as the CEO of Carlson (which owns hotels and restaurants), investors can probably expect a strong emphasis on customer service. This used to be a differentiating factor for Best Buy, but in the midst of cost-cutting the company allowed its reputation for service to drop off. If Joly can get customers feeling good about Best Buy again, that could revitalize sales.
In any case, Joly himself likely does not know what his turnaround plan will be at this point. But he brings solid experience and know-how to the job. For a company that has been floundering for a few years, having a steady hand on the tiller can be invaluable. With the company valued at a P/E in the mid-single digits (I'm conservatively assuming FY13 earnings of $3-$3.50), there is also a lot of upside in a turnaround scenario. I'm inclined to put money behind Joly; if he can convince the market that he has a workable plan, the stock could quickly rise out of the sub-$20 doldrums. As I mentioned above, there is some downside risk here if Joly cannot come up with a viable turnaround strategy or if the economy as a whole heads south. However, since I do not think business is eroding as fast as the market believes, I think $18 provides an adequate margin of safety for medium-long term investors.