Best Buy (BBY) has an enormous problem, threatening its very survival. The roots of this problem are deep, and it represents a change beyond the ability of the company's management to change. Somehow this retailer must find a way to adjust, and quickly.
The problem: Moore's Law.
With apologies to the flood of words that have been poured into the issue of "show rooming" and the claims that bricks-and-mortar retailers cannot compete, the rise of another distribution channel for a company well-versed in selling goods is more of an opportunity than a challenge. When Sears Roebuck, a predecessor company to Sears Holdings (SHLD), went public in 1906 it was a catalog retailer. The company opened its first store in 1925, and it built a dominant position in bricks-and-mortar retailing throughout the middle of the 20th century before losing its way. There is no law of retailing that says a company cannot master a new way to reach consumers.
No, the trouble facing Best Buy is that it's very raison d'être has been undermined by the steady improvement in quality and reduction in cost of consumer electronics. Amazon (AMZN) is not Best Buy's problem; Moore's Law is.
Best Buy is a consumer electronics bazaar, a playhouse for people who like electronic toys. But with those goods becoming increasingly cheap and increasingly reliable, there is less of a need for a class of specialty retailers providing nothing else. Consumers can get their electronics at Wal-Mart (WMT) along with everything else. Best Buy, much like smaller competitor RadioShack (RSH), is increasingly an anachronism.
A Profitable Decline
Despite the pain shareholders are feeling from the 35% decline the stock has endured over the past 12 months, at $17 a share there is upside for patient value investors.
- Sales: Same-store sales have been trending down for several quarters, and comparable-store sales have been down in three of the past four years. Revenue growth may be hard to come by for this king of a shrinking niche, but a focus on pricing discipline rather than sales growth could yield gross margin improvements. Additionally, with web sales of only $3 billion, there is room for improvement.
- Retail Footprint: With 1,062 U.S. Best Buy stores, management might want to seriously consider the possibility that the U.S. market is sufficiently covered. Nearly 75% of the company's retail square footage is in the U.S., and with capex of $13 per square foot in FY 2012, a 25% rationalization of the domestic footprint could result in a $140 million annual reduction in capital expenditures.
- Workforce: A company with 167,000 employees and $10.2 billion in SG&A has plenty of opportunities to cut costs, if management has the stomach for it.
- Bargain Price: The company is trading under 2.5 times TTM EBITDA, a price that would be considered a bargain for a company with $50 million in sales, let alone a publicly traded company with over $50 billion in sales. Even at $30 a share the company would only be valued at 3.5 times TTM EBITDA.
A pickup of a few percentage points of gross margin off a lower sales base, combined with a streamlined retail footprint and savings from staff reductions, would make Best Buy look even better than it already does. Yes, the steps from here to there will be messy and require careful execution, but investors get rewarded for their risks -- and this is a risk with minimal downside.
A Motivated Buyer
Founder Richard Schultze, who continues to own 20% of the company, is in talks with several private equity firms about taking Best Buy private. Clearly, we are in a different market than the P/E boom years of 2004-06. Out-of-favor companies with moderate debt in need of a turnaround out of the glare of the public markets are exactly the type that private equity firms seek.
Best Buy management can be as belligerent as it likes; Schultze is shopping a deal that makes too much sense for someone not to be interested. There doesn't need to be anything special about Schultze's plan for it to work.
The playbook is simple and well-aligned with private equity's core strengths. I could see a consortium backing this acquisition, selling the international operations and right-sizing the domestic footprint while bolstering web sales, taking advantage of the low cost of debt to juice returns, and generating a substantial win for their own investors within a short time frame.
There is no mystery regarding what needs to be done to fix Best Buy, although it would take a brave management group to endure the pummeling that would be leveled at a public company as the restructuring charges pile up and investors bemoan the lack of a growth strategy. Sometimes growth is not the key to value maximization, and that is OK.
It does not take much imagination to see Best Buy's share price rise at least to the level of founder Richard Schultze's offer of $24 to $26 a share (a 41% to 53% gain). This is a company whose management team needs to demonstrate its ability to accept that it won the game (becoming the dominant U.S. consumer electronics retailer), and found that there was a larger game in progress, which it was losing. Even at $30 a share a private equity buyer (or buyers) would have considerable margin for error. For those willing to shut out conventional wisdom, Best Buy offers a strong risk/reward profile.