Best Buy: Risk Now Tilted Toward Upside

| About: Best Buy (BBY)
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Back in August, I called Best Buy (NYSE:BBY) a "three ring circus". As I discussed in my earlier piece, the company is caught between three major developments: 1) declining sales and profitability concerns in the core business, 2) the arrival of a new management team, led by CEO (and turnaround expert) Hubert Joly, and 3) a possible LBO bid from company founder Richard Schulze. Over the past three months, these trends have been brought into focus even more. Last month, the company pre-announced that Q3 sales and gross margins would both be significantly lower than last year. As a result, the average analyst estimate for Q3 EPS rapidly dropped from 36 cents to 12 cents. Results ultimately came in even lower: Best Buy reported adjusted EPS of 3 cents last Tuesday. (On a GAAP basis, the company swung to a small loss.) At Best Buy's analyst and investor day earlier in November, Joly (who has only been on the job for two months) stated, "I am already sick and tired of negative comps."

At the analyst and investor day on November 13, Joly laid out the company's turnaround strategy. While most analysts complained that the presentation was light on details, I think management did a good job of pointing out the numerous opportunities to improve profitability. The company is already in the midst of a cost reduction plan centered on reducing store square footage, decreasing cost of goods sold (through supply chain efficiencies and increased private brand penetration), and cutting corporate overhead costs. The company's presentation highlighted those same areas, indicating that the new management team believes that Best Buy's cost cutting strategy was already on the right track.

None of management's plans for Best Buy are revolutionary, as some investors seem to want. However, revolutionary does not necessarily mean profitable, as J.C. Penney (NYSE:JCP) shareholders have recently learned. Best Buy is still a behemoth in the main markets it serves: consumer electronics and appliances. In the U.S., Best Buy has the #1 position with 16% market share in those categories, slightly ahead of Wal-Mart's (NYSE:WMT) 15%. Despite Amazon's (NASDAQ:AMZN) frequently touted growth, the online retail giant only has 4% of the combined consumer electronics and appliance market. (All data from slide 10 of Best Buy's presentation) While changes in the consumer electronics market cannot be ignored, most of Best Buy's troubles can be traced to overexpansion of the "big-box" format. Best Buy closed 50 big box stores earlier this year, but the company has identified another 64 stores that are candidates for eventual closure. Most of these are stores with leases expiring within four years or less that are still profitable but with a low ROIC. By replacing big box stores with smaller format "Best Buy Mobile" stores (which are much cheaper to operate), the company should be able to stabilize profitability.

One of the major reasons why Best Buy's stock price has plummeted over the past two years has been increasing competition from online competitors, particularly Analysts are worried that Best Buy will be the biggest victim of the "showrooming" trend, although other retailers like Target (NYSE:TGT) and Wal-Mart are also affected. One recent report noted that Amazon's prices are consistently lower than Best Buy's, and stated that many employees saw widespread use of Amazon's "Price Check" app in Best Buy stores. Yet Joly asserts that the pricing problem is an issue of perception more than anything else. As I noted earlier, Best Buy still leads Amazon by a wide margin in market share. The company should be able to leverage this scale to compete effectively on price. (Longer-term, Best Buy should focus on reducing online prices and trying to drive traffic to its website in order to compete better with Amazon and others in the e-commerce space.) Best Buy is combating the price-pressure by matching competitors' prices (including online-only prices) for most of the holiday season. The company is hoping that this tactic will produce significant improvement in the close rate (the percentage of shoppers who make a purchase).

We will probably have to wait until Best Buy reports Q4 results in February to learn how this strategy fares. However, I think that this decision was necessary; and if the company markets the price-match policy well, this should help Best Buy return to comp store sales growth in Q4. The risk is that matching Amazon's prices will lead to severe margin compression. However, as I wrote recently, the more alarmist reports about the impact of price-matching on Best Buy's profits are overblown. With analysts already expecting a nearly 40% year-over-year drop in EPS (from $2.47 to $1.52), I think the prospect of materially lower margins in Q4 is more or less priced in.

Despite the relatively weak Q3 results, Best Buy is still solidly profitable, and trades at approximately 5 times earnings. Therefore I believe that private equity firms will be receptive to Richard Schulze's leveraged buyout plan. A report last week stated that Schulze is currently working with Cerberus Capital, TPG Capital, and Leonard Green Partners. In Schulze, Best Buy has a highly motivated suitor; as the share price has plunged by nearly 75% over the past two years, Schulze has seen his net worth drop by about $2 billion. (Schulze owns approximately 20% of Best Buy.)

Moreover, Best Buy's weak Q3 may paradoxically be a boon for shareholders by clarifying the company's value. Whereas many analysts initially thought that Schulze's intended buyout range of $24-$26 was too low to succeed, with shares having fallen below $12, a buyout offer around $18 per share is now likely to garner sufficient support from shareholders and directors. This still offers a premium of more than 50% on the current share price. At $18, it should be much easier for Schulze to line up sufficient equity and debt financing for a buyout. If he retains his 20% stake, Schulze would need to secure less than $5 billion of capital at $18/share.

There is of course no guarantee that a buyout will happen. However, with Best Buy still solidly profitable and better convergence between investors, analysts, and private equity firms on the value of Best Buy shares, I think the likelihood of a buyout is high enough to justify taking a long position in Best Buy. Even if the buyout falls through, I think that the current share price preserves an adequate margin of safety for a long-term investment. However, it will take at least a year for Best Buy to convince investors that its turnaround plan can succeed (if the company remains public), so returns will be slower to materialize in that case.

Disclosure: I am short AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I may initiate a long position in BBY over the next 72 hours.