Best Buy's Credit Risk Overstated

Summary

• Moody’s is overstating Best Buy’s credit risk with their lower medium investment grade Baa1 credit rating.
• Credit markets are also overstating credit risk with a CDS of 194bps and cash bond YTW of 3.110%.
• However, fundamental analysis highlights the firm’s strong cash flows, substantial liquidity and robust recovery rate.
• These factors drive our two notch higher IG3 (A2) credit rating and 100+bps safer Intrinsic market spreads.

Moody's is overstating Best Buy Co., Inc.'s (NYSE:BBY) credit risk with its Baa1 rating. Our fundamental analysis highlights a safer credit profile for BBY, whose strong cash flows consistently exceed all operating obligations. While cash flows would slightly fall short in 2021, their substantial liquidity would allow them to overcome this with ease. We therefore rate BBY two notches higher at an IG3 (equivalent to Baa1) credit rating. (To register for free access to our corporate credit ratings, please click here.)

Additionally, cash bond markets are overstating the firm's credit risk with a CDS at 194bps relative to an Intrinsic CDS of 77bps, and a cash bond YTW of 3.110% relative to an Intrinsic YTW of 1.910%.

Cash Flow Profile

We produced a Credit Cash Flow Prime™ chart for Best Buy, as we do for every company we evaluate. The chart provides a far more comprehensive view of credit fundamentals than traditional ratio-based analyses. It shows the cash flow generation and cash obligations related to the credit of the firm, adjusted for non-cash financial statement reporting distortions from GAAP. The blue line indicates the gross cash earnings (Valens' scrubbed cash flow number) expected to be generated based on consensus analyst estimates and Valens Research's own in-house research team. The blue dots above that line include the cash available at that time while the blue triangles indicate that same amount plus any existing, available lines of credit.

The colored, stacked bars show the cash obligations of the firm in each year forecast. The most difficult obligations to avoid are at the bottom of each stack, such as interest expense. The obligations with more flexibility to defer year to year, such as pension contributions and maintenance capital expenditures, are at the top of the stacked bars. All of the calculations are adjusted for non-cash distortions that are inherent in GAAP accounting, including the highly problematic and often misused statement of cash flows.

If the company generates and has cash levels that are above their obligations, the risk of default is extremely low. Even if the cash generated yearly is close to the levels of the stacked bars, a company generally has the flexibility to defer payments of various kinds. For example, they can allow assets to age a little longer, or they can cut certain maintenance costs such as maintenance capex. While decisions such as those can create other business concerns, the issue in credit risk is simply this: Does the company have enough cash to service their credit obligations?

BBY's cash flows would consistently exceed all obligations in each year until 2021. While the firm's cash flows would slightly fall short of all obligations in 2021 due to their material $650mn debt headwall, their substantial expected cash build would allow them to easily overcome this. Additionally, their robust 277.5% recovery rate and sizable market capitalization should allow them access to credit markets to refinance their debt obligations if needed.

Management Incentives

Like most people, senior executives and board members do what they are paid to do. This is why BBY's Form DEF 14A is key to understanding this company's fundamentals, something that credit agencies seem to be missing. Our Incentives Dictate Behavior™ analysis focuses on BBY's senior executive compensation and governance. This analysis is meant to help investors understand corporate governance, how aligned a management team may be with shareholder interests, and the potential consequences of a management compensation framework to the business.

BBY management's short-term compensation is based on compensable enterprise operating income, enterprise comparable store sales (same-store sales), waste and efficiency, U.S. online revenue growth, and U.S. net promoter score, while long-term compensation is provided in the form of performance-based restricted stock units, stock options, and time-based restricted stock units.

The compensable enterprise operating income, waste and efficiency, and domestic online revenue growth compensation metrics should drive management to improve margins and expand revenues over time. This indicates that they should concentrate on both ROA' improvement and growth. Moreover, the same-store sales compensation metric may drive management to effectively manage their operating costs and capital allocation, which should lead to higher cash flows over time. This indicates that management should have ample liquidity resources to service the firm's debt going forward.

Management Representations

We provide analyses of companies' statements on earnings calls, termed Earnings Call Forensics™. This analysis is meant to help assess a management team's confidence in their conference calls when discussing certain areas of the business such as operations, stability, strategies, their ability to manage business risks, and especially, their liquidity and solvency.

In the case of BBY, the analysis of their Q1 2017 earnings call highlights highly questionable markers from management. Management may be concerned about the sustainability of health, wearables, home theater, and appliances growth, as well as about customer retention levels. Moreover, they may be concerned about the sustainability of market share gains, and may lack confidence in their ability to find sufficient cost reductions to offset investments. They may also be exaggerating their commitment to improving customer experience and unlocking future growth.

Conclusion

Ultimately, a company's credit risk (or lack thereof) is driven by cash available against cash obligations. BBY's credit risk is being overstated by credit markets and Moody's. Given BBY's strong cash flows, substantial liquidity, robust recovery rate, and favorable management compensation framework, even with near-term potential headwinds, ratings and credit market spreads are expected to improve.

Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article along with the lead analyst, Cheska Pablico. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.

Disclosure: I am/we are long BBY. 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.