Repeat After Me: Is Buying Best Buy a Good Buy?

By Charles Cody - August 9, 2012 | Tickers: AMZN, BBY, COST, SPLS, WMT | 0 Comments

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In the 1993 film classic, "Groundhog Day," Phil Connors, played by comic actor Bill Murray, is an egocentric Pittsburgh TV weatherman who keeps repeating the same day over and over again while on assignment covering the annual Groundhog Day event in Punxsutawney, Pennsylvania. He eventually finds a way to stop the cycle with the help of his producer, Rita, played by Andie MacDowell.  They fall in love, and the story ends happily.

Sometimes we witness Connors' (Murray's) dilemma in real life, and Best Buy (NYSE: BBY) founder Richard Schulze seems destined to repeat a "Groundhog Day" cycle with his lovechild. According to several major news reports this week, Schulze has offered between $24 and $26 a share to take the big box electronics retailer private in a leveraged buyout.  If the deal goes through, it will be valued at approximately $8.5 billion based on total shares outstanding on May 5 of 339.9 million shares.

Schulze was forced to retire as chairman three months ago because he failed to report alleged misconduct by the company's former CEO.  Apparently, his ego won't let him abandon the company he built and has put so much of his life into, and he seems determined to take control of the company for better or worse.   This begs the question: Is Schulze just being egocentric, like Phil Connors, or is this a smart move on his part?

According to S&P Capital IQ, Best Buy had revenue of $11.61 billion for the quarter ending May 5, and per share earnings of $0.46.  Last 12 months earnings were seriously hurt by the previous quarter's misfire of -$4.89 a share.   The negative earnings came as the result of a poor Christmas selling season.

Best Buy has a relatively high cost of goods sold (COGS) and this combined with selling, general and administrative costs (SG&A) result in a low (25%) gross margin, and an even lower operating (3%) and net profit (1%) margin.  After factoring in seasonal sales trends, Best Buy's revenue trend has been stable. Yearly revenue reported was $50.705 billion

Best Buy has approximately $9.297 billion in cash, inventory and receivables on its books. Cash on hand was at $1.386 billion, and cash from operations at $3.293 billion.  Accounts receivable are relative low at only $1.846 billion, or 16% of revenue.  The inventory picture is somewhat troubling, however. The company has $6.065 billion in inventory on its books, or 52% of revenue, and inventory has been growing steadily for the past several quarters.  Combine a growing inventory with days in inventory of 64 days and you begin to see the problem.  Electronics technology is changing rapidly and consumers want the latest models and versions for their money.  Consumers are strapped for cash, don't want to increase their debt, or are reluctant to replace their current cache of gadgets and gear until it wears out or becomes obsolete.  Obsolescence may happen before the computer dies, but why not wait? 

Despite Best Buy's decent cash flow, accounts payable are high at $5.731 billion with a payment cycle of 60 days.  This means there is some short term financing happening on the backs of the company's creditors.  In addition, accrued expenses -- another liability account -- are at $2.233 billion, and long term debt now stands at $1.678 billion.  All three liabilities equal $9.642 billion. The company spent $1.5 billion to buy back shares, as 48 million shares have been repurchased last 12 months.  Float reduction is a common tactic used to artificially boost earnings per share, and in this case it means that Schulze will pay about $1.2 billion less for the company than he would have paid a year ago.

Best Buy's inventory burden is its biggest problem, and it will doubtless require markdowns at the registers.  This inventory reduction will further hurt margins, but the private equity (PE) process should reduce costs through store closures and headcount reduction unless Schulze fails to wake up from his "Groundhog Day" dream.  The end process will be to re-emerge as a public company again with perhaps a revived business model, more along the lines of Amazon (NASDAQ: AMZN).  Best Buy needs to revamp its product selection, and it could learn a valuable lesson from Amazon about on-line purchases and "just-in-time" inventory methodology.  Best Buy must reconfigure its business model to compete more effectively with the likes of Amazon, Staples, Inc. (NASDAQ: SPLS), Walmart Stores, Inc. (NYSE: WMT), or even Costco Wholesale Corporation (NASDAQ: COST). 

The table below illustrates why excessive inventory can cause big problems for any retailer.  Excessive inventory is a drag on margins, and lengthy inventory turns means a longer, slower sales cycle. 

If this leveraged buyout happens, it could be a very good deal for Schulze and his PE partners.  By most commonly used valuation models, Best Buy is a good buy at $25 -- give or take -- a share. Best Buy has a book value of $10.73 and a tangible book value of $5.79. My guess is that the final price may end up higher than the recent per share offer.  While it's risky, you might buy some for a quick gain (or not!) and then wait to see what the new company looks like.

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