Best Buy-Out: The Numbers DO Add Up!

Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

As most people know, Best Buy (NYSE: BBY) founder Richard Schulze is attempting to orchestrate a leveraged buyout of the electronics retailer. A recent article on Yahoo! Finance entitled "Best Buy-Out: The Numbers Don't Add Up" tries to paint a picture of a doomed retailer that no one in their right mind would want to own. The two big points that the article makes are:

  1. The debt load from a leveraged buy-out would be too much because Best Buy isnt't profitable
  2. Competition is killing Best Buy

Let's look at Best Buy's profitability first.

Net Income Is Nonsense

For some reason, many people focus on net income (or earnings) to gauge a company's profitability. The problem is that many non-cash charges, such as goodwill write-offs, get taken out of net income even though they have no effect on profitability. Net income is an accounting number, and often is disconnected from the real performance of the company. Here is Best Buy's earnings per share for the last five years. (All data from Morningstar)

Best Buy EPS

<table> <tbody> <tr> <td><strong>2008</strong></td> <td><strong>2009</strong></td> <td><strong>2010</strong></td> <td><strong>2011</strong></td> <td><strong>2012</strong></td> </tr> <tr> <td>$3.12</td> <td>$2.39</td> <td>$3.10</td> <td>$3.08</td> <td><span>$-3.36</span></td> </tr> </tbody> </table>

* Fiscal 2012 ended in January

If you simply look at EPS and consider it gospel then indeed Best Buy was stagnant from 2008-2011 and then fell into a severe loss. You would naively conclude that Best Buy is a terrible company and should be avoided.

A somewhat better value to look at is the free cash flow. While net income is based on accrual accounting, where expenses are not recorded until sales are made, free cash flow represents the actual flow of cash into and out of the company. Here is Best Buy's free cash flow per share for the last five years.

Best Buy FCF/Share

<table> <tbody> <tr> <td><strong>2008</strong></td> <td><strong>2009</strong></td> <td><strong>2010</strong></td> <td><strong>2011</strong></td> <td><strong>2012</strong></td> </tr> <tr> <td>$2.71</td> <td>$1.35</td> <td>$3.72</td> <td>$1.07</td> <td>$6.90</td> </tr> </tbody> </table>

Free cash flow tells a different story. While the cash flow is much more volatile than net income, 2012 was not only profitable, but the most profitable year in the last half-decade. Why the big difference? This was partially due to a goodwill write-off of about $1.2 billion, which has nothing to do with profitability.

Free cash flow has its own problems, though. Included in the free cash flow are changes in working capital. Working capital fluctuates, but in general there is no reason for it to increase over time for a company like Best Buy. These fluctuations are largely what caused the volatility in the free cash flow. We can get around this by looking at owner earnings.

Owner earnings, a term coined by Warren Buffet, is defined as the net income plus depreciation and amortization plus certain non-cash charges minus the average capital expenditures. Only permanent changes in working capital should be included, not the fluctuations we see with Best Buy. Owner earnings represent the amount of cash, on average, that can be pulled from the company each year. Here is Best Buy's owner earnings per share for the last five years. I'll use the 5-year average capex in the calculations.

Best Buy Owner Earnings/Share

<table> <tbody> <tr> <td><strong>2008</strong></td> <td><strong>2009</strong></td> <td><strong>2010</strong></td> <td><strong>2011</strong></td> <td><strong>2012</strong></td> </tr> <tr> <td>$2.69</td> <td>$3.20</td> <td>$3.82</td> <td>$4.39</td> <td>$4.66</td> </tr> </tbody> </table>

What a difference! Owner earnings per share have increased each year included the supposedly unprofitable fiscal 2012. In my opinion owner earnings are the most reasonable way to gauge a company's performance, as they represent the average amount of cash someone who has purchased the company outright can expect to be able to pull out of the company each year. This is exactly the number which is important in a buy-out.

Fiscal 2012 ended in February, so lets look at the results for the first half of this new fiscal year compared to the first half of last fiscal year.

<table> <tbody> <tr> <td> </td> <td><strong>1H 2012</strong></td> <td><strong>1H 2013</strong></td> </tr> <tr> <td><strong>EPS</strong></td> <td>$0.85</td> <td>$0.43</td> </tr> <tr> <td><strong>FCF/S</strong></td> <td>$2.96</td> <td>$-1.59</td> </tr> <tr> <td><strong>OE/S</strong></td> <td>$1.18</td> <td>$1.46</td> </tr> </tbody> </table>

Although net income and free cash flow would point to a poor performance, this is mainly due to non-cash charges and fluctuations in working capital. Owner earnings per share actually increased.

In fiscal 2012, with $4.66 in owner earnings and a float of 366 million shares at the time, about $1.7 billion could reasonably be pulled from the company. Best Buy has about $2 billion in debt on the balance sheet, or about $5.90 per share. The current share price is $15.17 after a 10% drop on October 25th. If a buy-out takes place it is assumed to be in the $24-$26 range, possibly higher. Does Best Buy's profitability justify this price?

Let's assume that the offer is $24 per share. After including the debt that brings us to roughly $30 per share. Using last years owner earnings figure this price would be a just 6.4 times owner earnings, meaning it would take 6.4 years to recoup the investment. Even if Best Buy becomes less profitable, say $1 billion per year instead of $1.7 billion, that's still a ratio of 10.17. That's a 10% annualized return. I think it's safe to say that Best Buy offers real value here.

Competition  

The other argument put forth in the article was that Best Buy was being pinched by brick-and-mortar stores, like Wal-Mart (NYSE: WMT) and Target (NYSE: TGT), and online merchants, mainly Amazon (NASDAQ: AMZN).

Do Wal-Mart or Target offer any real benefit over Best Buy? The answer is no. The prices are largely the same, and the chances of finding an employee who has real knowledge of electronics are much, much higher at Best Buy. Many people like having someone knowledgeable help them weigh their options, and that's something you won't find at Wal-mart or Target.

For a long time people have predicted the end of retail as we know it due to Amazon. Here's the problem: The main advantage Amazon used to have over Best Buy was price because Amazon didn't charge sales tax, while Best Buy did. That's a 7%-8% difference, which is significant for a $1,000 TV. That has now largely changed, as states have started requiring Amazon to collect sales tax on purchases. This, along with Best Buy's plan to match prices this holiday season, means that there isn't much benefit to buying electronics on Amazon anymore. I think because of this Best Buy will have a solid holiday season.

The Bottom Line

You can claim just about anything by cherry-picking the numbers which you use. But what matters in this buyout is owner earnings, not net income. And on that front, Best Buy is plenty profitable. I think that the chances of a buy-out happening are fairly good, but even if it doesn't happen the company still generates ample cash, and the stock price is so low that the current valuation is bordering on ridiculous.

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TheBargainBin owns shares of Best Buy. The Motley Fool owns shares of Amazon.com and Best Buy. Motley Fool newsletter services recommend Amazon.com, Best Buy, and Wal-Mart Stores. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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