Best Buy's cash flows away from investors

  • Article by: THOMAS LEE , Star Tribune
  • Updated: June 3, 2012 - 7:23 AM

The consumer electronics chain needs all of its financial muscle to navigate turbulent times, analysts say.

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A Best Buy employee in Mountain View, Calif., looked over a cellphone contract. Best Buy’s first-quarter profit dropped 26 percent on restructuring charges as the struggling electronics retailer began implementing its turnaround plan.

Photo: Paul Sakuma, Associated Press

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Best Buy Co. Inc. generates billions of dollars a year in free cash, but investors are not likely to see much of it anytime soon.

That's because the Richfield-based consumer electronics retail giant needs every penny it can muster, whether from free cash or cost cuts, to fortify the company against aggressive rivals like Wal-Mart and Amazon, analysts say.

The money "needs to be reinvested into the business as Best Buy already faces brand slippage," Christopher Horvers, a retail analyst with JPMorgan, wrote in a research report.

That's not what investors want to hear. Since late March, when Best Buy announced a plan to cut $800 million over three years, the stock has fallen more than 30 percent to Friday's close of $18.30, partly because none of that money will go to shareholders. Instead, the company will spend the savings on closing 50 big-box stores, rolling out smaller-format Best Buy Mobile stores, and experimenting with "Connected" stores, which focus more on customer service.

In a recent conference call with analysts, interim CEO G. "Mike" Mikan promised to "return cash back to shareholders."

"We have a lot of work to do," Mikan said. "One part of that is rebuilding relationships with investors. That is an important priority and one I will personally address. ... We are moving from a big-box store-growth model to a return-on-investment orientation, as is appropriate for a retailer at our stage. I know there are skeptics out there. I see the share price."

But it's not clear what Mikan can immediately do to satisfy Best Buy investors. Publicly traded companies directly return cash to shareholders in two ways: pay out a dividend and buy back stock.

Best Buy already does both: This year, it will spend $750 million to $1 billion to repurchase stock. The company is paying a quarterly dividend of 16 cents a share, a penny more than last year. Even though its stock has dropped in recent years, Best Buy has gradually increased its quarterly dividend since 2007 by a penny a share. But that has not been enough to satisfy investors, who worry whether the company can maintain its free cash flow in the years ahead.

However, the company would not say whether it could do more than that.

"We're going to continue to target buying the amount that we said," Mikan said. "And with respect to the dividend, as we get our strategy put in place, we'll revisit that and come to the marketplace with our plans at that point in time."

Thus Best Buy's remaining option to boost shareholder value is pretty straightforward: increase the stock price by increasing profits. That means it must grow sales and/or cut costs.

The company has long touted its potential to grow revenue from its website, international stores and service offerings like Geek Squad. And Mikan said Best Buy will release a new long-term growth plan this summer. But investors are unimpressed.

"While the company is financially strong, a solid balance sheet is not a reason to buy" Best Buy stock, Gary Balter, an analyst with Credit Suisse, wrote in a research note.

That leaves cost-cutting. Jeremy Brunelli, an analyst with Consumer Edge Research in Stamford, Conn., said Best Buy has plenty of opportunities to trim expenses beyond its $800 million plan.

The 50 big boxes Best Buy said it will close this year represent a small percentage of the 1,100 stores it operates in North America. The company also employs about 180,000 people, Brunelli noted.

Best Buy's expenses "are much higher than other retailers," he said. "And their biggest cost is people."

During the conference call, Mikan said closing 50 big boxes represents only the beginning.

"I wouldn't stop at just the store portfolio," Mikan said. "But there's also a lot of other areas that we're going to continue to go deeper in. We're in a turnaround. We're going to make tough decisions. The nice-to-haves aren't going to be in our plan. And we're going to be focused on need-to-haves."

However, Horvers, the JPMorgan analyst, doubts the company can squeeze any more money from cost-cutting. On the store level, the company is already pretty efficient, Horvers said, noting that its adjusted cost per retail square foot of space bests Target, Home Depot and Lowe's.

"So at a higher level, we don't see a lot of room for more than the announced $800 million in cuts," he wrote.

Horvers thinks Best Buy could save another $100 million from slashing its advertising budget. However, Best Buy needs advertising to stay on top of rapidly changing trends in consumer electronics, he said.

In any case, Best Buy needs its cash to build up its online operations, pay for free shipping, and narrow its price gap with Amazon, Horvers said.

The company also needs to protect its profit margins as it sheds retail space. Fewer big boxes mean fewer sales and not all customers will stay loyal to Best Buy during this transition.

In any case, Best Buy stock remains highly undervalued. The company's shares are trading at little more than five times earnings, an astonishingly low price/earnings ratio for a business that generates around $2 billion in free cash a year. (By comparison, Best Buy stock traded at 11 times earnings just five years ago.)

But to unlock that value, Best Buy needs to give something extra to shareholders, analysts say. It just might not be cash.

Thomas Lee • 612-673-4113

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