'Shorts' dread a takeover of Best Buy

  • Article by: THOMAS LEE , Star Tribune
  • Updated: June 16, 2012 - 9:19 PM

An attempt to take Best Buy private might drive up stock price -- bad news for short sellers.

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A Best Buy employee in Mountain View, Calif., looked over a cellphone contract.

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Should Best Buy Co. Inc. founder Richard Schulze try to take the company private for $9 billion or more, institutional investors say they would be more than happy to take the money and run.

But there is at least one class of investors who won't be so pleased: the people who bet this precise event would not happen.

Known as "short sellers" or "shorts," these reverse type of shareholders have wagered that Best Buy's stock price will continue to fall for the foreseeable future. However, if Schulze offers investors a price that's considerably more than the company's current market valuation of $6.6 billion, an act that would surely boost Best Buy's shares, the shorts stand to lose quite a bit of money.

"If there is a credible buyout offer with a sizable premium, it would put the squeeze" on short sellers, said Matt Nesto, a former investment adviser for Lehman Brothers and Merrill Lynch who now works at Yahoo Finance.

Investors are eager to see whether Schulze makes an offer at the company's annual shareholders meeting on Thursday.

Since December, the number of shorted Best Buy shares has jumped 81 percent to 54.5 million shares, nearly 20 percent of the company's entire pool of freely traded stock, according to Bloomberg data. That makes Best Buy one of the most shorted stocks on the New York Stock Exchange. By comparison, investors shorted only 8.8 percent of the shares of all computer and electronics retailers, Bloomberg data show.

Here's how short selling works: An investor thinks a company's stock will lose value, so he borrows shares of that firm from a broker. Eventually, the investor must repay or "cover" the loan by buying back the shares.

If the stock price fell, as the investor had hoped, he pockets the difference between that lower price and the price those shares commanded when he initially borrowed them. However, if the stock price rose, he must buy back the shares at that higher price, resulting in a loss.

It's not hard to see why short sellers have focused their attention on Best Buy. The Richfield-based consumer electronics giant retailer has been struggling to grow sales as more consumers flock to the Internet for their purchases. Best Buy also faces tough competition from rivals Wal-Mart and Amazon.com.

But shorting stocks carries a lot of risk, mostly because any number of unanticipated factors, such as a private takeover or overenthusiastic investors, can drive up a stock price, said Bruce Fenton, managing director of Atlantic Financial, a wealth management firm in Boston.

For example, during the dot-com bubble of the late 1990s and early 2000s, some investors shorted tech stocks, correctly concluding that many of them were not making money, Fenton said. Still, the short sellers lost money because investor enthusiasm for tech start-ups, though irrational, continued to push stock prices up for many years, he said.

"You don't want to bet against mania," Fenton said.

Before the economic crisis in 2008, short sellers bet against the stocks of banks, insurers, and investment firms. But those investors did not anticipate the government bailing out those companies with taxpayer money and eventually banning the short sales of those stocks.

"Sometimes, even when you're right, you're wrong," Fenton said.

In Best Buy's case, some analysts have long speculated the company could be the target of a private takeover, or leveraged buyout (LBO). Wall Street mostly shrugged off those rumors, given Best Buy's struggles and its expensive price tag, about $10 billion to $12 billion by some estimates.

However, talk of a LBO has gained steam in recent days when Schulze resigned from Best Buy's board earlier this month in order to "explore all options" for his 20 percent stake in the company. Schulze has hired a prominent New York lawyer and Credit Suisse, an investment bank that specializes in LBOs, to help him take Best Buy private, according to sources close to the situation.

In some ways, Best Buy short sellers may have contributed to their own demise, experts say. By driving down Best Buy's stock price, short sellers only made it easier for Schulze or other private equity firms to purchase the company.

"You can become your own worst enemy," Fenton of Atlantic Financial said.

In March, Data Explorers, an analytics firm that tracks short sales, issued a report that identified Best Buy as the top American candidate for a LBO, partly because of its slumping stock price made worse by short sellers. Many potential acquirers are also sitting on piles of cash and would love to buy a company like Best Buy on the cheap, the firm noted.

"With increasing momentum in the mergers and acquisition market, we have screened for companies that have seen their share prices take a battering that could make for potentially dangerous shorts," the report said, "should their underlying profitability make them attractive takeover targets."

But LBO or no LBO, short sellers were already playing a dangerous game, said Jeremy Brunelli, an analyst with Consumer Edge Research in Stamford, Conn. Despite its problems, Best Buy is "ridiculously undervalued," given its strong cash flow and opportunity to cut costs, he said.

And more important, the company will likely see its share price rise this year because new product rollouts like the Windows 8 operating system and Apple's new version of its popular iPad tablet traditionally boost Best Buy's earnings, Brunelli said.

Anticipation for the new iPad prompted market researcher International Data Corp. last week to raise its annual forecast for worldwide shipments of tablets to 107.4 million units from 106.1 units. Best Buy is the No. 1 seller of tablets in the United States.

That's why short selling is not for the fainthearted, Fenton said.

"Any slight upside in earnings can boost a stock price and burn you," he said.

Thomas Lee • 612-673-4113

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