Wall Street is often characterized as a massive discounting mechanism. Right now its collective wisdom suggests that the odds that one of our lodestar public companies-- Best Buy -- will go private in a leveraged buyout are long.
Best Buy's stock is trading in the high teens, a steep discount to the tentative offer of $24 to $26 a share from Dick Schulze, Best Buy's founder and former chairman. As investors in below-investment-grade debt, or "junk bonds," we see this discount as an inaccurate signal of what could happen.
Getting a deal done won't be a cakewalk. A leveraged buyout of Best Buy, which could involve the issuance of as much as $7.4 billion in debt, would be the largest ever for a retailer. Obviously, that's a big number, but consider:
•Demand remains very strong for junk debt. Investors are searching for yield.
•A Best Buy offering, based on the ratios debt investors care about, could be structured well within the bounds of other, similar deals for retailers -- companies such as J.C. Penney, Office Depot, Radio Shack, Sears and Toys 'R' Us. All these companies are carrying similar levels of debt relative to their cash flow.
•Best Buy is still very much a going concern. The business generates anywhere from $1.25 billion and $1.5 billion a year in free cash flow -- a bondholder's elixir. Based on our analysis, Best Buy is capable of more than $3 billion a year in cash flow, even when rental costs are factored in -- a particularly important addition to the cash flow equation in this case.
Even after paying close to $600 million per year in cash interest expenses (assuming total interest expense at 8.8 percent), plus providing for working capital and other needs, the company could conceivably have more than $600 million a year left over for debt reduction.
Obviously, a fair number of pieces still have to fall into place.
Assuming the company rejects Schulze's offer and he has to go directly to shareholders, he will first have to make the deal appealing to investors, making sure that the private equity firms that have joined him come away from the transaction with sufficient influence (board seats, percentage of equity) to satisfy their commitment.
Schulze will also have to make his offer appealing to current equity holders. Our best guess: Watch for him to raise his per-share offer. But even at a higher share price, we think the numbers still work.
Then Schulze will have to present a business plan that makes sense. Both bond buyers and the private equity groups will want to know how he plans to fix the business before they hand over any money.
What will Schulze have to do? A few ideas:
•Get more aggressive in downsizing the brick-and-mortar portion of the business. Simply put, the stores are too big and there are too many of them. Best Buy has 5,000 stores, only 27 of which are company-owned. The rest are leased, with the company currently shelling out $1.2 billion a year in rent. Debt investors will be closely examining how the buyout group plans to reduce the company's footprint and rent burden.
•Redefine the company's value proposition. With Best Buy's value proposition essentially a cruel joke -- "Amazon's showroom" -- the company has to figure out how to grow again. Focusing on mobile phones and e-readers is good, but not enough. Can Best Buy both shrink its footprint and at the same time identify the mix of products that perform the best? With its considerable size and reach, might it be able to sign some exclusivity agreements -- say, with Apple on its rumored iTV, a product that requires more retail floor space than is readily available in the Apple stores?
•Redefine customer service. Here, penny-pinching debt investors might well applaud a greater investment in its sales staff -- higher compensation to attract more experienced people who can provide an edge over a website.
•Hope for some positive breaks. Revenue-starved states are beginning to chafe at the sales tax they're losing to Internet-based retailers. Both Democratic and Republican governors and legislators are pressing Congress to level the playing field on this front. Indeed, if online retailers had to charge sales tax to all of their customers, we calculate that the price difference between bricks-and-mortar retailers and the Amazons of the world is at most only about 2 percent. How many more consumers would pay that small differential to go to a store, ask some questions of a knowledgeable salesperson and then be able to take the product right home?
Best Buy also could catch a wave from a meaningful economic recovery. We are, in fact, seeing the nascent signs of that. Consumer spending is exhibiting some buoyancy and, even more important, the housing market, a tremendous growth driver for electronics and other durable goods, is showing signs of life.
Our bottom line: We think Best Buy is going to be a survivor. The company is profitable and, in spite of the brickbats thrown its way by some, still has an extremely strong brand. This deal could work.
