What’s Happening With Best Buy?

Best Buy‘s (NYSE:BBY) stock has shown extreme volatility in the last few days. It first rose sharply to the tune of 15% and then plunged by a similar amount towards the end of last week. The sharp movements have been attributed to speculation around a possible buyout by the firm’s founder Richard Schulze. It was first reported that there was a possibility of an offer being made by Schulze by December 15, one day before the deadline of December 16 that had been given to him by the company. On Friday, however, Best Buy agreed to extend this deadline. Schulze can now make an offer any time until the end of February. ^[1]

It seems to be in Best Buy’s interest to wait for the holiday season sales in order to shore up the value of the company to prospective investors. While Schulze made a tentative offer in August, pegging the company at around $9 billion, the valuation has plunged since then. The approximately $9 billion offer valued each share of Best Buy at around $26 per share which is no longer realistic, given that it is trading at almost half the value in the market now. The offer expected from Schulze last week was speculated to value the company at around $17-18 per share for an overall valuation of around $6 billion, thus reflecting the downbeat sentiment about its prospects. ^[2]

See our full analysis for Best Buy

Why Are Investors Not Enthused About Best Buy?

The company’s results have been dismal recently, with comparable store sales and gross margins declining. In the last quarter alone, while comparable store sales fell by 4.3% year-over-year, gross margins narrowed by more than one percentage point, to 24% from 25.6% in the comparable period last year. ^[3]

The problem of showrooming is largely to be blamed for falling comparable store sales. Declining gross margins are largely a function of structural changes in the business such as a change in product mix towards more smartphones and tablets from the traditional categories of TV’s and PC’s. Profitability in the smartphone category is primarily driven by the money Best Buy receives from the carrier and from the attachment of accessories in services that go with it. The price point of the smartphone is almost irrelevant in the calculation of gross margins, because it’s a heavily subsidized product. So when looking at a gross margin rate, even with a higher value smartphone Best Buy is still getting the same amount from the carrier and the same attachment at the end of the day.

We think that declining margins are here to stay for the foreseeable future since the biggest factor impacting gross margins is the product mix composition which is dictated by consumer preferences and is largely beyond Best Buy’s control. Controlling costs and improving efficiency through optimal store sizes and leasing agreements could help to some extent, but there is a limit to the extent by which efficiency can boost margins.

To improve comparable sales growth, Best Buy could leverage its multi-channel approach where it can engage consumers across multiple platforms like brick-and-mortar stores and online. The company has offered to match lower prices being offered by other retailers like Amazon. However, it’s too soon to say how successful this strategy is going to be. The holiday season may offer a better chance to evaluate it. In the last quarter, a 10% gain in online sales to $431 million failed to offset the slide at the company’s brick-and-mortar stores. ^[4]

What Does A Deadline Extension Mean For Schulze And Best Buy?

There has been speculation that Schulze has not been able to raise enough money from prospective investors to make a buyout bid. The extension gives him more time to work on raising funds. Also, the performance of Best Buy in the holiday season will be closely watched by all parties. While the extension offers Best Buy a chance to prove that there is still space for a big sized traditional bricks-and-mortar retailer in the market, it also affords investors a chance to make up their mind.

Best Buy will definitely pull out all stops to do well this holiday season. A good performance may be rewarded with a better valuation from the private equity investors Schulze is in talks with. This may help shore up the stock price and allow the Best Buy board to demand significant premiums if and when a buyout offer comes up for evaluation. On the flip side, a good performance will make the acquisition pricier for Schulze. We think that Schulze might actually prefer this over a lower price tag and the possibility of his bid being rejected by Best Buy’s board.

A sub par performance this holiday season may cause Best Buy’s stock to plunge further and scare off the investors who are in talks with Schulze.

At a more fundamental level, granting an extension in itself raises unanswered questions about the intentions of Best Buy’s board. If the company is confident enough of scripting a turnaround, which is expected to be a long-term process, why the extension? Is the board actually fishing for the company to be bought out? Was the intention only to avoid a hostile takeover battle as far as possible? We have no answers and it is difficult to know their motives behind this. For now, all eyes will be focused on Best Buy’s performance in the upcoming holiday season. The outcome will decide the future course of action on both sides.

We have recently revised our price estimate for Best Buy to $16 after the third quarter earnings results.

Understand How a Company’s Products Impact its Stock Price at Trefis

1. Best Buy extends deadline for founder to make takeover bid, Los Angeles Times [↩]
2. Best Buy dives on delayed buyout bid, New York Post [↩]
3. Best Buy Q3 2012 10-Q, SEC [↩]
4. Best Buy Suffers From A Perfect Storm Of Weaker Margins And Sales, Trefis [↩]