Monday, November 19, 2012

Not Sold on the Best Buy LBO

Best Buy, the troubled electronics retailer, is rumored to be a LBO candidate. A group led by its founder Richard Schulze is expected to bid soon. If successful, it will be a $10B+ deal, the largest since the financial crisis began over 5 years ago. Increasing capital market investor risk appetite should be sufficient to fund a transaction of this size.

On the surface the basic financial metrics appear reasonable. The estimated equity purchase price based on current price and a premium would be in the $8B range which appears cheap compared to the $3B+ EBITDA. The purchase price should, however, be judged relative to what you receive in return. That is difficult to estimate given the expected 15%+ EBITDA, 2%+ sales and 3-5% same store sales declines expected over the next 5 years.

Typical required equity levels in the current market are around 35% or $3.5B of the $10B price, which includes the refunding of around $2B of existing debt. This is a large number even after Schulze’s rollover equity. Thus, multiple private equity sponsors may be needed. The $6.5B balance could be funded with loans of $4-4.5B(60%) and high yield bonds for the balance.

However, just because something can be done does not mean it should be done. A deeper review shows the following concerns:
  1.                 The large equity need and problematic exit may depress expected private equity returns. The large amount of private equity dry powder may reduce the hurdle rate as PE firms look to invest capital vs. returning it to their investors.
  2.                 Leases represent a large off balance sheet liability at Best Buy. Using the standard rule of thumb of 8X annual rental to calculate lease liabilities yield $9B+. Thus, Total debt will exceed $15B. Compared to EBITDAR (EBITDA + Rent) of around $4.5B this still seems reasonable. Nonetheless, the debt multiple will exceed the current equity multiple. This tends to make new creditors nervous.
  3.                 Industry conditions are brutal with on-line competitors like Amazon and discounters like Wal-Mart stealing share and crushing margins. Best Buy’s largest competitor went bankrupt a few years ago. Both Best Buy and its competitor Radio Shack are suffering continued same store sales declines.
  4.                 Expected core EBITDA(R) is difficult to gauge as Best Buy’s sales and margins are falling. Their entire business model is being questioned given declining sales per store, same store sales and market share deterioration. Best Buy’s high cost structure compared to Amazon and Wal-Mart make it difficult for Best Buy to compete. A major business model change is probable. Absent a reliable core EBITDA(R) it is difficult to build a realistic capital structure.
  5.                 All retailers are experiencing macro head winds from an uncertain economy. This could further pressure sales and margins.
  6.                 The fact that the management team is yet to be decided is a big issue. Look at the sales collapse at JC Penny when a new CEO implemented a substantial high-risk business model change.
  7.                 Vendor impact is yet to be gauged. The substantial losses at Circuit City may cause vendor concern of an LBO. Remember, the senior secured bank debt places vendor inventory shipments into another creditor’s collateral pool. They could respond by curtailing shipment, reducing creditor or shipping “hot” high demand items first to Best Buy’s competitors.
  8.                 Competitor response needs to be considered. They could initiate price wars and talent raids to take share from a highly indebted Best Buy.
  9.                 Retailers need to maintain fresh stores. This requires substantial capital expenditures (CAPEX). Best Buy annual CAPEX is around $750MM.This serves to reduce its debt servicing capacity.
  10.                 Best Buy is already perceived as near noninvestment grade. Its probable post close debt rating would be in the “B” range.  The B market window is currently open. It is, however, subject to unpredictable closures. This could adversely impact  Best Buy’s liquidity should unexpected needs develop.

Bottom line, troubled retailers and high debt do not mix well – there is simply too much business risk. Successful retail LBOs involve firms with strong category positions like Staples who can continue to grow. I believe Best Buy does not make a good LBO candidate - others disagree. Nonetheless, as Warren Buffett notes,  deals may fail in practice, but they never fail in projections. Thus, beware receiving a slick-offering memorandum that proves a Best Buy buyout works. Keep a skeptical eye and question everything.

This will be a developing story. So more to follow.  See Fitch 11-8-12 report entitled “Best Buy LBO Significant Hurdles Remain” for additional details.


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