DEEP STOCK ANALYSIS: Best Buy Opens Their Books

The following is an excerpt from a report compiled by Michael Pachter of Wedbush Securities.

Best Buy (NYSE:BBY) and founder Richard Schulze announced an agreement that removes key obstacles to Mr. Schulze’s potential acquisition of the company. Under the terms of the agreement, a group led by Mr. Schulze will be granted immediate due diligence access to certain non-public information. Mr. Schulze and his team will have the opportunity to submit a fully financed definitive proposal within 60 days, extended under certain  circumstances. In addition, the company’s board granted Mr. Schulze permission to develop a takeover proposal with his private equity partners. According to the Minneapolis Star Tribune, state law prevents an owner of 20% or more of a company’s shares (such as Mr. Schulze) from voting those shares in a transaction without approval from the Board of Directors or shareholders.

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The parties agreed to certain standstill provisions that could end up delaying a takeover by Mr. Schulze. Best Buy announced that if a transaction is proposed and subsequently rejected by the Board, Mr. Schulze has agreed to not pursue an acquisition until January 2013. However, beginning in January 2013, Mr. Schulze will be allowed to present a second transaction proposal. The Best Buy Board would then receive 30 days to review the second transaction proposal before Mr. Schulze takes his offer to shareholders at the company’s 2013 annual meeting (which will likely be held in the summer of 2013) or at a special meeting. If both offers are rejected by the Board and by the shareholders, Mr. Schulze has agreed to not pursue a transaction again until the expiration of the one year term of the agreement.

Mr. Schulze is expected to receive two Board seats. Best Buy also announced on Monday that Mr. Schulze will be offered two Board seats, proportionate to his share ownership. However, if Mr. Schulze presents a transaction proposal directly to shareholders, or if he violates the aforementioned standstill provisions, this offer will be withdrawn.

Although certain obstacles to a potential transaction have now been removed, we continue to view a buyout by Mr. Schulze as unlikely. We are not optimistic that a deal will be completed on the terms described by Mr. Schulze without significant equity participation from a partner, and we think the likelihood of such a partner emerging is remote, particularly as Best Buy’s profitability declines. However, as the specter of a buyout remains on the horizon, we expect some upward volatility for Best Buy shares each time the company or Mr. Schulze makes an announcement or discloses information that indicates that the takeover is proceeding. Today’s market reaction demonstrates that the market has assigned a likelihood of 10 – 20% that a deal can be completed at the proposed $24 – 26/share offer price.

Mr. Schulze’s overtures have been ongoing since he resigned from the Board in June 2012. On June 7, Mr. Schulze resigned as Chairman and Director effective immediately in order to explore all available options for his ownership stake. In an August 6 letter to the Board of Directors, Mr. Schulze offered to acquire all of the common stock of the company for $24 – 26 per share in cash, a 36 – 47% premium to the prior closing price. On August 19, the Board of Directors announced that its proposal to Mr. Schulze, which included access to the company’s non-public information to perform due diligence on condition that he provide a fully financed proposal within 60 days, had been declined. In his own statement, Mr. Schulze responded that he was disappointed and surprised by the Board’s abrupt termination of discussions, and that he remained hopeful that the Board would engage in good faith discussions with him.

We remain skeptical that Mr. Schulze’s “turnaround plan” will be effective.  We note that Mr. Schulze founded Best Buy, was its board chairman until June 2012, and somehow neglected to mention or implement his turnaround strategy while associated with the company, notwithstanding his control over executive appointments.  We find it hard to believe that Mr. Schulze developed a strategy only since his departure from Best Buy’s board, and we expect that potential equity partners will share our skepticism.  While he was on the board, Best Buy did little to address the threat of Internet retailer share gains.

We reiterate our UNDERPERFORM rating and 12-month price target of $14.50 which reflects low visibility, lack of FY:13 guidance, our view that a takeover is unlikely, and our skepticism about the company’s new CEO. We believe Best Buy has been unable to stem sustained comps declines and eroding margins, and remains at a significant disadvantage to its lower-priced and lower-cost peers. Our price target reflects a P/E multiple of ≈ 5x our FY:14 EPS estimate of $2.90, and is well below Best Buy’s historical 12-15x multiple.

Risks to attainment of our share price target include changes to the macroeconomic outlook, variability in new product release timing, the effect of competition from other consumer electronic and big-box retailers and changes in consumer demand for consumer electronics.

Michael Pachter is an analyst at Wedbush Securities.

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