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Gad: Best Buy's Best Bet

Advancements in technology and the growth in online shopping have crushed electronics retailer Best Buy's (BBY)business model this year. Many folks are coming into stores, picking the TV they like, then turning around and ordering it online. On top of that, today's most profitable electronic devices are smart phones, tablet computers, and other mobile devices - items that require very little retail selling space. The era of big-box electronic retailing is changed forever. If that wasn't enough, the company CEO was forced out after making some inappropriate personal decisions.

Despite all this, there may be silver lining to owning the shares today. Recently, company founder Richard Schulz announced that he was putting his 20% equity stake on the block. With the shares currently trading around $20, Best Buy holds a market cap of $6.7 billion. Realistically, Schulze's stake needs to be sold in a private transaction. Trying to sell on the open market would not make sense. Even though Best Buy is struggling at its current valuation, appeal for a private equity firm or other strategic investors to buy the shares still exists.

At its peak, Best Buy was valued at nearly $30 billion. At today's current valuation, even a share purchase at 50% would not seem outrageous. Despite reporting its first-ever annual loss in fiscal 2011, Best Buy still managed to generate more than $2 billion in free cash flow. At an enterprise value (EV) of $7.3 billion, the company is changing hands at less than 4x EV/free cash flow (FCF). No retailer comes close to that multiple. According to data compiled by Bloomberg, the median enterprise value to the FCF multiple was 19. If Best Buy has a future, the shares are ridiculously cheap.

Since it has established such an iconic brand name in electronics retailing, the company can continue to thrive if can adapt to the changing environment. Current management appears to understand this. The company is shutting down many of its large under-performing big-box locations and focusing on growing much smaller, mall-based "Best Buy Mobile" shops. These smaller stores cost a fraction to set up and focus on selling mobile equipment, which is the fastest and most profitable segment of the electronics industry.

With $2 billion in debt and $1.4 billion in cash, Best Buy is ripe for private ownership. As a privately owned company, not only would Best Buy avoid the expenses of being publicly traded, but the company would also be freed from its annual dividend expenditures of nearly $300 million. All those cash savings support the thesis that a deal to go private would create value. Even at $10 billion, the valuation would be highly attractive and likely supported by the majority. At $10 billion, one would be getting a retailer that could easily generate in excess of $2 billion in free cash flow. Even if the company became smaller and more niche focused, profits could increase. Just look at Apple's (AAPL)retailing home run in selling iPhones, iPads, and notebooks.

Best Buy shares are worth keeping an eye on. Unlike former competitor Circuit City, Best Buy can still succeed by operating large stores in under-penetrated markets and focusing on smaller mobile locations in other areas. If the shares continue to decline, the upside will get better and better.

At the time of publication, Gad had no positions in the stocks mentioned, although positions may change at any time.

Sham Gad is the managing partner of Gad Capital Management, a value-focused investment firm based in Athens, Ga. Gad has written extensively for The Motley Fool and was a securities analyst for UAS Asset Management, a small value investment fund in New York City, in 2007. From 2002-2005, Gad managed assets for the Gad Investment Group.

Additionally, Gad has just released a new book, The Business of Value Investing: Six Essential Elements to Buying Companies Like Warren Buffett. He earned his BBA and MBA at the University of Georgia. Gad appreciates your feedback; click here to send him an email.

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