Best Buy buyout story, updated to reflect Standard & Poor's downgrade

NEW YORK (TheStreet) -- Best Buy's (BBY - Get Report) founder and former chairman Richard Schulze has proposed a $24 to $26 per share buyout of the struggling big box electronics retailer, but the offer comes with strings attached. While the deal appears to offer shareholders a premium, they would be wise to treat the prospective buyout in the same way they would a bid by Carl Icahn.

With the deal, which could be worth $8.8 billion excluding Best Buy's debt, Schulze is pinning his hopes on heavy private equity and debt financing, in a proposal that closely resembles Carl Icahn's failed bid for Clorox ( CLX - Get Report) in 2011.

That's because while Schulze is willing to include his 20.1% stake in Best Buy shares worth roughly $1 billion in the deal, extensive buyout financing from advisor Credit Suisse ( CS - Get Report) and still unspecified private equity investment will be the deal's linchpin. Icahn's $76.50 a share bid for cleaning products giant Clorox in July 2011 -- the activist had a near-10% share stake -- hinged on a multi-billion dollar debt financing commitment from Jefferies ( JEF) and unspecified strategic interest from competitors outlined by Icahn.

Icahn's bid failed after a hostile battle between the activist and Clorox, which called the financing commitment and indication of strategic M&A interest flimsy. The board projected Icahn's offer as a bluff to shareholders, who came to a similar conclusion and rejected a slate of Icahn-appointed directors for the company's board. In September, Icahn withdrew his offer and began liquidating Clorox shares.

Monday's prospective Best Buy offer would come at a premium of 36% to 47% to the company's Friday close, in a buyout that would be the biggest since the financial crisis. Best Buy shares rose over 13% in late-afternoon trading on Monday to $19.98. That rise cut into year-to-date losses nearing 25%, but shares were still well below Schulze's offer price, and came down from an early morning high that sent shares up by as much as 21%.

Best Buy's board said it received and will review the proposal, which it characterized as a "highly conditional indication of interest." The company's board of directors "will review and consider the letter in due course, consistent with its fiduciary duties, in consultation with its financial advisors," said Best Buy in a statement.

With Icahn in mind, Best Buy investors should be skeptical of Schulze's Monday buyout proposal. Before assuming that Schulze will succeed or even unveil a formal takeover offer, investors need to focus on the proposal's details.

The bid is simply a written proposal to buy Best Buy at between $24 to $26 a share and is subject to due diligence and board permissions that would preempt a formal buyout offer. In addition, Schulze's proposal includes financial arrangements that are very much uncertain in still-tight credit and private equity markets.

"Even if the offer is deemed sufficient by Best Buy's board, there are still significant questions about the ability to raise the necessary financing," wrote UBS analyst Michael Lasser in a note to clients, citing the amount of private equity investment needed to complete the deal.

There is also uncertainty as to whether Best Buy's balance sheet and declining profitability can withstand the pressures of a debt-fueled buyout. On Monday, ratings agency Standard & Poor's downgraded Best Buy's bonds to BB+, a sub investment grade rating otherwise known as 'junk,' as a result of Schulze's proposal.

"In our opinion, a meaningfully debt-financed transaction by Mr. Schulze would weaken Best Buy's credit protection metrics considerably from current levels," wrote S&P credit analyst Jayne Ross in the downgrade, which left Best Buy's ratings on a negative credit watch, citing concerns about the company's current business model, competitive pressures in the retail sector and the prospect that Schulze moves forward with a takeover offer.

Meanwhile, Schulze's buyout pitch contains a string of caveats that signal Icahn-like gamesmanship in unfriendly buyout negotiations. "I have made repeated requests to the Board for several weeks to provide me with due diligence information and the consent to form a group required under Minnesota law, both of which will be necessary to reach a definitive agreement," wrote Schulze in the Aug 6 letter.

"While I preferred a private negotiation, time is of the essence. I am deeply concerned that further delay and indecision will cause additional loss of both value and talented leaders who are now uncertain of the company's future," he added.

Schulze stressed that the proposal would most likely materialize as a formal offer if the board allowed him to conduct due diligence on the finances of the company he founded decades ago. Meanwhile, the offer's only certainty is Schulze's existing $1 billion in stock that he is willing to include in a buyout -- Schulze is Best Buy's largest shareholder.

Citigroup analysts estimate that a prospective deal hinges on what's likely to be up to $5 billion in debt financing from Credit Suisse and $4 billion more in investment from a private equity consortium.

Schulze didn't disclose any actual financing commitment from Credit Suisse or whether any buyout money has been raised and instead said generically that the investment bank "is highly confident it can arrange the necessary debt financing." Meanwhile, the notion of a consortium of private equity investors in a share buyout of Best Buy cuts against a slowing in so-called "club deals" since the financial crisis. Investors would also need to make a big bet on Best Buy's turnaround, amid an onslaught of online competition.

In 2012, Best Buy lost $1.2 billion as margins and sales struggled to grow -- its first annual loss since the early 1990s. Meanwhile, the Richfield, Minn.-based retailer has also been hit by management change, including Schulze's departure.

In June, Schulze resigned from his chairmanship of Best Buy after the company's board said he acted improperly in handing "personal conduct" improprieties, which caused CEO Brian Dunn's ouster in April.

The key will be for debt and private equity investors to agree with Schulze's assertions that he and other former executives can turn the business around. On both fronts, the proposal appears challenged.

Citigroup analyst Kate McShane notes that while the possibility of a Best Buy takeout has risen to 50% from 20% prior to Monday's disclosure, the prospect of a stretched debt market remains a key risk, in addition to little clarity on private equity investment and the company's willingness to proceed. McShane noted that subtracting the $1 billion in Schulze's equity stake leaves a deal of $7.8 billion to be financed, of which Citi estimates $2 billion to $3 billion in private equity is available. Using data from Citi's Event Driven Desk, that would still require $4 billion to $5 billion in debt, and Citi calculates that buyout debt has been stretched at $3 billion to $4 billion in recent deals.

In May, privately held beauty conglomerate Coty failed in a $10.7 billion deal for Avon Products ( AVP), even after receiving an equity financing commitment from Warren Buffett-run Berkshire Hathaway ( BRK.A).

Best Buy's entire business model is also seen as becoming increasingly at risk as retailers like Amazon ( AMZN - Get Report) offer lower prices online and are using smartphone applications to actually allow savvy tech consumers to price shop while in Best Buy stores. While private equity investors may value the company's free cash flow, it may not pre-empt the investment that Schulze's Monday proposal indicates.

Lasser calculates that to raise the equity portion of the deal, a consortium of up to five private equity firms contributing up to $600 million apiece might be needed. "In our view, this would be a lot of exposure to an investment that has a high degree of uncertainty surrounding a potential exit," he wrote.

Both Lasser and McShane maintained neutral ratings on Best Buy shares and price targets of $20 and $21, respectively -- far below Schulze's prospective offer.

Still, Best Buy shares are on the rise because Schulze's proposal is likely to be taken favorably by some shareholders who are looking for a way to exit the company, as it loses customers to online retailers like Amazon.

Schulze, who spent 46 years at Best Buy, may also be seen in a favorable light by shareholders were he to piece together a formal share bid. In his letter, Schulze said that former Best Buy executives Brad Anderson and Allen Lenzmeier would "be interested in rejoining the company," potentially restoring a management team that made Best Buy into a leading electronics retailer.

During the period from 1991 through 2009 when Schulze, Anderson and Lenzmeier led Best Buy, the company's revenues increased from approximately $900 million to over $45 billion. Earnings before interest, taxes, depreciation and amortization (EBITDA) increased from approximately $30 million to $2.9 billion, Schulze noted in the letter. Meanwhile, shareholders enjoyed a total return in excess of 16,000%.

"This proposal represents a unique win-win opportunity for everyone involved," said Schulze in the letter. "It would create a new day for Best Buy employees and provide public shareholders with a significant all-cash premium for their shares. Importantly, it would eliminate the market and execution risk for Best Buy shareholders associated with a turnaround under an interim CEO."

While Schulze is talking up the offer as a win-win, the similarities to Icahn buyout tactics suggest anything but a guaranteed victory for the former Best Buy chairman, or shareholders.

For more on potential large buyouts, see details on why reports of LabCorp's ( LH) takeover hinge on a pre-bust M&A market.

-- Written by Antoine Gara in New York