Best Buy Earnings: You Break It, You Best Buy It

(Best Buy earnings, buyout story, updated to reflect analyst comments and additional company data)



NEW YORK ( TheStreet) -- After Best Buy ( BBY) reported worse than expected second quarter earnings and declined to provide any outlook on the year's second half, it's time for the company's founder and former chairman to put up or shut up on a takeover offer that could reach nearly $9 billion.

On the heels of the top and bottom line earnings miss on Tuesday -- in addition to Best Buy's suspension of earnings guidance and a share buyback program -- both the company and founder Richard Schulze need to get serious about whether a private takeout is in the cards, after months of speculation. Investors are now more likely than ever to accept a premium-priced buyout offer as Best Buy's shares tumbled to a value as low as $16.31 in early Tuesday trading -- their lowest level since 2002 -- though shares made up much of the early 10% dip by Tuesday afternoon amid heavy trading.

The take-private deal unveiled by Schulze on Aug. 6 hit new snags on Monday, when Best Buy said Schulze declined to conduct due diligence in his $24 to $26 per share buyout proposal.

Schulze had publicly challenged a seemingly hesitant Best Buy board to open its books since announcing his takeover offer. The big box electronics retailer said on Monday that Schulze didn't accept the company's offer to open its books and waive Minnesota laws that would prevent a private equity buyout proposal, a move that caused analysts to question whether the bid has stalled, and precipitated a freefall in Best Buy shares that continued after Tuesday's earnings.

The gamesmanship continues on both sides of the Best Buy divide: Schulze contends he wants to move fast on a takeover as the Richfield, Minn.-based company's earnings tumble. The Best Buy founder argues he can't sit on an offer until January -- a look at the books would entail deferring a takeover proposal or tender offer to 2013.

The jury remains out on whether Schulze is a legitimate bidder, but his complaint that timing is everything isn't without merit. Liquidity at Best Buy appears to be a concern after the company reported a 67% drop in cash to $680 million from the year-ago level. Still, Best Buy said it expects to earn $1.25 billion to $1.5 billion in free cash flow for the year, a cash generation level that may yet appeal to the debt and private equity investors needed to make a private takeover happen.

In a complicated dance between Schulze and his former company, one thing is clear: Shareholders and analysts aren't buying into either Best Buy's turnaround story or its M&A prospects.

Best Buy left investors and analysts scratching their heads on Monday when it announced the hiring of Hubert Joly, the former head of hotels operator Carlson Companies to be its CEO, replacing interim chief executive Mike Mikan.

"We find Mr. Joly's resume unimpressive, and believe he lacks sufficient experience to engineer a turnaround at Best Buy," wrote Wedbush Securities analyst Michael Pachter in a Monday note to clients. "Should the buyout discussions resume, we would continue to view a buyout by Schulze as unlikely," the analyst added.

Meanwhile, investors are suffering as Best Buy drifts without direction amid an onslaught of competition from online electronics retailers like Amazon ( AMZN) and as more popular destinations like Apple ( AAPL) stores cut at its viability. Overall revenue of $10.5 billion and adjusted EPS of 20 cents in the second quarter missed analyst estimates polled by Bloomberg of $10.6 billion and 31 cents, respectively.

Best Buy profit tanked by 90% compared with the year-ago quarter, while same store sales were down 3.2% -- 1.6% in the U.S. and 8.2% internationally, continuing a multi-year declining sales trend across the chain's locations.

Deutsche Bank analyst Mike Baker highlighted promotions that cut into gross margins, as competition weighed on profits. "The decline was due to a mix toward smart phones as well as promotional activity as Best Buy tries to keep pace with Amazon pricing," wrote Baker in a note to clients.

Greater-than-expected overall and comparable store sales declines were driven by underperformance in gaming, digital imaging, televisions and notebooks, according to KeyBanc Capital Markets analyst Bradley Thomas. Regarding growth areas like e-commerce and international markets like China, Baker and Thomas both noted weaker-than-expected performance.

Initially, Schulze's buyout offer was viewed skeptically by analysts because of vague language surrounding the billions in debt financing and private equity co-investment that the company's founder would likely need to take Best Buy private.

Analysts also questioned why Schulze, who owns over 20% of Best Buy shares, wasn't willing to throw his entire equity holding in the company into a takeover effort -- the $1 billion in equity that Schulze said he was willing to put into the deal compares with estimates of a $1.7 billion value for his Best Buy stake earlier in August.

After carrying around a financing letter from Credit Suisse ( CS) and the purported interest of unnamed private equity investors, Schulze's Aug. 6 bid resembled a Carl Icahn-like takeover choreography.

However, Icahn, a famed activist investor, either puts his chips all-in on takeover efforts or folds. In the case of Clorox ( CLX), a similar sized takeover proposal to Best Buy, Icahn put in a tender offer to buy the company and nominated a hostile slate of directors to the cleaning products giant's board. Shareholders rejected Icahn's board nominees and halted his takeover effort, and the failed bid is instructive as Best Buy shareholders are caught between an increasingly uncertain management turnaround effort and murky private buyout offer.

Now, the sparring period between Best Buy and Schulze needs to come to an Icahn-like head. For shareholders, it would be best if Best Buy allowed Schulze to conduct due diligence and waive Minnesota laws on forming a private equity consortium, and it also should allow proposals to go to shareholders before 2013.

In Schulze's case, he still needs to submit a valid offer for shareholders to even consider.

There is reason for investors to take a Schulze takeover attempt seriously if one ever surfaces. The 46-year company veteran's offer now represents a near-60% premium to current Best Buy share value. Meanwhile, Schulze's record and his stated intention of bringing long-time executives back to Best Buy may be a better turnaround solution than newly hired CEO Carlson, whose experience isn't in electronics retailing.

In his buyout proposal, 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 his proposal.

Were Best Buy to allow Schulze to proceed without any more gamesmanship, 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 financing fronts, though, the proposal appears challenged.

"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 reacting to the initial proposal. 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.

There is also uncertainty as to whether Best Buy's balance sheet and declining profitability can withstand the pressures of a debt-fueled buyout. Earlier in August, 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.

Citigroup analysts initially estimated 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. But analyst Kate McShane notes that debt financing would still require $4 billion to $5 billion in debt, and Citi calculates that market's ability to provide buyout debt has already been stretched at $3 billion to $4 billion in recent deals.

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.

Having worked at the retailer for nearly 50 years, the company's founder has a strong hand yet to play in any turnaround pitch to shareholders, financiers and private equity funds. But after making his initial Icahn-like proposal, Schulze now needs to go all in or walk away from the table.

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