Best Buy Buyout Is No Sure Thing

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Richard Schulze Best Buy
Shares of Best Buy (BBY) soared 13% on Monday after founder Richard Schulze sent a letter to the retailer's board requesting permission to explore a buyout of the company.

Schulze's plan to take the struggling consumer electronics chain private has been swirling for weeks. He owns 20% of the company, and he was dismissed by the company for not being more forthcoming on actions that led to CEO Brian Dunn's dismissal.

It would be poetic justice. Schulze would get back the company he started, and Best Buy would be able to attempt a turnaround outside of the public limelight, where quarterly disappointments are weighing on both its shareholders and employee morale.

Unfortunately, it won't be easy to get to the fairy tale ending.

There are Billions at Stake

Schulze's letter suggests a takeover price between $24 and $26 a share. The buyout would come as sweet relief to investors who saw the stock hit a fresh multiyear low in the mid-teens just two weeks earlier.

He already owns roughly a fifth of the company, but it's the other 80% -- and the company's net debt -- that makes this a tough deal to pull off.

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Best Buy Buyout Is No Sure Thing

Showrooming -- the troublesome practice for local store owners that finds potential buyers kicking the tires of products before buying them cheaper online -- isn't going away.

Amazon.com (AMZN) reported a 34% spike in net sales during its first quarter on Thursday. Best Buy doesn't operate on the same fiscal calendar as the leading online retailer, but analysts feel that the company's top line will inch less than 3% higher when it reports next month.

It's not Best Buy's fault. A company with the overhead of manning physical stores can't afford to sell at the prices that nimbler Web-based retailers can offer. The wide availability of the Internet as a research tool also makes the hands-on perspective that local retailers provide less necessary, and in some cases even less desirable.

Some real-world chains are fighting back through exclusivity. Cheap-chic discount department store operator Target (TGT) has been a strong player in stocking up on items that are only available through Target.

Best Buy doesn't have that luxury.

Best Buy confirmed on Thursday that it's killing Best Buy Connect, the retailer's private-label mobile broadband service. It never took off, and the service reportedly had just 11,000 customers. Yes, the company has private labels for home theater and other consumer electronics, but it's not as if the merchandise is considered unique. This isn't Sears (SHLD) with brand equity for its Craftsman tools and Kenmore appliances.

Walk into a Best Buy and check out the racks of CDs, video games, books, and movies. All four of those media platforms are losing physical appeal as those industries go digital.

In Thursday night's quarterly report, Amazon revealed that nine of the 10 best-sellers were digital products. Best Buy may think it's scoring a sale when it sells a tablet or a smartphone, but it's really simply handing over the tools that will result in that shopper relying less on in-store purchases.

Another nugget in Amazon's report is that 130,000 of the books in its virtual marketplace are exclusive to the Kindle Store. Yes, a lot of that is vanity press stuff from authors who couldn't land real publishing deals, but 16 of Amazon's 100 best-selling e-books were exclusive to its store.

Apple (AAPL), on the other hand, is the poster child of the modern ecosystem. The success of iTunes has turned Apple into the country's largest music retailer. There are now hundreds of thousands of apps in the company's iconic App Store.

Best Buy has tried its hand at digital distribution of music and movies -- even to the point of buying Napster and CinemaNow -- but that hasn't panned out. Brick-and-mortar chains just don't have the high-tech appeal to launch cool digital ecosystems.

The worst part about movies, music, books, and games going digital isn't just the empty space that Best Buy will have to fill. The company has enough sharp retail vets to put the space to work with store remodeling plans that are currently in the works.

The worst part of the migration is that these are the items that forced shoppers to come back to Best Buy. You may only need a new washer once every 10 years, but there are always new DVDs hitting the market every Tuesday. New video games, CDs, and books are also always coming out. As more people replace physical media with digital -- and you do realize that Apple and Amazon are selling millions of tablets every passing quarter -- Best Buy will be a less frequent stop for even its most loyal customers.

Best Buy conceded in its most recent report that it will have to get serious about lowering prices in the future. Its aggressive expense-shaving efforts will be partly passed on to shoppers in the form of better pricing.

"We intend to invest some of these cost savings into offering new and improved customer experiences and competitive prices," Best Buy explained last month.

The problem is that it will probably never be able to cut its overhead to the point where it's truly competitive with Amazon and even cheaper e-tailers. This will force Best Buy into sacrificing margins on products, but hoping to make a profit by selling extended warranties, obsolescence insurance, and Geek Squad services. It's a plan that sounds fine on paper, but consumers are already tiring of the hard sell during the checkout process for services that they may never need. If Best Buy sees this as its future, it's underestimating what shoppers do when they're annoyed.

They stop coming back!

hhgregg (HGG) and Conn's (CONN) are some of the rare survivors in this field, and it's because they key in on heavy appliances, furniture, bedding, and even lawn care equipment that's harder to secure cheaper online, given the bulk of the items.

Best Buy naturally sells appliances, but that's just 5% of its business. If Best Buy wants to emphasize big-ticket items that are purchased very infrequently -- thereby taking on the smaller hhgregg and Conn's -- it would probably have to close all but a store or two in each of its major markets. There just isn't enough business for these products to justify Best Buy's existing store base and square footage.

In short, it's not going to happen.

Best Buy may be in the process of closing nearly 50 stores over the next few weeks, but there will be more of that in the future unless trends reverse and positive catalysts emerge.

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Schulze will need to convince private-equity firms to invest billions to complete the transaction, and these are savvy institutions that don't buy into something that they can't sell for more later. Does that sound like Best Buy to you? Yes, the stock has been beaten down over the past couple of years, but most watchers will argue that the markdowns have been warranted.

Best Buy is losing market share to cheaper and nimbler online retailers. Plans to grow sales by offering extended warranties and service plans are backfiring. The push to open smaller Best Buy Mobile stand-alone stores doesn't seem so great after seeing RadioShack (RSH) tumble while incorporating a similar strategy.

In other words, it will be hard to find financial backers to complete the transaction, especially after private equity firms crack open the company's books and assess the future of physical retail in a time when CDs, books, games, and DVDs are all going digital.

Bored of Directors

Schulze also needs to get permission from Best Buy's board to get to the point where potential buyers can begin their due diligence. That's a requirement under Minnesota corporate law, and it's not a slam dunk.

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The corporate graveyard is loaded with once-proud companies that ignored buyout overtures. Best Buy's now deceased rival Circuit City rebuffed two different buyout offers before eventually filing for bankruptcy and liquidating its assets.

Throwing out a price in the mid-$20s may have gotten Wall Street's attention, but it remains to be seen if Schulze can pull that off. The privatization effort will likely require the retailer to take on even more debt, giving it less wiggle room to complete a potential turnaround.

Sensing that there may not be a way out of Best Buy's downward spiral, potential buyers may simply want to wait to see if they can acquire the chain for less later.

Investors may want to follow suit.


Longtime Motley Fool contributor Rick Munarriz does not own shares in any of the stocks in this article. The Motley Fool owns shares of Best Buy and RadioShack.

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