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No holiday blues at Best Buy

| March 1, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Best Buy debt has outperformed in the wake of impressive earnings and management achieving 2021 revenue and earnings per share targets two years ahead of schedule. The trading differential between Best Buy and peer Walgreen’s bonds could collapse further, with the Best Buy 2028 bonds outperforming by up to 30 bp.

Earnings review

Best Buy (BBY, Baa1 (p)/BBB/BBB) bucked the holiday blues as the company turned in strong 4Q results, posting same store sales of 3.0% which beat street estimates of 1.7%. The 3.0% growth was off of a very difficult comp of 9.0% for the year ago period.  Furthermore, domestic online same store sales were up a strong 9.3%, again off of a very strong comp of 19.3% in 4Q18. The largest growth drivers for sales were wearables, appliances, gaming and smart home. These categories were partially offset in the mobile phone category.  Same store sales could have been a lot worse, but company management had the foresight to view the mobile category as maturing, and shut its mobile only format stores roughly one year ago.

The company expanded its adjusted operating margin by 30 bp in the quarter to 6.7%, driven primarily by better cost controls. Operating margin for the full year was 4.6%, flat from the year ago period. Notably, Best Buy hit its fiscal year 2021 revenue and operating income targets 2 years ahead of schedule with fiscal year 2019 results.  Roughly two years ago at the company’s Investor Day, management laid out FY21 targets of $43 billion of annual revenues and $1.9 to $2.0 billion of adjusted operating income.  For FY19, BBY posted revenues of $42.9 billion and $2.0 billion of operating income.  Furthermore, the company’s non-GAAP EPS of $5.32 beat management’s FY21 target.

Exhibit 1: Best Buy investor day targets

Source: Company reports

Balance sheet remains solid

BBY moved to a net cash position in the summer of 2013 and has maintained a net cash position while executing its Renew Blue Transformation. During the transformation, management felt that a cash position of at least $3.0 billion was the right approach in order to provide the company with financial flexibility while reinvesting in the business and reducing debt. Now that the transformation is complete, management plans to operate with less cash on the balance sheet moving forward.  However, the company remains in a net cash position and ended the year with cash on hand of $1.98 billion relative to $1.39 billion of total debt.  Expectations are that management will maintain this level of cash on the balance sheet going forward, with perhaps some temporary declines as they look to expand further in the services business.

Exhibit 2: Best Buy cash versus debt

Source: Company reports

Credit metrics indicative of higher ratings

Current credit metrics are indicative of higher ratings, as debt/EBITDA remains at a half a turn and lease adjusted leverage remains solidly at 1.5x. Other mid to high BBB retail peers all have lease adjusted leverage in the 2.0x-2.5x range (including AAP, ORLY, and KSS).  Walgreen’s (WBA-Baa2/BBB), which is still reducing debt from its Rite Aid purchase, ended the most recent quarter with lease adjusted leverage of roughly 3.6x.  WBA is not expected to reduce leverage below 3.0x.

Relative Value

While the better than expected results pushed BBY debt spreads about 15 bp tighter, the BBY 4.45% 2028 bonds are still attractive relative to peers. While it is hard to compare BBY to the much higher margin auto part retailing peers, Walgreen’s could be the best comp given the single digit margins associated with the pharmacy space. For comparison purposes, WBA posted last twelve month same store sales of 4.1%, while its EBITDA margin was 6.3%. Lease adjusted leverage was 3.6x while coverage was 13.0x.  This compares to same store sales of 4.8% at BBY for the full year and an EBITDA margin also of 6.3%. As noted earlier, Best Buy ended the year with lease adjusted leverage of 1.5x, while coverage was a strong 38.0x.  Currently BBY 4.45% 2028 bonds are trading roughly 63 bp (g-spread) behind WBA 3.45% 2026 bonds, while in 5yr CDS, BBY only trades 7 bp behind WBA.  Furthermore, BBY 10-year CDS has tightened over 15 bp since results were released and trades roughly 30 bp behind WBA. The trading differential between BBY and WBA could continue to collapse further in the bonds and estimates are that fair value for BBY 2028 bonds is around the 180 bp (g-spread) area, or 30 bp behind WBA.

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