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Potential upgrade of Best Buy highlights relative value

admin | November 22, 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. This material does not constitute research.

Moody’s placed Best Buy’s (BBY) Baa1 rating on review for an upgrade, highlighting the company’s consistent operating performance coupled with its conservative financial policies and strong credit metrics relative to peers. Despite the potential for an upgrade to the low A category, BBY continues to trade at a considerable discount to its mid-to-high BBB retail peers. A particularly attractive retail swap is out of ORLY 3.9% 6/1/29 into BBY 4.45% 10/1/28: investors shorten maturity by 8 months, pick up 60 bp (g-spread), while staying within the same ratings category (Baa1/BBB) and deal size.

Exhibit 1. BBB/BBB+ Retail Space – 7-10yr (excluding department stores)

Source: Bloomberg; APS

Best Buy’s debt/EBITDA currently stands at 0.4x with lease adjusted leverage at 1.0x. Leverage that low is indicative of much higher ratings – for example, Target Corp. (TGT – A2/A/A-) and Ralph Lauren Corp. (RL – A2/A-) are currently levered on a lease adjusted basis at 1.85x and 1.7x, respectively. Most BBB retail peers (Exhibit 1) have been operating with lease adjusted leverage in the 2.2x-2.5x range, while both Dollar General (DG) and Dollar Tree (DLTR) operate closer to 3.0x.

The right strategy

Despite the consumer electronics business being highly promotional and competition from the likes of Amazon (AMZN A3 (p)/AA-/A+ (p)), Walmart (WMT Aa2/AA/AA) and TGT, BBY has found the right strategy to resonate with customers. The company has become a trusted retailer for consumer electronics vendors including Apple, Amazon, Google, Microsoft, Samsung and Sony. Management’s vision to properly utilize square footage to showcase products that consumers typically like to test prior to purchase, coupled with investments in its staff and a strong and growing services business, has helped differentiate BBY from its competition. BBY is also forging a path in healthcare services for aging seniors, with its recent acquisitions of GreatCall and Critical Signal Technologies (CST). These devices and services not only help seniors live longer in their homes, but also help to reduce health care costs for their customers. Furthermore, they are a great complement to BBY’s Geek Squad and In-Home Advisors services as more customers are demanding “smarter” homes.

Balance sheet remains strong

BBY moved to a net cash position in the summer of 2013 and 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 is operating with less cash on the balance sheet. However, with the exception of fiscal 2Q19, BBY has remained in a net cash position, which as of 2Q20 was $348 million. This is after completing the acquisition of CST on 6/4/19 for $125 million in cash. It is likely the company will maintain a similar level of cash on the balance sheet going forward, with the potential for some temporary declines as BBY continues to expand its services business. The strong cash position, untapped $1.25 billion revolver (maturing 4/17/23) and estimates for over $2 billion of free cash flow this year puts BBY in an exceptional liquidity position. Furthermore, BBY has no debt maturing until 3/15/21, when $650 million comes due.

Exhibit 2: BBY cash vs. debt

Source: BBY Company Reports

Financial Goals Achieved Early

At the company’s investor day back in September 2017, BBY listed financial targets that they expected to achieve by FY2021. BBY was still in the midst of its Renew Blue Transformation program and felt that 4 years was ample time to achieve what was considered somewhat aggressive goals given the competitive and changing retail landscape. Retailers were not only heavily investing in omni-channel at the time which was pressuring margins, but also left in a position where promotional activity was necessary to both compete and grow the top line. Despite the headwinds, BBY achieved its financial goals two years ahead of target. Furthermore over the same time period, BBY increased its share of wallet by over 200 bp.

Exhibit 3. BBY Financial Goals

Source: BBY Company Reports

The growth in the online business, which now accounts for 17% of BBY’s top line was a big part of the company’s ability to hit its targets early, as supply chain and omni-channel investments have paid off. BBY has centralized access to its inventory and can fulfill an online order from a store or distribution center, depending on the customer’s preference for shipping speed. BBY noted that 80% of customers are now located in a zip code where next day deliveries are available. Additionally, 42 markets now have access to same day service, and customers wanting a buy online/pick up in store option can typically pick up their item within 30 minutes or less post online purchase. This speed in delivery/pickup provides a convenience factor which is highly valued by the consumer.

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