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The Parallels Between Best Buy (BBY) and Circuit City

Added on by Lee Ho Fook.
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After several decades as the electronics retail leader, Circuit City was forced into bankruptcy as Best Buy (NYSE: BBY) seemed to always be one-step ahead, stealing market share year after year. What was a big part of Circuit City’s demise were its management and real estate issues. Circuit City lagged in getting into the gaming market and prematurely dumped its appliance-product segment. Best Buy was on top of the world as Circuit City was closing its doors in 2008, generating some $1.59 billion in free cash flow in the year following Circuit City's demise.

When Circuit City went bankrupt in 2008, Best Buy was expected to become the premier electronics retailer. Poor management, specifically inventory management, helped Circuit spiral out of control. The company was not liquid enough to buy new and popular products and the commercial paper market turned its back on the struggling retailer. In Circuit City’s final fiscal year its quick ratio was only 0.4, but Best Buy’s is 0.3 for its most recent quarter. The real estate problem for Circuit City steamed from its store locations, which were in inconvenient locations for customers. Just as Circuit City hiccuped on its locations and product offerings, Best Buy has lagged major e-tailer (NASDAQ: AMZNin improving its online presence. The fear is that Best Buy could fall to the same fate as Circuit City.

There is no doubt Best Buy still attracts some solid hedge fund interest, especially when its pays a 4.8% dividend yield and continues to have high free cash flow. The likes of Jeffery Vinik, Legg Mason's Bill Miller, Adage Capital, D.E. Shaw and Israel Englander were all upping their stakes in Best Buy during 3Q 2012. Billionaire Ray Dalio was one one of the major hedge funds that dumped shares of Best Buy (check out Ray Dalio's big sells).

In looking at the numbers, during the three years leading up to the Circuit City bankruptcy the company produced net income and free cash flow of. The Best Buy trends are also similar on a net income basis, but the retailer has still managed to generate very large amounts of free cash flow.

Taking a longer-term view, Best Buy went from generating only $574 million in free cash flow in FY2008 to $2.2 billion in free cash flow over the last twelve months—a 280% increase. Over the last twelve months the earnings loses have continued to pile up, with Best Buy managing to lose $1.5 billion (TTM), but generate some $2.2 billion in free cash flow (TTM). Although its dividend is relatively high at 4.8%, it appears to be well covered:  the current annual dividend payment comes out to $0.68 per share, compared to the $6.48 of free cash flow per share (TTM) and $2 per share of cash on hand.

The other big electronics retailer is GameStop (NYSE: GME). The real estate footprint is much smaller for GameStop, where the retailer has more diversity in its locations - being able to pop up in strip malls with ease. The retailer is up 20% year to date despite a 2012-holiday season that was worse than 2011. GameStop posted 4.4% lower total same-store sales and 4.6% lower total global sales. GameStop has a high level of short interest but is still loved by billionaires, including Ken Griffin and Steve Cohen (check out Steve Cohen's top picks).

Best Buy has shown some glimmers of hope of late; ComScore listed the company as one of the top three most trafficked websites for the Thanksgiving holiday and Black Friday, and Experian ranked the company’s site as the number three-retail site on Cyber Monday. Its revenue was, however, relatively flat year over year—a positive compared to GameStop’s performance. On the other hand, Wall Street does expect GameStop to outperform on an earnings basis over the long-term, and the retailer pays a similar dividend as Best Buy.

The great brick-n-mortar slayer, Amazon, will continue to wreak havoc on both Best Buy and GameStop. The online commerce company shows no signs of letting up. Market share gains will come from new offerings, including its tablet (Kindle Fire), which make purchasing and shopping with Amazon even easier and more convenient. Amazon Prime is another on of its services that is making shoppers' lives easier. Billionaire Ken Fisher – founder of Fisher Asset Management – is the top fund manager owning Amazon (check out Ken Fisher's newest picks).

In late December Best Buy founder Richard Schulze extended his time frame for making a buyout offer for the retailer. Schulze's initial offer came in at $24-$26 per share, but much uncertainty remains over whether he can put together the necessary funding. Now that the stock is trading below $15 per share it is unlikely that Schulze would still be willing to pay such a premium. Best Buy going bankrupt is very unlikely; its free cash flow generation is much more robust and its real estate portfolio is not under siege like Circuit City's. Yet, we would remain cautious on jumping into Best Buy shares given the uncertainty of its ability to pivot its business model and questionable ability of Schulze to raise the needed capital to take the retailer private.