Best Buy Investors Should Brace for Tough 2Q

 Best Buy (BBY) is set to report second-quarter results before the market opens Tuesday, and while we believe there is downside risk to our estimates (already well below the consensus outlook), all eyes will probably be on the escalating showdown between the board and founder Richard Schulze (who controls a 20% stake in the company and submitted a bid to buy the remaining shares for $24-$26 each earlier this month) as well as the company's new CEO appointment.

On Sunday, Best Buy's board announced that it had convened Friday to discuss Schulze's indication of interest in the company and authorized its advisers to initiate discussions on a cooperation agreement whereby Schulze, his potential private equity sponsors, and debt-financing sources would be given access to financial, operational, and legal information to move forward with a possible bid for the company, but only after agreeing to certain protections for Best Buy shareholders. Also included in the board's proposal was the opportunity for Schulze to bring a fully financed buyout proposal to the board within 60 days as well as the ability to take his buyout offer to shareholders beginning in January 2013, should the board decide to reject any proposal to acquire shares.

According to a rebuttal statement by Schulze, he had rejected the board's initial offer for an 18-month "standstill" period before a takeover could be made (deeming it "completely unacceptable in light of the fact that urgent change is needed at Best Buy and value is eroding further every day that change is not effected"), but was still under the impression that negotiations over the standstill period would continue when the board issued its statement without notice. Given that he would need approval from the board before having serious negotiations with potential private equity sponsors and lenders, we believe this development will make it extremely difficult for Schulze to complete a buyout offer for the company.

Complicating the situation is this morning's separate announcement that the company has appointed Hubert Joly as president and CEO as well as a member of the board. Based on his turnaround experience across the media, technology, and services sectors, Joly seems like an appropriate choice to lead the effort to make Best Buy more competitive in the rapidly evolving consumer electronics retail industry. Joly most recently was CEO of Carlson, a global hospitality and travel company based in Minneapolis, and also held executive roles with Vivendi's video game business unit and French-based Electronic Data Systems as well as a long tenure with consulting firm McKinsey & Co. We believe Joly's experience with service and technology companies will be an asset in improving Best Buy's in-store service offering and making it a more competitive online retailer. Still, it remains unclear what decisions Joly will make regarding Best Buy's retail square footage, where we've long since believed a dramatic reduction was necessary to narrow the pricing parity gap with players like  Amazon (AMZN) and generate positive economic returns.

We believe Joly and interim CEO Mike Mikan will focus much of the second-quarter call commentary on Best Buy's efforts to optimize its cost structure and trim the size of its store base, reconnect with consumers, become more competitive in electronic and mobile commerce (especially when key vendors like  Apple (AAPL) have become less dependent on Best Buy as a channel of distribution), and overcome consumers' perception of pricing disparity between the company and players like Amazon and  Costco (COST). We've long held the stance that consumer electronics consumers will gravitate to the retailers with the lowest prices regardless of the level of the in-store service offerings, and until we are convinced that Best Buy's turnaround efforts will be sufficient to drive enough price parity in the marketplace, we will maintain our negative long-term outlook. Even if pricing parity is achieved, price competition will probably keep Best Buy's operating margins on a downward trend toward the 2%-3% range over the next several years.

Consensus estimates call for second-quarter revenue of $10.63 billion (including a same-store sales decline of 2%), operating income of approximately $213 million, and earnings per share of $0.31 excluding restructuring costs ($0.27 on a GAAP basis). Our estimates are already well below Street estimates, including revenue of $10.47 billion, a same-store sales decline of almost 5%, operating income of $86 million, and EPS of $0.12, with much of the shortfall coming on the gross margin line.

While smartphones have traditionally been a margin-accretive category for Best Buy, we've witnessed rapid consolidation in this category over the past several quarters (with Apple and Samsung commanding a greater percentage of the overall market), putting downward pressure on wireless category gross margins.

We also believe some of the pressures that dragged down margins in the first quarter could resurface this quarter, including aggressive industry price competition and the ongoing service revenue mix shift away from one-time transactions to ongoing tech support memberships.

Based on our pessimistic second-quarter outlook, we expect a reduction in management's full-year outlook for revenue of $50.0 billion-$51.0 billion, comparable-store sales declines of 2%-4%, a 4%-11% decrease in operating income dollars (after adjusting for restructuring costs, discontinued operations, and one-time items), and adjusted EPS of $3.50-$3.80. We also wouldn't rule out a reduction or outright suspension of the dividend (currently representing a payout ratio of 23% based on our full-year EPS outlook and yielding 2.8% at current prices), as management looks to conserve cash for its turnaround efforts.

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