Editor’s Note: This post analyzes Best Buy (BBY) using Mike Price’s checklist.

Mike Price sends: Best Buy has a business description that Mohnish Pabrai would like: it’s only two paragraphs. My translation:
Best Buy is a speciatlity consumer electronic retailer. It does this through its brands: Best Buy; Five Star; Future Shop; Geek Squad; Magnolia Audio Video and Pacific Sales Kitchen and Bath Centers. Best Buy attempts to make life fun and easy for consumers. They believe they offer customer advantages in store environment, product value, product selection, and a variety of other servcies related to product purchasing.

Customers, Suppliers
This one is easy for Best-Buy it has millions of customers (literally), and most likely will never have to worry about anyone of them accounting too high a percentage of sales. The suppliers are less diversified with the top 20 vendors accounting for >60% of their products. This includes huge companies that will likely not go under or stop selling at Best Buy soon, so this does not worry me.
Risks
Of the risks mentioned only two come across as being big enough to stop me from investing. First, the competitive pressures from traditional retailers and the Internet. Best Buy absolutely blows all the other brick-and-mortar competitors out of the water, but I am very worried about the potential for a tech-focused, or even Amazon (AMZN), website to come along and compress Best Buy’s margins and returns.
Second, and less risk, Best Buy’s earnings are very dependent on the fourth quarter (Christmas). This is true with most retailers, but if they screw up one or two ads in October it could mean a huge hit to total earnings.
Products
Best Buy is a tech retailer. It’s products, like computers, DVD players, TVs, etc. are not repeat purchase products, but I do believe that customers who buy a TV from Best Buy and are satisfied with the service are very likely to come back and buy the DVD player for the TV and a few DVDs from Best Buy. Also, tech is traditionally a high growth industry and I believe Best Buy is shielded from the volatility of more focused tech companies because it doesn’t suffer from bad products releases because consumers would just buy a different computer (or other product) which Best Buy also sells.
Consistency
Best Buy has done pretty well over the past ten years, and pretty consistent, it did not post negative growth year-over-year.

Returns
Over the past 10 years Best Buy’s returns have routinely thrashed the industry average.
That concludes the business section of the check list. If you have any things you feel should be added, please comment with your suggestion.

Moat
Does it have a moat?
Best Buy currently has a huge moat, and as shown before, it has thrashed its industry returns average over the past ten years.
In my personal experience, I and a lot of friends feel Best Buy is the best place to get a gift card, and I have never seen it not completely full around Christmas.
What is the moat?
Best Buy competes indirectly with tons of stores, like Costco (COST), Wal-Mart (WMT) and Sears (SHLD). But, nationally it only has two real direct competitors, Circuit City (CC) and Tweeter. In the speciality retail industry it absolutely dominates all other competitors. It does this through vastly superior service. Other retailers try to compete with it based only on price, but consumers still flock to Best Buy because of the service it offers.
It’s Geek squad brand (which offers at home fixes for technology problems and enhance the computers by deleting useless free trial programs) and knowledgeable sales people compel consumers to go to their store instead of Circuit City or even Costco.
How long will it last?
Best Buy has been doing this for a long time, and it seems like it knows how to do it, recently renewing focus on customer service. But, retailers traditionally can’t keep competitive advantages for a very long time, Sears, K-Mart and Macy’s (M) are all retailers that once had big moats only to fall to innovation.
In a conservative estimate I believe Best Buy can keep its moat for at least 5 more years as it continues to fend off tons of companies focused on taking its customers. I also believe that even if a brick-and-mortar competitor can break its moat (very unlikely) or a website can be established (more likely) Best Buy would still be a very attractive buy-out opportunity for a company like Amazon or Costco.

Management
Integrity
Pay
Best Buy CEO Robert Willert was paid $8.65 million last year, as opposed to $6.95 million by Circuit City CEO Philip Schoonover. Best Buy’s market cap is about 26x larger than Circuit City’s, Willert’s salary isn’t even close to being double Schoonover’s.
Restructuring
Best Buy has no one-time charges in the last three years.
Related-Party Transactions
Best Buy has multiple related party transactions:
-Two stores are leased from founder and chairman of the board Richard Shulze, the rents paid for these stores in 2007 were $976k. The company also leases airplanes from a corporation owned by Schulze, and paid him $393k for them.
-The company does business with Shulze’s brother’s business Phoenix Fixtures, and paid them $19 million last year.
-His daughter, Susan Hoff, received $505k for running The Best Buy Children’s Foundation
-A director, Ari Bousbib, is president of Otis Elevator which received $230k for equipment in 2007.
-Director, Elliot Kaplan, is a partner in the law firm that serves as Best Buy’s general counsel, they paid them $83.8 million in legal fees in 2007.
-Kaplan’s daughter, Jane Kirshbaum, is their senior corporate counsel and received $200k in base salary and was rewarded 1,255 shares in options.
-Director, Matthew Paull, is a senior VP with McDonald’s, with whom Best Buy has a co-marketing agreement and paid $3.1 million dollars for coupons and gift cards through the marketing agreement.
-Director, Frank Trestman, owns a third (his son also owns a third), of The Avalon Group, from whom Best Buy is leasing a property for the next ten years, at $700k for the next five years then $745k for years six through ten.
All this related-party stuff scares me about Best Buy’s management, especially the fact that they claim, “It is our policy not to participate in related-party transactions… unless the transaction provides us with a demonstrable incremental benefit.”

I’m not an expert, but I bet they could have found someone other than the founder’s daughter to run their charity organization, and I’m pretty sure they wouldn’t have to pay this person half a million.

Board of Directors
Best Buy has eleven members on their board, which is a lot considering since members include:
-The former chairman of Pepsi Bottling in Mexico
-The founder of a patient access and revenue cycle service company for health care providers
-A former CFO of McDonalds
-The executive chairman of a wireless Internet provider in California and
-A partner in the law firm that serves as their general counsel
I’m not sure they really need any of those five, and am starting to become suspicious of the company’s management.
Pension Fund Issues
There is no mention of the pension fund in the 10f or the proxy.

Revenue
Best Buy records revenue when:
The sales prise is fixed or determinable, collectibly is reasonably assured and the customer takes possession of the merchandise, or in the case of services, at the time the service is provided.
Sounds good, and I don’t think Best Buy really has a business model where revenue recognition would ever come into questions.
Receivables are up 35% over the past year, and 97% since 2004, while sales are up 8% and 53% over the same periods. Again, this is a warning that Best Buy could potentially get itself into trouble.
Earnings
Best Buy missed analyst estimates by more than 20% in the May 07 quarter, so I don’t think fudging earnings for this reason is a problem.
Total net income over the past ten years is $5,936 million, over the same period they have free cash flow of $6,772 million this is a 14% differential, which over ten years is probably fine.
Ownership
I can’t find Willert’s direct holdings, but 18% of Best Buy is held by insiders, and considering this is a $17 billion company that’s fine with me.
Auditing
Best Buy was audited by Deloitte & Touche, apparently a good company to work for, that I believe is fine here.

Competence
Expenses
Best Buy’s only real direct competitor, Circuit City, has 2% higher COGS and 5% higher SG&A than Best Buy, so it looks like management is good at cutting costs.
Debt
Best Buy has $642 million in long-term debt, but over $1.3 billion in cash. It is troublesome that they have over $4 billion in accounts payable, however.

Returns
Best Buy’s has a 26% return on equity, but just 11% return on assets which shows they use leverage to pump returns.
Retained Earnings Contrasted to Market Cap
Over the past ten years they have created $3 in market value for every dollar in retained earnings, which shows they are good at creating shareholder value.

Earnings Reports
The report is called, “Best Buy’s Fourth-Quarter Earnings Per Diluted Share Rise 10% to $1.71″ - this is satisfactory, at least they use GAAP earnings instead of some pro forma crap (not that GAAP isn’t crap, its just generally accepted).

Income Statement
Margins
Best Buy’s margins are among the best in the industry. While it has a five year-average of a 25% gross margin and 4% profit margin, Circuit City has averaged 24% gross margins and less than half a percent profit margins.
Growth
Best Buy has a good history of growth. Over the past nine years it has a steady history of 17% revenue growth and 30% (though a lot less steady) income growth. The income growth is volatile, but I believe they can grow in double digits for at least a few more years.

Balance Sheet
Cash
Best Buy’s cash makes up 10% of its assets and has grown an average of 16% per year over the last nine, 19% in the last year.
Other Assets
Best Buy has inventory of almost half of its assets, though this is fine since it is a retailer and this could signal good revenue growth soon.
Debt
Best Buy’s long-term and short-term debt account for only 3/4’s of its cash, so it is not over-leveraged. It does have a lot of accounts payable, but this is fine.

Cash Flow
Free Cash Flow
Best Buy has Free Cash Flow of $1 billion which is about a 6% earnings yield.
Owner’s Earnings
Best Buy’s Owner’s earnings are $1.25 billion which is a 7% earnings yield.
Free Cash Flow to the Firm
Best Buy’s FCFF is $1.7 billion which is a 9.7% earnings yield.

Valuation
In the Best Buy valuation I will use a 5% margin on Revenue, the FCFF of $1.7 billion, growth over the next five years of 12%, growth in years 6-10 of 8% and growth from years 11-20 of 5%, terminal growth of 2.5% and a discount rate of 10%.
Target Price
At 12% growth in five years revenue will be about $69.6 billion, 5% of that is about $3.5 billion, then assuming no share dilution (and to be conservative no shares repurchased). At a 17x multiple this gives a share price of $122.27, which is 186% growth in five years from the current price, or 20% annualized.
Pabrai Multiple
Applying a 15x multiple to Best Buy’s current EPS of $3.19 give a value of $47.85 per share, it has negative excess capital because of its high accounts payable so I will just add the cash per share which is $2.73 this gives a value of $50.58
Pabrai DCF
Using the expected growth and not adding excess capital Best Buy has a value of $69.76 per share.
Matt Richey’s DCF
Using 3% more for the growth in the best case and 3% less for the low case, I get values of $130.26, $90.69 and $64.75. This gives very high values, if the discount rate is changed to 12% the median case drops almost $18 per share, and as shown 3% less per year growth makes it drop $26 per share.
Absolute P/E
16.4 x [1+(1 - .95)] x [1 + (1 - .95)] x [1+ ( 1- 1.05)] = 17.18
$3.19 * 17.18 = $54.86
Croesus Test
These three inputs all assume and ending P/E of 15x, and using the net income of 1.4 billion. To get a 25% CAGR over two years Best Buy would need earnings CAGR of 22.7% over the same period. For 17% over five years, 16%. For 15% over the next ten years, 14.5%.
Reverse DCF
Using Quicken if Best Buy grows 6% terminally and using a 15% discount rate (the 6% can’t be changed and 15% discount rate is used to offset it) Best Buy needs to grow 4.7% annually over the next ten years.
Liquidation Value, in Millions
Cash - $1319, Value $1319
Marketable Securities - $295, Value $295
Accounts Receivable - $739, Value $628
Inventory - $7451, Value $3276
PP&E - $3260, Value $1467
Goodwill - $1182, Value $0
SUM = $6,985

Conclusion
Margin of Safety
For this I will use two values, the value from Pabrai’s multiple and Matt Richey’s DCF.
The value form Pabrai’s multiple was: $50.58 this is a margin of safety of just 13%. The lower case scenario gave a value of $64.75, and the middle case gave $90.69, though it was $72 with a 12% discount rate. This present margins of safety of: 32%, 52% and 39%. I’d say the range of values is from $50.58 to $72, so the margin of safety is from 13% - 39%, because best Buy dominates its industry and continues to repurchase shares I think this is sufficient.
Why it’s undervalued
Best Buy reached a high of $52.29 in December, after that some funds sold their stake and in February it reduced guidance for this year and fell to $39.87, since then it’s creeped up a little to $43.83 where it stands now.
Catalyst
I believe Best Buy has a few catalysts:
Future earnings growth propelled by battles between HD and Blu-Ray and its continued market share gains as Circuit City falls off the planet or is bought by Blockbuster (BBI).

Buy or Sell
This is a hard one for me, I will continue to examine AXP and some special situations at which I’m looking, and decide whether Best Buy has better potential than these, but for investors looking to find a good undervalued company I believe Best Buy is worthy.

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