TEXT - S&P cuts Best Buy rating to 'BB'
Overview -- In our view, U.S. consumer electronics and services retailer Best Buy Inc.'s weak operating and financial performance trends will continue due to fierce competition and continued margin pressure. -- We believe that it will be very difficult for the company to improve its gross margin over the next year, given the industry dynamics and the new management team's plans to turn around operations. -- We are lowering our corporate credit and senior unsecured debt ratings on the company to 'BB' from 'BB+'. In addition, the ratings are removed from CreditWatch, where they were placed with negative implications on April 4, 2012. -- The negative outlook reflects our view that if there is further deterioration in operating performance, margins, and credit metrics, we would consider lowering the rating. Rating Action On Nov. 21, 2012, Standard & Poor's Ratings Services lowered its corporate credit and senior unsecured debt ratings on Richfield, Minn.-based Best Buy Inc. to 'BB' from 'BB+.' The ratings are removed from CreditWatch, where they were originally placed with negative implications on April 4, 2012. The outlook is negative. The recovery rating on the senior unsecured debt remains '3', indicating our expectations for meaningful (50% to 70%) recovery in the event of a payment default. The downgrade of Best Buy reflects our view that it will be very difficult for the company to improve its gross margin in the fourth quarter of the year given the highly promotional nature of year-end holiday retailing in the wireless and consumer electronic categories. It is our belief that all segments of the company's business will remain under margin pressure for 2012 and into 2013. In addition, we believe that the new management team still needs to fully formulate its strategy for improving the continued decline in same-store sales and margins. Given the highly seasonal nature of the company's operations, skewed heavily to the fourth quarter, we may not begin to see any tangible results until the second half of fiscal 2013 or beyond. Rationale The ratings on Best Buy Co. reflect Standard & Poor's assessment that the company's business risk profile is "weak" and its financial risk profile is "significant." In our view, the company's "weak" business risk profile factors in the inherent risks of the consumer electronics business, which is cyclical and dependent on new products for propelling sales growth. It also incorporates our view of the extremely competitive environment Best Buy faces from internet-based retail formats, discounters, warehouse clubs, other big-box retailers, and smaller regional consumer electronic chains, in many of its product categories. We believe these factors and the commoditization of many products will continue to limit pricing flexibility. In addition, margins will continue to be constrained as the company looks to match competitors' pricing. While the new management team has outlined the key problems the company faces and acknowledges that many are self-inflicted, it will take some time for the CEO and senior management team to full formulate its turnaround strategy and execute it. In our view, we will not begin to see any tangible results until the second half of fiscal 2013 at the earliest. Given that the strategy, cost savings, and spending are all unknown at this time as well as its possible success, we are therefore viewing the new management team and governance as "fair." While these endeavors will be challenging, given the fierce competition and commoditization of certain products, we believe that the company's success depends on how quickly it can change its strategy to reflect the shifts in the industry. We assess Best Buy's financial risk profile as "significant," reflecting the substantial seasonality in the company's operating performance, which is heavily skewed to the fourth quarter; its adequate liquidity position; thin margins; and weaker cash flow generation and credit protection measures. For the 12 months ended Nov. 3, 2012, margins declined to 7.1% from 7.6% in the previous quarter. We forecast that credit metrics will weaken further for fiscal 2012, because we expect further gross margin pressure in the fourth quarter. We estimate adjusted total debt to EBITDA of about 2.8x, EBITDA interest coverage of about 4.9x, and funds from operations to total debt of about 33%. This is based on our following assumptions: -- Revenues and same store sales decline in the low-to-mid single digits. -- Gross margin contracts by 100 basis points (bps) this year and next year. -- Capital expenditures of about $750 million in 2012 and $800 million in 2013. -- Dividends of about $230 million in both 2012 and 2013. -- No further share repurchases until operating performance stabilizes. Liquidity We believe Best Buy's liquidity is "adequate" to meet its needs over the next 12 months. Furthermore, we estimate that there should be no significant shortfalls in liquidity in the next two years, given that the company has manageable debt maturities. Our view of the company's liquidity profile incorporates the following expectations: -- We expect that liquidity sources (including cash, cash flow from operations, and availability under its revolving credit facilities) will exceed uses by 1.2x or more. -- We expect that liquidity sources will continue to exceed uses, even if EBITDA were to decline by 15%, and that debt will remain more than 15% below any covenant limits. -- We believe that the company has the ability to absorb high-impact, low-probability events, with limited need for refinancing. In our view, if needed, liquidity could be supplemented by Best Buy lowering its capital spending. -- In our assessment, we believe that Best Buy has sound relationships with banks and generally prudent risk management. The company had cash and cash equivalents of approximately $309 million as of Nov. 3, 2012, and full availability under its $1.0 billion 364-day senior unsecured revolving credit facility, maturing August 2012 and a $1.5 billion senior unsecured revolving credit facility, maturing Oct. 7, 2016. We expect liquidity sources to largely fund seasonal working capital needs (which typically peak in the third quarter), capital expenditures, dividends, and 2013 debt maturity. Recovery analysis We rate the company's unsecured debt 'BB' (the same as the corporate credit rating) with a recovery rating of '3', indicating our expectation of meaningful (50% to 70%) recovery for note holders in the event of a default. Outlook Our negative rating outlook reflects our expectation that Best Buy's operating trends will remain at their new lower level over the next year. We believe that the same-store sales trend and revenue growth will be flat to negative (in the low single digits) for the remainder of 2012 and into fiscal 2013, given the weak industry dynamics in consumer electronics and the company's recent performance. Also, we are estimating that margins will continue to be under significant pressure. We would consider a downgrade if gross margin contracts by more than 100 bps and revenues decline in mid- to high-single-digits, resulting in debt leverage trending to about 3.5x or more. In addition, we could lower the rating if the company's cash flow generation continues to decline resulting in liquidity concerns or we believe that the new management team's strategy for the company does not begin to improve its operating performance. Also, we could lower the rating multi-notches should the company receive and accept a leveraged buyout offer. Although unlikely in the near term, we would consider a stable outlook if business conditions improve, such that Best Buy consistently posts positive same-store sales and revenue growth and credit metrics strengthen. We estimate that if gross margins improved by more than 150 bps and revenues rose in the low- to mid-single digits, credit metrics would strengthen, with debt leverage below 2x. Related Criteria And Research -- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012 -- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Criteria Guidelines For Recovery Ratings On Global Industrials Issuers' Speculative-Grade Debt, Aug. 10, 2009 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 Temporary contact numbers: Jayne M. Ross (973-735-3761; Chuck Pinson-Rose Ratings List Downgraded; Recovery Rating Unchanged; Outlook Action To From Best Buy Co. Inc. Corporate Credit Rating BB/Negative/-- BB+/Watch Neg/-- Senior Unsecured BB BB+/Watch Neg Recovery Rating 3 3