NEW YORK--(BUSINESS WIRE)--Fitch Ratings has upgraded its long-term Issuer Default Rating (IDR) on Best Buy Co., Inc. (Best Buy) to 'BB' from 'BB-'. The Rating Outlook is Stable. A full list of ratings follows at the end of this release.
KEY RATING DRIVERS
The upgrade reflects Fitch's expectation that management's investments in sharper pricing funded by cutting excess costs and changes to the revenue mix towards higher growth and higher margined products could stem losses both in the top line and EBITDA over the next 12-18 months. Fitch sees the potential for additional downside to the current EBITDA level of $2 billion, but it is likely to settle in the $1.7 billion to $2 billion range on domestic comparable store sales (comps) declines in the low single digits. This would enable Best Buy to generate $500 million to $700 million in free cash flow (FCF; post dividends) annually and keep leverage reasonable in the low 3.0x range.
Defending Market Share: Best Buy has defended its market share against the onslaught of competitive pressures from e-tailers and discounters over the last three to four years, although at a significant cost to its bottom line. Best Buy's comps have been negative for the last four years and Fitch expects comps for the domestic business (which accounts for 85% of total revenue) to be modestly negative over the next 12-18 months. This assumes strong growth in online sales of 15% to 20% (which equates to +1.5% to 1.6% comp contribution) somewhat offsetting Fitch's expectation of a 3% decline at the store level.
Pricing Investments Pressure Results: Best Buy has been investing heavily in sharper pricing to maintain share, given a majority of its product categories are in a secular decline. It will likely take another few quarters for volumes to increase enough to offset the lower price points. EBITDA declined 17% to $2 billion in 2013 but is expected to be relatively flat in 2014 given that cost reductions (Fitch expects SG&A dollars will decline by another $600 million in 2014) are essentially funding the price investments in the business.
EBITDA Downside Appears More Limited: Should comps remain modestly negative and Best Buy choose to continue to fund price investments in 2015-2016 without significant offset from cost reductions, Fitch expects EBITDA may decline another 10%-15% to $1.7 billion to $1.8 billion. However, Best Buy's investments in sharper pricing funded by cutting excess costs -- and changing the revenue mix towards higher growth and typically higher margined categories such as mobile, small accessories, and appliances -- could start to pay off. This would provide support to EBITDA at the $2 billion level. As a result, adjusted leverage is expected to remain in the low 3.0x range.
While Best Buy has dominant market shares in many categories, a majority of product categories in which Best Buy operates are in a secular decline. Fitch estimates that these categories -- mainly computing ex-tablets and mobile phones (estimated at 30%), entertainment (8% of current sales versus 12% in 2011), and CE (30% of current business versus 36% in 2011) -- will decline in the low single digits over the next three years, given the lack of new product introductions, price deflation, and shift towards digital products.
The main growth areas are mobile, small accessories and appliances, which Fitch estimates account for about 20% of Best Buy's business. Fitch expects these categories in aggregate carry higher gross margins than the company average and expects these businesses in total to grow in the high single digits over the next two to three years.
Management is making concerted efforts to reduce square footage dedicated to negative growth areas such as entertainment (physical media), and to shift mix towards the higher growth and more profitable categories, thereby driving revenue and gross profit per square foot. These initiatives are being supported by dedicating more space to strategic partners such as Samsung, Sony and Microsoft. Changing the product mix towards higher growth categories and driving higher volume through price investments could stabilize the business over the intermediate term.
The company has also made strong progress in reducing its cost structure and realized $765 million in annualized cost reductions in 2013. It has targeted a total of $1 billion in annualized cost reductions, the majority of which is expected to be realized in 2014.
Strong Liquidity Position: Best Buy generated FCF (after dividends) of $314 million in 2013, ending the year with $2.7 billion in cash and $223 million in short-term investments. The company has full availability on its $1.25 billion domestic credit facility, which was downsized from $2 billion in June 2014. The credit facility is jointly and severally guaranteed by certain operating subsidiaries including BBC Investment Co., BBC Property Co., and Best Buy Stores, L.P. on an unsecured basis.
Fitch expects Best Buy to generate FCF (after dividends) in the $700 million range in 2014 (excluding any material working capital swings), ending the year with $3.6 billion in cash. FCF is expected to be in the $400 million-$500 million range in 2015-2016 if EBITDA declines to the $1.7 billion-$1.8 billion range.
Best Buy has suspended its share repurchase program since first-quarter 2012 to preserve liquidity. The company still pays regular dividend which was recently increased to $0.19 per quarter per share (or an annualized dividend of about $270 million based on current diluted shares).
The next maturity of unsecured notes is March 2016 which Fitch assumes Best Buy will pay down with cash on hand.
Negative Rating Action: A downgrade could be caused individually or collectively by the following factors: worse-than-expected sales declines of negative 3% or more for the domestic business versus Fitch's negative low single-digit-range projections; material gross margin decline without any significant offset from cost savings, which would result in EBITDA declining below $1.5 billion and therefore adjusted leverage increasing to the high-3x to low-4x range.
Positive Rating Action: Fitch would need to see stabilization in comps and modest growth in EBITDA on a sustained basis from the current level of $2 billion to consider a positive rating action.
Fitch has upgraded its ratings on Best Buy as follows:
--Long-term IDR to 'BB' from 'BB-';
--$1.25 billion bank credit facility to 'BB' from 'BB-'; and
--$1.50 billion senior unsecured notes to 'BB' from 'BB-'.
The Rating Outlook is Stable.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology' (May 28, 2014).
Applicable Criteria and Related Research:
Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage