Sunday, May 11, 2008

Best Buy and The Carphone Warehouse, a value investor's perspective

Much has been made of Best Buy's (NYSE: BBY) $2+ billion investment in The Carphone Warehouse, announced Thursday, May 8th. This article suggests a manner in which to think about this investment, from the point of view of a value-oriented owner of Best Buy shares.

Previously, Best Buy had announced that it plans to buy back approximately $5 billion worth of shares in the next few years (original release). Best Buy has implied that the cash from the investment in The Carphone Warehouse will come from money that was originally earmarked for share repurchases (they stated as much in their announcement here). Therefore, the question is, would investors benefit more from the investment in The Carphone Warehouse, or from the repurchase of outstanding shares?

This will depend on what your valuation is for Best Buy's shares. You can think of the repurchase of its own shares as you would any other investment Best Buy makes. Is it a good use of capital? My valuation of Best Buy comes to approximately $58, and the median analyst target is $53 (according to Yahoo Finance). You can subsitute your own valuation for best buy's shares to determine the ROI from the share buyback. Using the median analyst estimate, with the share price before the announcement of approximately $44, this equates to an ROI of about 20% ($9 in value gained for every $44 spent).

Can Best Buy get a 20% return on their investment in The Carphone Warehouse? It's possible. Best Buy's ROE for 2008 is just over 30%. However, a better gauge of the return to expect from this investment would be the returns The Carphone Warehouse has been generating, as the competitive environment in Europe is what's relevant, and Carphone CEO Charles Dunstone will lead the new joint venture. Return on Equity for The Carphone Warehouse is consistently closer to just 10%.

Clearly, I believe the better choice would be to use that money to repurchase shares. But management has done an excellent job of getting returns on shareholder capital, so I'm inclined to allow this team to continue to make these difficult capital allocation decisions. I do still fear that management wishes to expand its empire at the expense of profitability, but on the other hand I'm hopeful they believe The Carphone Warehouse can improve its profitability with the benefits of the scale that Best Buy brings to the table. Or maybe management does not believe the shares are as undervalued as I do. It's a situation worth keeping an eye on.

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