Commentary: Best Buy? Maybe Not for Investors
By Robert Berner
For four years, investors have loved Best Buy Co. (BBY ), the nation's largest electronics retailer, and its exuberant growth. The stock soared during the bull market and beat the major indexes well after the bears took over. But since April, the company has said three times it would miss Wall Street earnings forecasts because of unforeseen costs at three companies it has bought since December, 2000. On one occasion, Sept. 5, it took a $348 million charge, because two acquisitions--Musicland and Magnolia Hi-Fi--weren't worth their purchase prices. Its stock price has fallen by 57% since early April.
Best Buy says a weak economy and a drop in big-ticket sales hurt its business. But the pattern of nasty surprises at Best Buy's acquisitions raises the question of what more might be lurking. What would reassure investors is a detailed explanation of the accounting for Future Shop, a Canadian electronics chain Best Buy acquired in November, 2001, for $377 million. While Best Buy's treatment of Future Shop seems to comply with accounting rules, four accounting experts BusinessWeek interviewed say a key question remains: Why did Best Buy cut Future Shop's value by $99 million after it bought the company?
The chief issue is this: Future Shop's July, 2001, accounts, its last before the deal, show the net value of its assets, minus liabilities, as $61 million. That excludes $12 million of goodwill--premiums paid for past acquisitions--that Future Shop listed in its Apr. 7, 2001, annual report. Yet, when the deal closed Nov. 5, 2001, Best Buy said Future Shop was worth -$38 million. What did Best Buy find to cause a nearly $100 million drop in value? Future Shop, by all accounts, was prospering.
In written responses to questions, Chief Financial Officer Darren Jackson says several factors raised Future Shop's liabilities and cut its assets. On the liability side, the company set aside reserves for "probable exposures" to U.S. and Canadian taxes. It also increased liabilities to reconcile differences in the two countries' accounting. U.S. rules required it to book certain lease costs sooner than Canadian rules and to book revenues from service contracts more slowly. As for asset values, he says, Best Buy wrote down goodwill and cut the value of an obsolete checkout system. Jackson also said "normal changes in business volume" affected Future Shop's balance sheet, but did not give details.
Jackson says Best Buy has a year from its purchase to adjust Future Shop's value. The Securities & Exchange Commission, he adds, asked for no restatements when it reviewed Best Buy's numbers for the last two fiscal years as part of increased scrutiny of big companies. But Jackson would not provide--despite BusinessWeek's repeated requests--a breakdown of the changes in Future Shop's value. Public filings only show how it allocated the purchase price to broad categories of assets and liabilities. Jackson says he can't say more because of "competitive reasons" and "the constraints of" SEC Regulation Fair Disclosure, which bans companies from giving information only to some investors. But Reg FD wouldn't stop Best Buy from better explaining the drop in Future Shop's value.
The accounting experts BusinessWeek interviewed say the size of the change raises concerns that Best Buy may have used loose rules for merger accounting to obscure merger costs and make sales look more profitable after the deal closed. Such tactics would have made Future Shop's earnings appear to explode.
In fact, Future Shop's 5 cents a share contribution to Best Buy's earnings for the fourth quarter ended Mar. 2 was triple the original estimate. Its profits pushed company earnings just over Wall Street's consensus. That capped a sizzling quarter when Best Buy raised earnings estimates three times, and it sold $402 million of convertible bonds. It appears, says Charles Mulford, an accounting professor at Georgia Institute of Technology, as if "Best Buy spring-loaded Future Shop's earnings." Jackson calls that assertion "categorically false."
The experts interviewed say Best Buy may have increased Future Shop's liabilities to create reserves for potential restructuring costs. That's fine. But companies aren't allowed to set up excessive reserves, then count ordinary operating expenses as restructuring costs instead of deducting them from earnings. That would inflate profits artificially. The lack of detail leaves open the question that "some of these types of reserves are built into the higher liabilities," says Paul R. Brown, an accounting professor at New York University. Best Buy may also have written down the value of Future Shop's inventory, reducing the cost of the goods it sold and boosting profit margins, say some experts. Asked if the company took excessive restructuring reserves or wrote down inventory to boost profits, Best Buy CFO Jackson says: "Emphatically no."
If the experts are right, Future Shop's apparently meteoric earnings growth may not be sustained, and there could be a writedown, as happened with Musicland and Magnolia. Best Buy says that Future Shop, the No. 1 electronics retailer in Canada, has great promise. Best Buy's Canadian unit--mostly Future Shop--lost 2 cents a share in the fiscal first-half ended Aug. 31 because of consulting fees and costs of new stores, but it should make 4 cents for the full year.
Times are hard for retailers. Investors understand that. Best Buy's fall from grace shows that investors fear they're not getting the whole story. If the company wants to regain its place in the firmament, it will have to tell us more.
Berner covers retailing from Chicago.