By Melissa Mott
March 20 (IFR) - The credit default swap (CDS) market is still signaling heightened risk of default for Best Buy, with spreads wider by 159 percent in the past year amid eroding same store sales, flat revenue and increased competitive pressure.
Though the international consumer electronics giant is investment-grade rated (BBB-/Baa2/BBB-), its spreads trade in high-yield territory, and CDS investors increasingly see it as a "crossover" name -- a high-grade entity that is especially vulnerable to being downgraded to junk bond status.
With the company due to announce fourth-quarter results next week, Best Buy's CDS are currently trading at around 450bp -- a whopping jump from 170bp in March 2011.
Though that has tightened from an approach to the historical wide of 570bp in January, the CDS market indicates there is significant doubt about the company's credit picture.
The rise in CDS has been accompanied by a large increase in net notional volumes -- that is, the actual net sum of protection against a default purchased by investors.
According to Depositary Trust & Clearing Corp data, the company's net notional CDS in March 2011 was around $211m. The current figure is about $537m -- a more than 250% increase.
In other words, credit protection for Best Buy is getting more expensive -- and investors are still buying more of it.
Best Buy, which has more than $50bn of annual revenue, had always touted its solid profit margins, and credit markets have traditionally looked favorably on the company's history of a strong free cash flow and tight inventory controls.
But things started to go awry one year ago, in the midst of a struggling economy and a downturn in consumer discretionary spending.
From March to June 2011, Best Buy CDS widened from 144bp to 242bp -- some 68%, compared to an average 11.6% widening in the consumer retail sector overall.
"CDS spreads are treading deeper into speculative grade territory," research and analysis company Fitch Solutions warned at the time.
Best Buy was then in the process of restructuring; it exited some international operations, including in Turkey, and shuttered some of its stores in China.
But the credit default swap market was not impressed. By October, Best Buy CDS was up to 380bp; it was into the 420s a month later.
The widening was more due to deteriorating fundamentals than the overall weakness in the economy.
Best Buy's second-quarter results were a miss, as gross margins declined 42bp to 25.31% and operating margins fell 108bp to 2.55%.
That put even more pressure on Best Buy for a solid performance during the 2011 holiday period, but the company stumbled again.
The retailer ran into well-publicized difficulties fulfilling Black Friday orders in time for the holidays -- a bout of bad publicity the company clearly didn't need.
Meanwhile margins bore the brunt of promotions and shrank significantly. Fiscal third-quarter 2012 results released mid-December were yet another miss.
In that earnings call, CEO Brian Dunn surprised investors by announcing a major shift in strategy toward market share instead of profit margins, a traditional strength.
The reversal was particularly surprising as, like other brick-and-mortar retailers, Best Buy had steadily been losing market share to Amazon.com as well as to Apple.
Within a month, Best Buy's CDS were nearing their all-time wides seen in 2008.
The company in January announced a leadership shake-up, and the CDS have dialed back to the 430bp-450bp range. But it is expected to miss earnings targets again when Q4 results are announced on March 29.