Circuit City CC
November 12, 2007 - 2:31pm EST by
algonquin222
2007 2008
Price: 6.46 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,112 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

 
Description

 
Circuit City Stores, Inc. operates as a specialty retailer of consumer electronics, home office products, entertainment software, and related services. It sells brand-name consumer electronics, personal computers, entertainment software, and related services in Circuit City stores in the United States and via Web sites, www.circuitcity.com and www.firedog.com. As of February 28, 2007, it operated 642 superstores and 12 other stores in 158 U.S. media markets. (Source: Capital IQ)

 

Summary

 

 

Circuit City is a contrarian play on a stock that is down over 70% so far this year and currently sits at its 52 week low. It is in the midst of a multi-year turnaround, yet the market has essentially written off any possibility that the turnaround will be successful as evidenced by the precipitous share price decline and that fact that it is nearing cash value. Based on management’s comments it appears that the turnaround is on track to be successful, but is just taking longer than expected. Circuit City has $4.57 in cash and receivables (including a $0.24 tax refund expected this quarter) on its balance sheet representing 70% of its market value. Ex cash and equivalents, Circuit City trades at 2.8% of sales which is a historical low for the company.  Circuit City also trades at two thirds of book value and it hasn’t traded below book value since September 2003 when it traded as low as $4. These factors provide an adequate margin of safety that allows an investor a free call option on a successful turnaround. Circuit City has over $12bln in sales which represents significantly optionality should they be able to improve their operating margins and effect a profitable turnaround.

 

 

Thesis

 
So why does Circuit City trade at such depressed levels? The sell-off began in large part due to the rapidly decreasing price of flat screen televisions (far greater decline than management expected) which negatively affected Circuit City’s margins and operating performance. The timing was poor as management was in the process of instituting a multitude of changes and unproven initiatives including revamping staffing procedures and changing store locations. Not only did these major changes adversely affect operations, but they also created significant uncertainty among the analytical community. Given that almost 2/3rds of the yearly EBITDA is earned in the second half of the year, there is an extreme amount of uncertainty regarding what Circuit City will earn in FY2008. In fact, management has echoed this sentiment by withdrawing their guidance and telling analysts that they remain confident in the turnaround, but are less confident in the timing. When Circuit City missed estimates in the quarter ended August 30th it seems analysts and shareholders threw in the towel on the turnaround. I believe it is too early to call defeat as the quote from the most recent conference call makes clear: (parenthetical references added for clarity)

 

“As the quarter started out we were in the middle of a tremendous amount of change. We had just come off going from ten to eight regions. We changed the management model in every store that we had, and then we started to change the labor model. So a way to think about that, if it didn't come out clearly, literally we had 40,000 people learning a new job. They may have had a similar job to their position, but they might have had a different area of responsibility. They had something new to learn. That created the distraction and that absolutely affected us early in the quarter, particularly in June and July as they were learning new roles and going to training centers and cascading about their learning to other people inside the business. That hurt our ability not only in conversion, as I stated earlier. It hurt our ability in attachments. We were-- hurt us with City Advantage (warranties), services, other things we typically attached for the consumer. What we saw, though, is we saw that as this change was getting behind us, and what we've learned from our regional learning centers (pilot programs) is it takes about 4-8 weeks for the change to settle in, and as the change was getting behind us month to month our stores began to stabilize. First our regional learning centers (pilot programs) which improved their performance every month of the quarter, then our divisional learning centers, and the rest of our chain is 4-8 weeks behind those. So we did see an improvement in performance over the course of the quarter. We have a long way to go. There's still a lot of people still learning new roles. But we have some history here that says that we'll be able to continue to improve in this quarter.”

 

Basically what management is saying is that the pilot programs for the changes they are instituting have shown to be working, but the majority of the stores are still in the transitional phase. The pilot programs certainly do not suggest that the turnaround will fail and management continues to state that it will be successful, but will just take longer than expected. In what appears to be irrational behavior, though, the stock has sold off to valuation levels that would suggest the turnaround is an abject failure and the company will end up liquidated. I believe this is a case of the market overly discounting uncertainty.  Circuit City currently trades at 0.66x book value versus a 5-year avg of 1.45x book value. It trades at 0.06x TEV/LTM sales versus a 5-year avg of 0.23x. As mentioned earlier, ex cash and receivables, it trades at a P/S of 0.028 versus a previous historical low of 0.10x. These extremely low multiples combined with 70% of the market cap in cash and equivalents suggests that there is enough margin of safety inherent in the shares to be able to bet on a successful turnaround. At these valuations, I believe shares in Circuit City are a high uncertainty, but low risk situation especially as management has noted that the majority of their stores remain free cash flow positive.

 

I believe Circuit City provides asymmetric risk/reward potential because of the limited downside risk suggested by the historically low multiples and significantly high return potential if they are able to successfully complete their turnaround and improve their operating margins. The market appears to be assigning zero probability to this occurrence, which is why the stock is currently a bargain in my opinion.

 

Assuming management’s turnaround is successful and they are able to match Best Buy’s operating margins of 5% (best case), there is over 500% upside potential from current levels. Assuming sales growth of 7% per year, a three year time horizon, and a 15x PE multiple at that time, Circuit City’s shares could be worth $39.26. Again the market is not assigning any value to the optionality of the turnaround despite that fact that many of the initiatives are still in the process of being implemented and pilot programs appear to be working.

 

 

2010

Sales (7% growth)

14,700,516,000

EBT margin

5.00%

EBT

735,025,800

Taxes 40%

294,010,320

Net Income

441,015,480

x 15 multiple

6,615,232,200

Shares out

168,500,000

Share price

$39.26

Current price

6.46

Upside

507.73%

Annualized

169.24%

 

 

Even if Circuit City is only able to get to a 3% EBT margin, the upside potential is still over 260%.

 

 

               2010

Sales (7% growth)

14,700,516,000

EBT margin

3.00%

EBT

441,015,480

Taxes 40%

176,406,192

NI

264,609,288

x 15 multiple

3,969,139,320

Shares out

168,500,000

Share price

$23.56

Current price

6.46

Upside

264.64%

Annualized

88.21%

 

 

 The company currently has a huge number of initiatives ongoing of which the benefits have yet be reflected in the share price. Recent SG&A (headcount reduction) savings have been masked because of lowered margins due to the television issues as well as restructuring charges due to store closings. While, this may continue into FY 08 (continued IT and restructuring initiatives) once the store openings/closings slow, this improvement should finally become evident in the financial statements. It is instructive to compare the SG&A/Sales for Circuit City (22.9%) to Best Buy (18.8%). Given that there is over 400bps of possible improvement versus the nearest competitor and Circuit City is implementing a similar strategy (keep in mind CC’s new CEO used to work at BBY), it is reasonable to assume that Circuit City will be able to decrease their SG&A/Sales. Perhaps not to the same level as Best Buy, but a 100bps improvement would not be unreasonable. Should Circuit City be able to reduce its SG&A/Sales to 21.9% (only 1/4 of the difference with Best Buy), its EBT would increase by over 2000% and its EBT margins would reach 4.5%. This is an example of the trmendous operating leverage inherent in Circuit City which makes the upside potential of this investment quite significant.

 

 

 CEO Philip Schoonover used to work at Tweeter, Best Buy and Sony (supplier experience). While he has spent his entire career in consumer electronics, his experience at Best Buy was especially noteworthy as he was a key player in developing new initiatives there. His knowledge of Best Buy, gives confidence that Circuit City can follow the same roadmap to improving their stores, sales, and margins. Management’s goals and interests seem to be aligned with shareholders as their cash and stock bonuses are dependent on EPS and EBT margin targets. Schoonover holds 1m stock options with a strike price of $23.845. He also owns 500k shares outright. He is clearly incentivized to improve the margins and operating performance of Circuit City.

 

 

 

 

Anecdotal evidence that suggest higher valuation warranted

 

v     Circuit City trades significantly below a February 2005 $17 buyout offer by Highfields Capital Management. This offer was rejected by the board who stated that they could maximize shareholder value on their own. Highfields manager Jon Jacobson spoke about Circuit City in his interview with Value Investor Insight in February 2006. He said he invested in Circuit City because it was cheap and had optionality in correcting several years of bad management. He said he originally bought the shares at $9 when they had $6 per share in cash and receivables leaving the stub to trade at less than 10% of sales. The stock looks even cheaper today with same stub (ex cash and credit card receivables) trading at 2.8% of sales.

 

v     Circuit City has been an active acquirer of their own shares having bought back almost $1bln worth of shares since 2001 at an average price of around $16. In FY2007, Circuit City repurchased 10m shares at an average price of $23.69 and as recently as Q1FY08, they repurchased shares at an average price of $18.08. Given management’s commitment to the repurchase program, it is clear they saw value in the shares at levels significantly above the current price. However, Circuit City did not buy any shares back in the most recent quarter as they said they wanted to keep cash on hand given the debt market conditions. I think this move spooked investors who saw it as a more signal that the turnaround would not work.

 

v     Management at Best Buy is also acting Bullish.  Their CEO recently bought 500k shares at $43.86 and boosted their buyback program to 5.5bln signaling bullishness in future prospects. While it is not quite as simple as saying what’s good for Best Buy is good for Circuit City because, of course, Best Buy is a superior business with expansion opportunities in China and other advantages. However, some of the major sources of uncertainty with regards to Circuit City are the strength of the consumer and TV selling prices/margins. These issues would affect both Best Buy and Circuit City in a similar manner and Best Buy’s recent bullish actions can serve, by proxy, to alleviate some of the similar concerns with regards to Circuit City.

 

v     In addition, an interesting optionality exists due to the 2009 mandatory transition to digital television. Larry Haverty from Gabelli Asset Management  in the July 23rd, 2007 issue of Barron’s called this, the “mother of all catalysts for Best Buy.” Haverty estimates that 200 million TV sets will become obsolete because of the new law and consumers will either have to purchase a new set or a converter. This should drive sales growth and margins not only for Best Buy, but also Circuit City. In fact, if this prediction becomes true, it could actually be more beneficial to Circuit City then Best Buy as Circuit City sells a greater percentage of TVs then does Best Buy. Also, currently only 10% of homes have a high definition TV and Circuit City CEO Paul Schoonover calls this a “massive opportunity.”

 

 

Conclusion

 

 

Bill Nygren was quoted in Outstanding Investor Digest saying that retail turnarounds always take longer than expected. It appears that this is the case with Circuit City and a large majority of holders and sell side analysts have essentially given up hope and thus the market price assigns a negligible probability of a successful turnaround. Circuit City has only recently begun several initiatives and we have not yet seen tangible results. Its operating margins are currently under 1% while its closest competitor has margins over 5%. Based on historically low multiples, it appears that Circuit City has a significant margin of safety. Given this margin of safety, there exists an asymmetric return matrix as the optionality of the turnaround and margin improvement suggest possible multiples of upside. In addition, knowledgeable and intelligent investors have valued Circuit City at higher levels in the past.

 
I or affiliates of mine may hold shares in Circuit City and may transact in this stock at anytime without notice. This is not a recommendation to buy or sell

Catalyst

Low expecations, margin expansion, successful turnaround
    sort by    

    Description

     
    Description

     
    Circuit City Stores, Inc. operates as a specialty retailer of consumer electronics, home office products, entertainment software, and related services. It sells brand-name consumer electronics, personal computers, entertainment software, and related services in Circuit City stores in the United States and via Web sites, www.circuitcity.com and www.firedog.com. As of February 28, 2007, it operated 642 superstores and 12 other stores in 158 U.S. media markets. (Source: Capital IQ)

     

    Summary

     

     

    Circuit City is a contrarian play on a stock that is down over 70% so far this year and currently sits at its 52 week low. It is in the midst of a multi-year turnaround, yet the market has essentially written off any possibility that the turnaround will be successful as evidenced by the precipitous share price decline and that fact that it is nearing cash value. Based on management’s comments it appears that the turnaround is on track to be successful, but is just taking longer than expected. Circuit City has $4.57 in cash and receivables (including a $0.24 tax refund expected this quarter) on its balance sheet representing 70% of its market value. Ex cash and equivalents, Circuit City trades at 2.8% of sales which is a historical low for the company.  Circuit City also trades at two thirds of book value and it hasn’t traded below book value since September 2003 when it traded as low as $4. These factors provide an adequate margin of safety that allows an investor a free call option on a successful turnaround. Circuit City has over $12bln in sales which represents significantly optionality should they be able to improve their operating margins and effect a profitable turnaround.

     

     

    Thesis

     
    So why does Circuit City trade at such depressed levels? The sell-off began in large part due to the rapidly decreasing price of flat screen televisions (far greater decline than management expected) which negatively affected Circuit City’s margins and operating performance. The timing was poor as management was in the process of instituting a multitude of changes and unproven initiatives including revamping staffing procedures and changing store locations. Not only did these major changes adversely affect operations, but they also created significant uncertainty among the analytical community. Given that almost 2/3rds of the yearly EBITDA is earned in the second half of the year, there is an extreme amount of uncertainty regarding what Circuit City will earn in FY2008. In fact, management has echoed this sentiment by withdrawing their guidance and telling analysts that they remain confident in the turnaround, but are less confident in the timing. When Circuit City missed estimates in the quarter ended August 30th it seems analysts and shareholders threw in the towel on the turnaround. I believe it is too early to call defeat as the quote from the most recent conference call makes clear: (parenthetical references added for clarity)

     

    “As the quarter started out we were in the middle of a tremendous amount of change. We had just come off going from ten to eight regions. We changed the management model in every store that we had, and then we started to change the labor model. So a way to think about that, if it didn't come out clearly, literally we had 40,000 people learning a new job. They may have had a similar job to their position, but they might have had a different area of responsibility. They had something new to learn. That created the distraction and that absolutely affected us early in the quarter, particularly in June and July as they were learning new roles and going to training centers and cascading about their learning to other people inside the business. That hurt our ability not only in conversion, as I stated earlier. It hurt our ability in attachments. We were-- hurt us with City Advantage (warranties), services, other things we typically attached for the consumer. What we saw, though, is we saw that as this change was getting behind us, and what we've learned from our regional learning centers (pilot programs) is it takes about 4-8 weeks for the change to settle in, and as the change was getting behind us month to month our stores began to stabilize. First our regional learning centers (pilot programs) which improved their performance every month of the quarter, then our divisional learning centers, and the rest of our chain is 4-8 weeks behind those. So we did see an improvement in performance over the course of the quarter. We have a long way to go. There's still a lot of people still learning new roles. But we have some history here that says that we'll be able to continue to improve in this quarter.”

     

    Basically what management is saying is that the pilot programs for the changes they are instituting have shown to be working, but the majority of the stores are still in the transitional phase. The pilot programs certainly do not suggest that the turnaround will fail and management continues to state that it will be successful, but will just take longer than expected. In what appears to be irrational behavior, though, the stock has sold off to valuation levels that would suggest the turnaround is an abject failure and the company will end up liquidated. I believe this is a case of the market overly discounting uncertainty.  Circuit City currently trades at 0.66x book value versus a 5-year avg of 1.45x book value. It trades at 0.06x TEV/LTM sales versus a 5-year avg of 0.23x. As mentioned earlier, ex cash and receivables, it trades at a P/S of 0.028 versus a previous historical low of 0.10x. These extremely low multiples combined with 70% of the market cap in cash and equivalents suggests that there is enough margin of safety inherent in the shares to be able to bet on a successful turnaround. At these valuations, I believe shares in Circuit City are a high uncertainty, but low risk situation especially as management has noted that the majority of their stores remain free cash flow positive.

     

    I believe Circuit City provides asymmetric risk/reward potential because of the limited downside risk suggested by the historically low multiples and significantly high return potential if they are able to successfully complete their turnaround and improve their operating margins. The market appears to be assigning zero probability to this occurrence, which is why the stock is currently a bargain in my opinion.

     

    Assuming management’s turnaround is successful and they are able to match Best Buy’s operating margins of 5% (best case), there is over 500% upside potential from current levels. Assuming sales growth of 7% per year, a three year time horizon, and a 15x PE multiple at that time, Circuit City’s shares could be worth $39.26. Again the market is not assigning any value to the optionality of the turnaround despite that fact that many of the initiatives are still in the process of being implemented and pilot programs appear to be working.

     

     

    2010

    Sales (7% growth)

    14,700,516,000

    EBT margin

    5.00%

    EBT

    735,025,800

    Taxes 40%

    294,010,320

    Net Income

    441,015,480

    x 15 multiple

    6,615,232,200

    Shares out

    168,500,000

    Share price

    $39.26

    Current price

    6.46

    Upside

    507.73%

    Annualized

    169.24%

     

     

    Even if Circuit City is only able to get to a 3% EBT margin, the upside potential is still over 260%.

     

     

                   2010

    Sales (7% growth)

    14,700,516,000

    EBT margin

    3.00%

    EBT

    441,015,480

    Taxes 40%

    176,406,192

    NI

    264,609,288

    x 15 multiple

    3,969,139,320

    Shares out

    168,500,000

    Share price

    $23.56

    Current price

    6.46

    Upside

    264.64%

    Annualized

    88.21%

     

     

     The company currently has a huge number of initiatives ongoing of which the benefits have yet be reflected in the share price. Recent SG&A (headcount reduction) savings have been masked because of lowered margins due to the television issues as well as restructuring charges due to store closings. While, this may continue into FY 08 (continued IT and restructuring initiatives) once the store openings/closings slow, this improvement should finally become evident in the financial statements. It is instructive to compare the SG&A/Sales for Circuit City (22.9%) to Best Buy (18.8%). Given that there is over 400bps of possible improvement versus the nearest competitor and Circuit City is implementing a similar strategy (keep in mind CC’s new CEO used to work at BBY), it is reasonable to assume that Circuit City will be able to decrease their SG&A/Sales. Perhaps not to the same level as Best Buy, but a 100bps improvement would not be unreasonable. Should Circuit City be able to reduce its SG&A/Sales to 21.9% (only 1/4 of the difference with Best Buy), its EBT would increase by over 2000% and its EBT margins would reach 4.5%. This is an example of the trmendous operating leverage inherent in Circuit City which makes the upside potential of this investment quite significant.

     

     

     CEO Philip Schoonover used to work at Tweeter, Best Buy and Sony (supplier experience). While he has spent his entire career in consumer electronics, his experience at Best Buy was especially noteworthy as he was a key player in developing new initiatives there. His knowledge of Best Buy, gives confidence that Circuit City can follow the same roadmap to improving their stores, sales, and margins. Management’s goals and interests seem to be aligned with shareholders as their cash and stock bonuses are dependent on EPS and EBT margin targets. Schoonover holds 1m stock options with a strike price of $23.845. He also owns 500k shares outright. He is clearly incentivized to improve the margins and operating performance of Circuit City.

     

     

     

     

    Anecdotal evidence that suggest higher valuation warranted

     

    v     Circuit City trades significantly below a February 2005 $17 buyout offer by Highfields Capital Management. This offer was rejected by the board who stated that they could maximize shareholder value on their own. Highfields manager Jon Jacobson spoke about Circuit City in his interview with Value Investor Insight in February 2006. He said he invested in Circuit City because it was cheap and had optionality in correcting several years of bad management. He said he originally bought the shares at $9 when they had $6 per share in cash and receivables leaving the stub to trade at less than 10% of sales. The stock looks even cheaper today with same stub (ex cash and credit card receivables) trading at 2.8% of sales.

     

    v     Circuit City has been an active acquirer of their own shares having bought back almost $1bln worth of shares since 2001 at an average price of around $16. In FY2007, Circuit City repurchased 10m shares at an average price of $23.69 and as recently as Q1FY08, they repurchased shares at an average price of $18.08. Given management’s commitment to the repurchase program, it is clear they saw value in the shares at levels significantly above the current price. However, Circuit City did not buy any shares back in the most recent quarter as they said they wanted to keep cash on hand given the debt market conditions. I think this move spooked investors who saw it as a more signal that the turnaround would not work.

     

    v     Management at Best Buy is also acting Bullish.  Their CEO recently bought 500k shares at $43.86 and boosted their buyback program to 5.5bln signaling bullishness in future prospects. While it is not quite as simple as saying what’s good for Best Buy is good for Circuit City because, of course, Best Buy is a superior business with expansion opportunities in China and other advantages. However, some of the major sources of uncertainty with regards to Circuit City are the strength of the consumer and TV selling prices/margins. These issues would affect both Best Buy and Circuit City in a similar manner and Best Buy’s recent bullish actions can serve, by proxy, to alleviate some of the similar concerns with regards to Circuit City.

     

    v     In addition, an interesting optionality exists due to the 2009 mandatory transition to digital television. Larry Haverty from Gabelli Asset Management  in the July 23rd, 2007 issue of Barron’s called this, the “mother of all catalysts for Best Buy.” Haverty estimates that 200 million TV sets will become obsolete because of the new law and consumers will either have to purchase a new set or a converter. This should drive sales growth and margins not only for Best Buy, but also Circuit City. In fact, if this prediction becomes true, it could actually be more beneficial to Circuit City then Best Buy as Circuit City sells a greater percentage of TVs then does Best Buy. Also, currently only 10% of homes have a high definition TV and Circuit City CEO Paul Schoonover calls this a “massive opportunity.”

     

     

    Conclusion

     

     

    Bill Nygren was quoted in Outstanding Investor Digest saying that retail turnarounds always take longer than expected. It appears that this is the case with Circuit City and a large majority of holders and sell side analysts have essentially given up hope and thus the market price assigns a negligible probability of a successful turnaround. Circuit City has only recently begun several initiatives and we have not yet seen tangible results. Its operating margins are currently under 1% while its closest competitor has margins over 5%. Based on historically low multiples, it appears that Circuit City has a significant margin of safety. Given this margin of safety, there exists an asymmetric return matrix as the optionality of the turnaround and margin improvement suggest possible multiples of upside. In addition, knowledgeable and intelligent investors have valued Circuit City at higher levels in the past.

     
    I or affiliates of mine may hold shares in Circuit City and may transact in this stock at anytime without notice. This is not a recommendation to buy or sell

    Catalyst

    Low expecations, margin expansion, successful turnaround

    Messages


    Subjectwarranties
    Entry11/12/2007 03:06 PM
    Memberthistle933
    Interesting idea, and certainly cheap relative to sales.

    I've seen an argument that the company makes excess profits on warranties. Since this is commission income, incremental margin is near 100%. Disclosure bundles it in with other services, but it may be 3-4% of sales and therefore operating margin, which is a lot given current profits (or lack thereof).

    Do you think there is risk from a Wal-Mart or Costco pricing warranties on flat screen TVs more cheaply? (Seems to me I can guess how Sinegal would price them).

    SubjectWarranties
    Entry11/12/2007 05:23 PM
    Memberalgonquin222
    Yes, warranties are certainly a high margin item. CC shifts obligation to a third party and only pockets a fee. Warranties are included in net sales but CC breaks it out in their 10-Ks as follows: "The percent of domestic segment sales attributable to sales of extended warranties was 3.5 percent in fiscal 2007, 3.8 percent in fiscal 2006 and 3.8 percent in fiscal 2005".

    Clearly warranty sales are trending in the wrong direction and this has been a big culprit in their poor performance this year. I actually see warranty sales as a major source opportunity for CC rather than a ding. There is no inherent difference between Best Buys customers and CC's which would lead the former to be more predisposed to purchase warranties so therefore, the lower percentage of warranty sales must be related to execution. Unlike other problems, execution can be fixed. After the current restructuring, a salesperson who had previously been responsible for only DVDs may now selling TVs as well so it is not surprising that they are selling fewer warranties then a seasoned TV salesmen. I have to believe that CC management is extremely focused on improving warranty sales as they know it is the easiest way to improve their margins (on which a large part of their bonus is based). Combine this with salespeople becoming more experienced selling, and I think you have the opportunity for warranty sales to buck the current trendline. I believe that the market is discounting any type of improvement on that score so you aren't paying for it. As warranties are such a high margin item, any improvement could be significant for margins.

    As to your second question, I admit I have not done much work on the price differential of warranties so probably shouldn't comment as I would just be blindly speculating. That being said, I do believe there will always be significant competition in this industry and margins will always be somewhat low because of the commodity nature of the products and the willingness of customers to purchase based strictly on price.

    Subjectwarranties
    Entry11/12/2007 05:53 PM
    Memberthistle933
    There's a good story on this here: http://www.businessweek.com/bwdaily/dnflash/nov2005/nf20051110_5243_db016.htm?chan=search

    I got so scared by this that I haven't looked at BBY or CC since. Do you have any view as to what the discounters are doing with warranty pricing these days?

    This is kind of interesting: http://www.warrantyweek.com/archive/ww20061024.html

    It just seems to me that Wal-Mart and Costco live to rip inefficiency like this out of the system - but I could be wrong.

    Subjectre: warranties
    Entry11/12/2007 06:13 PM
    Memberles179
    Wanted to chime in since I have done work in this sector. Wal-mart and Costco will definitely affect the big box players in pricing of electronics, but warranties are a different issue. Hardly any consumer cross shops warranties - they cross shop price and financing options, but not warranty pricing. It is very opaque - you never see warranty prices in circulars. As a result, being 10% or 20% higher than Walmarts warranty doesn't really matter, as the consumer doesn't even know what the competitors offer for warranty pricing - consumers only think about cost of warranty as a % of their purchase price (20% tends to be the breaking point on TVs, if it is materially higher than that, consumer generally opts out). So, as long as CC and BBY can get the consumer in the door and make the sale of the electronics, the warranty will follow as long as it is reasonably priced relative to the good. Obviously, this means that BBY and CC need to be competitive in price for the goods themselves, which is a valid concern long-term (although one can argue that having knowledgeable salespeople and services might mitigate this - another argument entirely).

    CC has had a problem attaching warranties for 2 reasons. The first is pricing - their warranty pricing was not flexible and did not adjust properly to the rapidly declining ASPs and was not reasonably priced relative to the good. Warranties were priced well above the 20% threshold (there were instances where the warranty was over 50% of the price of a camera). Walmart and Costco had nothing to do with this, it was just slow reaction and execution (i.e., fixable). They have since adjusted their policies and are offering more reasonably priced warranties. The second is associate distraction/disruption over the past few quarters. I'd expect this to improve as associates become comfortable with the new operating procedures.

    Subjectre:warranties
    Entry11/12/2007 06:35 PM
    Memberalgonquin222
    Thanks for the links. I wasn't aware of the warranty pricing issues. I'd agree with Les in that I don't think consumers shop around based on warranty prices. The main reason being most never intend to buy warranties in the first place and are eventually convinced at the point of sale. At that point its too late to say, what would a Wal-Mart warranty cost me. They also may assume that pricing is equivalent no matter where you shop.

    Subjectcomparison to toys r us
    Entry11/13/2007 04:50 AM
    Membergearl1818
    this story seems similar to toys r us in the sense that wmart/tgt and others can offer electronics for the holiday season at very low prices (loss leaders?) to drive traffic...other than the television upgrade cycle, what catalysts are in place to help cc? w/ flat screens coming down that can't help...i would think retail turnarounds in this mkt are very difficult/highly unlikely...the thesis on cc to generate margins closer to bby has been around for years and continues to be a mirage

    Subjectre: comparison to toys r us
    Entry11/13/2007 03:32 PM
    Memberalgonquin222
    I'm glad you brought that up because it highlights what I am trying to get across. When a stock has been a dog for so long that people assume it will always be a dog simply because it has been dog in the past and you combine that sentiment with a company undergoing major change, you get the potential for a great investment. Circuit’s valuation suggests that the market has completely written off ANY chance of CC recovering their margins. I think the market is misunderstanding the high level of change that CC has undergone in the last 12-18 months and actually continues to undergo. They are revamping nearly everything. They are improving the store layouts, the store locations, the IT structure, the employee structure, inefficiencies in the how products are delivered and brought out to the selling floor etc.

    I look at the situation like a free call option. If the restructuring fails and the margins never recover, it really can’t go much lower (famous last words I know) but the stores are still free cash flow positive and Firedog (which I didn’t discuss) is growing like wildfire (and has much higher margins) and would be worth something to a strategic buyer . Firedog has around $200m in sales (which they expect to double in 2008) and I’d have to believe it would be worth a 2-3x multiple of sales given its growth, brand awareness, and high margins. CC is also trying to sell off their Canadian operations, InterTan, which should be worth around $200m. Add this to the cash and receivables and you get pretty much the entire market value. The lease liabilities complicates things and I am unsure of how that would be handled in a liquidation which is why I am not recommending it based on a liquidation value. If the restructuring works then you have multiples of upside because of the low margins and large sales base.

    As you reference, the electronic retail business has always been a price deflating and highly competitive business yet BBY and CC in the past have been able to make solid returns. There is no logical reason they shouldn’t be able to return to that level.

    So how can they improve?. Well they brought in a guy from Best Buy to basically replicate the strategy that Best Buy used to eat CC’s lunch in the 90s. CC had previously placed their stores in strip centers or away from major thoroughfares or population centers betting that customers would have to come to them. When Best Buy came into the picture, they scooped all the prime real estate and customers no longer had to or wanted to travel to Circuit. They are working at rectifying this by closing poor performing stores and relocating them to better locations. You can imagine this type of change takes a while to have an effect. BBY has an advantage is sales per square foot that should erode as CC opens more of these better located stores. CC actually has a better mix of products then BBY with higher margin electronics versus BBY’s lower margin computers and software. Another key factor is looking at SG&A which I believe is artificially high due to the ongoing restructuring. Once the restructuring stops, margins should expand simply because they will no longer be paying out $2 million to close and open each new store. SG&A is artificially high because of the store openings/closings as well as the development of a new IT infrastructure both of which should provide bottom line benefits when they are up and running. In the most recent quarter, 200bps of SG&A/Sales expense was related to those two factors. Eventually those costs will stop and margins should expand in kind. That alone is roughly $240m run rate that drops to profit before any operational improvement from the turnaround. If the new stores are operationally superior, overall profitability could be further improved.


    CC also fired 3,400 store associates and replaced them with employees who make around standard market rates. They totally revamped their store sales layout with fewer associates but the creation of a store midlevel supervisor. This move happened right when TV prices slid dramatically making the operational impact get mixed in with the industry wide problems. Its unclear how much exact impact the fired associates had but I think warranty sales were definitely hurt. Warranties are high margin items and I would argue that they take more experienced sales people to sell because customers do not come in wanting to necessarily buy them. As the new employees gain experience, we could see warranty sales improve which will significantly boost margins because they are almost 100% margin items.

    Firedog’s growth should also help improve margins as they not only end up selling the installation but higher profit margin cables and whatnot that are involved in getting the TV working in the living room. CC is moving their selling model from just selling TVs to more of a razor blade/razor model in which the TV is sold at a slim margin but the real profit is driven by the services and installation products (razor blades). This is key because its total paradigm shift that they are getting no credit for. Combine this with all the other initiatives that they are implementing to be more like Best Buy and you have potential for margin improvement even if Wal-Mart poaches some of their sales.

    The market hasn’t given nearly enough time to see if all of these changes have had an effect. Yes there is a probability that it won’t work but its not the 100% failure rate that the market is currently assigning it. Combine that with the huge upside potential and you get a pretty good asymmetric risk reward. Will it work, I can’t say for certain, but I do like the return weighted probabilities.


    Subjectwarranties
    Entry11/14/2007 11:28 AM
    Memberedward965
    While I don’t think warranties are the #1 issue, they I have a different opinion on them, and they are probably #2

    First, CC’s warranties aren’t a little overpriced, they are almost 3x those at WMT and 50% more than BBY, if one gets it close to apples to apples (per year).

    One example is the Garmin 350 GPS (I looked at many, but using this as an example). WMT charges $11 per year to warranty it, and CC charges $38/year. CC and WMT have basically the same warranty structure (CC makes you call in and go through 3rd party warranty people, like WMT).

    Second, I don’t know that consumers don’t shop warranties. CC has seen declining warranty attach rates while BBY, WMT, and almost everyone else has seen increasing, and in the case of WMT quickly increasing.

    This makes sense because CC’s pricing strategy is to be a little below BBY’s price on products, much higher on warranty costs. The hope is that people price shop products and not warranties, which probably is true more times than not. That said, it isn’t always true, and when I talked to someone in CC’s warranty department it was fairly obvious that it’s a gut feel that consumers don’t price shop warranties and has no actual research behind it.

    Example: when you buy that Samsung 32” TV T3242H ($899 at CC, $949 at BBY). CC’s warranty cost is $230 vs. BBY’s $129 (5 yrs vs. 4 yrs, admittedly), and CC want another $300 to install it using their service department, it’s harder to say people will never price shop since that $230 cost is a large percent of the product cost (and 50-70% margin, I will add). Seems to me, at the margin, people will self select into product only vs. product + warranty, and that is showing in the data.

    So, if one assumes that warranties are over 100% of profit (that number varies a lot over time based on my analysis, but probably accurate this year), you are banking on this whole warranty pricing thing being okay.

    Next, there is an issue of electronics pricing at WMT or AMZN. For those who have noticed, AMZN now ships same-day electronics to many cities. I can pay $369 for a Garmin 350 + $7 shipping (same day), vs $499 + tax at CC (or $368 at Wal-Mart). Based on some WMT people I talked to, I think in general they are charging COGS + 10% on their items, which means ~15% lower prices on average than CC. Of course, WMT and AMZN aren't replacing CC on flat-screen TVs anytime soon, but a $50 DVD player, or DVDs?

    Oh, and hard to compare BBY’s 5% margins with CC’s – way different product mix, including appliances, financing, etc, and different overhead levels.

    All that said, I’m thinking management will slow down its 10% store expansion here soon, perhaps stop it, and that could lift the stock a couple of bucks.




    Subjectquestions
    Entry11/14/2007 12:31 PM
    Membercarbone959
    1) Let’s say you have a warranty-eligible printer. Shouldn’t warranty revs be viewed as tacked onto the printer price with servicing costs as part of printer COGS? If we look at it this way and – as I understand - it’s a much better business compared to the non-warranty-eligible items, what’s the use of such items? Are they effective loss leaders? With the Internet + WMT + COST, the value of shopping at CC for these miscellaneous items really comes into question. For example, CC and Best Buy have “rip-off” items like a USB cable for $30 vs. $4 on an Internet site.
    2) As you mentioned before, the customer does not think in advance about warranty price/type, they only think of the underlying product. At the end of the sales process they are prompted to buy warranty and they get an “oh...right...” moment. After thinking over for a few seconds, a decision is made. It’s true that this process makes the warranty high-margin and non-comoditized, but my gut tells me that this warranty decision is very recession-sensitive precisely *because* it wasn’t budgeted, and also because one can’t accurately predict how likely the product is to break, as they stand with a rep. So I am concerned about warranty top-line weakness. What do you think about this?
    3) Finally, I still don’t understand: what is the gloomiest part in the short thesis? At 0.06 EV/sales with no debt and positive FCF, which issue is scaring the market?

    Subjectlease question
    Entry11/14/2007 04:39 PM
    Memberad188
    "The lease liabilities complicates things and I am unsure of how that would be handled in a liquidation which is why I am not recommending it based on a liquidation value"

    I am curious, if you got the time, if you could research this in more detail bc it seems to me you could have a potential K-MArt situation here where you have below-market leases and stand alone locations for many of their stores. Would they have to go through CH11 to capture the value in below-market leases for instance? It could be an interesting angle.

    SubjectLeases
    Entry11/14/2007 05:29 PM
    Memberalgonquin222
    Unfortunately I haven't analyzed it fully from that angle as I don't have the expertise or manpower to determine if CC's leases are below market or not and how much they would be worth. My sense is that ever since Kmart, retailers leases have been picked over for hidden value and since CC has never made any of those lists, it suggests that there is limited value. Also as CC is relocating stores because their current locations are subpar it suggests that the leases are not particularly valuable.

    Subjectleases
    Entry11/14/2007 08:01 PM
    Memberfinn520
    I looked at this a little while back and came to the following conclusions:

    1) Circuit City getting closer to Best Buy margins through better operation is a fantasy. The root cause is structural.

    Best Buy’s stores are, on average, 25% larger and sales per square foot are 69% higher. Combining the two, their stores do 112% higher sales than Circuit City. Amortizing this over the fixed cost base of rent, advertising, and G&A gets you to roughly 380 bps difference in EBIT margin.

    Best Buy
    41k SF per store
    $958 Sales PSF
    $39.7 million sales per store

    Circuit City
    33k SF per store
    $566 Sales PSF
    $18.7 million sales per store


    2) Sub-par real estate is an albatross.

    Circuit City management talks about leases in conference calls over the past few years and lays out the following story. A good part of the sales difference is due to quality of real estate. When Circuit City was the gorilla in the 1990's, it focused on locking up cheap rents (what they called "B" and "C" spaces) in the market areas and for a period, captured a huge spread. This left the room for Best Buy to come in and lock up the A spaces. Circuit City was largely asleep at the wheel from the late 1990's to 2005. Circuit City management estimates that 400 of its 652 stores are in subpar locations and need to be moved, at a cost of $1.4m per new/relocated store. This is a tough game to play. They are planning on moving 65 new stores this year and 100 next year (with 1/3rd of those being new and the remaining 2/3rd relocations).


    3) Strategy

    The new strategy basically boils down to “execute better”, and the company is currently overhauling most of its processes/systems on the fly. It is currently a) outsourcing its IT infrastructure to IBM, b) implementing an Oracle Retail suite for its merchandising c) implementing new standard “store operating procedures” at all its domestic stores, and d) rolling out a new retail point-of-sale system (currently 20% complete). Poor execution in 2007 H1 due to having so much going in is a part of waht lead to the $220m loss in 2007 H1.

    Whether this all works is anyone's guess and the company may well muddle through, but there are virtually no saleable assets and a bad second half will likely result in Chapter 11.

    Last week's news regarding the departure of Dave Mathews was not a good sign, either. Mathews was VP of Merchandising and Marketing, one of two main execs under the CEO, and a guy championed as a big part of the turnaround effort in the past year as most of the other senior execs have left.

    SubjectRe: comments
    Entry11/15/2007 09:49 AM
    Memberdoggy835
    "At 0.06 EV/sales with no debt and positive FCF, which issue is scaring the market?"

    Long term uneconomic leases are debt in all but name.

    Positive FCF? Net current assets are down over the last 12 months. You could say they've extracted cash from working capital to invest in growth capex, but the company isn't growing. By Warren Buffett's definiton it's all maintenance capex.

    I don't know if Boy Wonder can produce an operations miracle or not, but it's always hard to manuver in a box.

    SubjectGeneral Thoughts
    Entry11/17/2007 08:40 AM
    Membernauset323
    Thanks for the write-up. While CC certainly seems cheap on several levels, you have to believe in a big event to see any real near-term upside. Finn makes some interesting points. I worked for the company from 1999-2002, and the "restructuring" they talk about was started then. In 2000 they were "reinventing" the brand, changing the compensation structure of the sales force (essentially firing the higher-paid but higher-producing people), selling off FNANB, and re-evaluating the horrific real estate situation. CC has been stuck with numerous bad locations by locking in long-term leases during the 1970s - 90s when they were an early big box retailer and suburban malls were not yet popular. Being the early mover hurt them in that sense. They have also had a nightmare of mgmt turnover, with no one who is any good staying at the company. They have been playing with their store format for the past 8 years, trying to figure out what works best, and they still have locations that look like a Dollar Store. Until someone completely changes the company's philosophy and decides to get rid of all the incompetence, I think they will continue to flounder. They are stuck between competing with WMT for pricing and projecting a higher-end, cleaner image like BBY or Tweeter, Ultimate, etc. (the latter 2 also having blown up - consumer electronics is a tough business). The best thing the company ever did was create KMX.

    Subjectalgonquin222
    Entry12/21/2007 12:37 PM
    Memberbafana901
    Any comments on todays results.

    Thank you.

    SubjectQ3 results
    Entry12/27/2007 10:32 AM
    Memberalgonquin222
    Q3 was quite dissapointing although not entirely surprising. As I said, CC is trying to implement a tremendous amount of change in a short period of time. These changes, most notably the firing of its most experienced salespeople, hurt their results tremendously. Please read any analyst report to get more color on what went wrong as it has been widely published. Management continues to have faith in their turnaround plan even as investors jump ship.

    I have framed this situation as a call option on the turnaround and I still believe the risk/reward to be favorable. CC has $2.86 in cash on their balance sheet and another $3.19 in account receivables and income tax refund receivable. Management expects to be able to pull out another $0.53 in cash from reducing net owned inventory by $100m. CC is attempting to sell their Canadian operations, InterTan (which actually had an improved Q3) and expects to get another $1.00 - $1.50 in proceeds. Given these numbers, it appears that the market is applying a negative value to the franchise and its roughly $12bln in sales.

    I vehemently disagree that CC is headed for iminent bankruptcy as the share price seems to suggests. As reported on the conference call, the vast majority of their stores are cash flow positive and cash on the balance sheet actually increased quarter over quarter. It has only $50m in long term debt and other liabilites are current leases which the Soleil analyst recently suggested were below market value meaning they may actually be an asset. Management also stated on their call that trends at the end of the quarter improved which gives hope that the changes implemented are becoming less disruptive as time passes. Most importantly, and somewhat paradoxically, CC's problems are self inflicted. The fact that they are willing to admit their mistakes and are working to correct them implies that their is a probability that the will be fixed. Should CC exhibit signs that operations are improving the stock price could increase by several multiples.

    I believe part of the rapid sell off has been related to year end tax loss selling and you could see a rally as bargain hunters jump in at the start of the new year.

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