By Tom Graves, CFA On Tuesday, Dec. 17, shares of electronics retailers Best Buy (BBY) and Circuit City (CC) fell 5.5% and 11.2%, respectively, after reporting third-quarter results and raising concerns about profit-margin pressure in the important holiday-season quarter now under way. The main culprit: Heavy price discounting of compact disks and other gadgets.
We at S&P downgraded Circuit City shares to 2 STARS (avoid) from 3 STARS (hold). Its November-quarter 10 cents loss per share, vs. 4 cents in EPS a year ago, was a few pennies better than estimates. However, we see the stock being hurt by concerns about gross margin pressure, lower finance income, and absence of February-quarter EPS guidance.
We reduced our fiscal 2003 (ending February) EPS estimate to 40 cents from 43 cents and fiscal 2004's estimate to 42 cents from 52 cents. We view Circuit City as being in transition mode, with both years including 14 cents per share of store remodeling or relocation costs. However, we're wary of its shares, which are trading at a price-earnings (p-e) premium to the S&P 500-stock index (based on calendar 2003 profit projections). Circuit City shares closed at $7.27 on Dec. 17.
NOT QUITE THE BEST. We also kept our avoid recommendation on shares of Best Buy. After its recent guidance, the reported third-quarter EPS of 26 cents, vs. 25 cents a year ago, shouldn't be a surprise.
With its Musicland business expected to have a loss of at least 14 cents per share in fiscal 2003 (ending February), we're trimming our overall fiscal 2003 profit estimate for Best Buy to $1.72, from $1.75. Also, we lowered our fiscal year 2004 estimate to $1.90, from $1.95.
We expect concerns about near-term margin pressure and the prospective difficulty in turning around or divesting Musicland to weigh on Best Buy stock. In our view, this more than offsets its below-market p-e. Also, we figure that unexpensed options could have reduced fiscal year 2002 EPS by 16 cents. Best Buy shares settled at $24 on Dec. 17.
DIGITAL LIFE. Our short-term investment outlook for the group of computer- and electronic-retail stocks that we cover is moderately negative. That reflects, in part, some concern about consumer spending levels and the extent to which new products or technologies will be fueling near-term sales and profits.
Investors should keep in mind that these stocks can have sharp, relatively quick price movements. Year-to-date through Dec. 13, the S&P Computer & Electronics Retail Index was down 40.5%, compared with a 22.5% decline for the S&P 500 index. In 2001, the industry index jumped 64.3%, vs. a 13% fall for the S&P 500.
Over the long term, though, we expect electronics retailers to further benefit from consumers' shift to using more digital products and services. As new products are introduced, we see management of inventories and product mix becoming increasingly important in determining which retailers are the most successful. Also, we expect that some consumer-electronic retailers will be placing a growing emphasis on building service-related businesses.
DOWNLOAD BLUES. Another trend is the growing convergence between computers, televisions, cameras, and telecommunications equipment. This should include portable devices that make it increasingly easy to access information and entertainment from anywhere.
The bad news is that the growing availability of downloadable entertainment on the Internet is likely to hurt long-term sales of prerecorded disks and cassettes. The extent to which the Internet is used to download or distribute recorded entertainment is likely to depend, in part, on the pace of consumers' switch to faster Internet hookups through cable modems and digital subscriber phone lines.
Still, we expect that retailers will have increasing opportunities to sell devices that play downloaded content and possibly to sell new subscription services for music and video. Analyst Graves follows electronics retailing stocks for Standard & Poor's