Circuit City Gets Crushed

The electronics retailer's net loss looks even worse next to Best Buy's upside surprise earlier this week

In the world of pricey consumer electronics, where customer service is arguably as important as quality products, Circuit City Stores (CC) is missing the mark and further eroding its profits.

At the beginning of this year, the specialty retailer fired 3,400 of its highest paid, and presumably best qualified and performing, employees, as part of a broad cost-cutting program. That's led to substantial deterioration in customer service, says William Armstrong, an equity analyst at CL King & Associates.

The Richmond (Va.) company on Dec. 21 posted a net loss of $1.26 per share for its third quarter, which ended on Nov. 30, vs. a 12-cent loss a year ago, on a 3.1% drop in revenue to $2.96 billion, and a $102.8 million tax expense.

Excluding the non-cash tax expense, the net loss from continuing operations was 64 cents per share, still much worse than the 31-cent loss anticipated by analysts polled by Thomson Financial. Sales at stores open at least one year fell 5.6%, while the gross margin dropped by an additional 3.0% on top of the 2.0% decline seen in the prior-year period.

Circuit City’s shares tumbled nearly 28% to $4.80 during trading on Dec. 21, and hit a new 52-week low of $4.76 earlier in the session.

The company also said it now expects to report a modest loss from continuing operations in the fourth quarter, on an assumption that current sales and margin trends continue for the balance of the quarter. A fourth-quarter loss would be unprecedented for Circuit City, said Armstrong, who has a neutral rating on the stock.

Goldman Sachs analyst Matthew Fassler kept his neutral rating on the stock, but put his earnings estimates – 66 cents per share for the fourth quarter -- and target price under review, calling the continuing decline in warranty penetration and the reported decline in television margins "particularly striking." He also said that in view of minimal earnings, valuing Circuit City's business has become difficult.

"We underestimated the financial impact from the disruption of our transformation work, which contributed to lower close rates, reduced attachments of higher margin accessories and firedog (SM) [remote tech support] services and lower extended warranty net sales as compared wit the prior year," Chairman, President and Chief Executive Philip Schoonover said in a news release.

Schoonover said the company is still on track to slash expenses by $150 million this year and achieve $200 million in annual cost savings starting in fiscal 2009. Six of the 21 stores it opened during the third quarter were "The City" stores, its newest concept, which is intended to overhaul its store culture through smaller formats that make better use of selling space and improve customer service through new technologies, according to a Dec. 5 research note by analyst Scot Ciccarelli at RBC Capital Markets.

However, rejuvenation efforts such as The City have, in the past, proved to be temporary and not sustained, the note said. (RBC or one of its affiliates has provided investment banking services to Circuit City within the past 12 months.)

On its conference call to discuss the latest results, the company said it has implemented seven new standard operating procedures for employees, but didn’t provide any detail, said Anthony Chukumba, an analyst at FTN Midwest Research in New York, who has a neutral rating on the stock.

"Even in the best of times, you have an incredibly high turnover rate among employees," Chukumba said. "When you’re putting a lot of things on employees, it confuses them, and if they’re confused, it ends up affecting the in-store experience of the customer."

Replacing high-paid employees with lower-paid workers has clearly hurt Circuit City's attachment rates – its ability to get customers to accept extended warranties for products they buy, which raises gross margins -- and its ability to convert casual shoppers into returning customers, he said.

These execution issues are hurting the company during its most important season, when it should be benefiting from the fact that consumer electronics are at the top of many people's holiday wish lists, Chukumba said.

A decline in promotional offers on Black Friday, the day after Thanksgiving that traditionally kicks off the Christmas shopping frenzy, would normally help boost gross margins, as it did for Best Buy (BBY), but it didn't seem to have helped Circuit City, said Armstrong at CL King.

Earlier this week, Best Buy, Circuit City's main competitor, reported a 71% surge in third-quarter earnings from a year ago to 53 cents per share, beating analysts' expectations. Best Buy's flat gross margin and higher operating margin show that it's better able to take advantage of industry trends, such as more than 10% increases in sales of flat panel televisions, notebooks and GPS products, compared with last year, analyst Mike Baker said in a Deutsche Bank Securities note on Dec. 21.

"We believe Circuit City's current weakness will make it a share donor for some time, helping to buoy Best Buy's results," Baker predicted. (Deutsche Bank has a hold rating on the stock and does and seeks to do investment banking with the companies covered in its research reports.)

Besides having better store locations and merchandise displays, Best Buy offers superior customer service, which is reflected in its latest earnings numbers, said Chukumba at FTN Midwest.

"They have spent a lot of time and a lot of money on their customer centricity initiative, where they've trained employees to anticipate customers' needs," he said. "They have a better managed team, and a lot less turnover."

In addition to Best Buy, Circuit City is facing tougher competition from big box discounters like Wal-Mart (WMT) and Target (TGT), as well as from warehouse clubs such as Costco (COST), Sam's Club (owned by Wal-Mart) and BJ Wholesale (BJ). And as if that weren’t enough, the company also has to prepare for the possibility of a pullback in consumer spending going into 2008, Chukumba said.

Put all those pressures together and it’s hard to predict when Circuit City may be able to return to profitability, he added.

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