Electronics Stores Get A Cruel Shock

Even in the best of times, selling mass-market consumer electronics is a low-margin business. In times such as these, profits all but vanish. That's why retailers flat-out love extended-service warranties. For as little as $15 or as much as $200, consumers can buy the service plans to pay for repairs on compact-disk players, camcorders, and other products after the manufacturer's warranty expires--usually within 90 days. Extended warranties can add as much as five years of protection, providing peace of mind for wary shoppers and fat profits for retailers. Analysts figure that half of the operating profits for big consumer-electronics chains come from extended warranties. Some 40% of customers buy them, and on some products, such as big-screen TVs, the figure is as high as 75%.

Small wonder, then, that the electronics retailing industry is howling, now that the Financial Accounting Standards Board has changed the way revenues from those warranties are recognized on earnings statements and balance sheets. Beginning in January, instead of recording all of the revenues when they receive payment, minus expected repair costs and sales commissions, sellers of extended warranties must allocate the revenues over the life of the contract. Instead of recording the proceeds from a $100, three-year extended-warranty contract all at once, the retailer will have to spread out the revenue stream, recognizing $33.33, minus costs, in each of three years.

PAINFUL MOVE. The change applies to plenty of extended-warranty sellers beyond consumer-electronics dealers. Auto makers, along with manufacturers of televisions and other home appliances, must comply with the new rule, too. But those manufacturers have long followed practices similar to FASB's new, more conservative approach, so they don't expect the change to hurt earnings.

The same can't be said for consumer-electronics retailers. By booking extended-warranty revenue as soon as it's received, they have been able to boost their earnings. But with the more conservative approach, consumer electronics stores face a period of painful adjustment. Circuit City Stores Inc., the biggest U. S. consumer-electronics chain, with $2.4 billion in sales and 185 stores, is already switching over to the new FASB reporting method for its fiscal year ending Feb. 28.

The company, based in Richmond, Va., expects that the revision in warranty accounting will cut 25~ a share from earnings for the year. That's roughly 16% of fiscal 1991's estimated profit of $1.55 a share. And, because it prefers not to drag out the change over several years, Circuit City also plans to take a one-time charge to account for warranty sales in prior years. That will cost an additional $1.15 a share, the company estimates. Although the charges won't affect actual cash flow, they will all but wipe out stated earnings.

Best Buy Co., based in Bloomington, Minn., is also converting ahead of time. The company won't disclose the expected charges for fiscal 1991 until it releases results for its third quarter, ended Nov. 30, says Chief Financial Officer Allen Lenzmeier. But William Blair & Co. analyst Skip Helm figures the move will lop 10~ to 15~ off estimated earnings of $1 a share. The company will take at least a dollar more a share in a one-time adjustment, Helm predicts.

Other stores are waiting. Tandy Corp., which operates the Radio Shack, VideoConcepts, and McDuff chains, and Dayton-based Audio/Video Affiliates Inc., with 90 Rex outlets, don't plan to make the switch until next year. They say they don't know what it will cost.

Some chains may avoid earnings problems altogether, and others won't have to reveal publicly how much it hurts. For example, Good Guys Inc., a 30-unit San Francisco chain, resells its service contracts to an outside repair company. And the 232-store Silo Inc. chain in Philadelphia is a subsidiary of Britain's Dixons Group PLC, so its results aren't reported separately.

BALKING BANKS? Regardless of when the change is made, the new rule could trigger other troubles. "The biggest problems could be with the banks" that keep a close eye on debt-to-equity ratios, warns Leslie Gordon, Silo's chief financial officer. The accounting change will result in lower retained earnings, which reduces stockholder equity. So stores that borrowed heavily to build inventory and finance expansion could end up in technical violation of bank lending agreements pegged to certain ratios.

But don't expect electronics retailers to pull back from selling extended-service plans. Gross margins for the warranties top 70%, vs. 20% to 30% for the products themselves. With retailers slashing prices to lure customers, service plans are even more important these days, says Audio/Video Affiliates Chairman Stuart Rose. "Anyone making money now, it's probably 100% from warranties," he says. Indeed, revenues from extended warranties are one way to withstand the never-ending price wars. And even if the chains can't report all the proceeds immediately, they still pocket badly needed cash. That will keep their love affair with extended warranties going.