Is Circuit City Headed for a Blowout?

Blockbuster's decision not to buy the retailer sent the stock tumbling. A Chapter 11 bankruptcy filing may be in the offing

Will Circuit City (CC) join the long list of electronics retailers, like Tweeter Home Entertainment and Harvey Electronics, that have filed for Chapter 11 bankruptcy protection in the past year? Given that shares of the Richmond (Va.) company are trading at just over 2, Wall Street is betting that could be a possibility. "Circuit City is in very serious trouble, and any scenario is possible today," says Nick McCoy, senior consultant at TNS Retail Forward, a research firm.

Circuit City's market capitalization currently is a mere $368 million—pocket change for a large private equity firm. But buyers are not lining up and have clearly concluded that the chain's problems won't be easy to resolve. On July 1, beleaguered movie-rental company Blockbuster (BBI) effectively delivered a slap in the face to the nation's second-largest electronics retailer by withdrawing its proposal to acquire Circuit City. "Based on market conditions and the completion of our initial due diligence process, we have determined that it is not in the best interest of Blockbuster's shareholders to proceed with an acquisition of Circuit City," said Blockbuster Chairman and CEO Jim Keyes.

Plenty of Cash

Blockbuster's move sent Circuit City’s stock tumbling a further 15%, to $2.14 a share, on July 2.

Now, even if a private equity player decides to buy Circuit City, there's speculation that the buyout might take place under a Chapter 11 reorganization plan. Such a filing could certainly take care of a key problem that CEO Philip Schoonover has often pointed to, which is that many of the company's 682 stores are in poor and underperforming locations, and would be expensive to close because they have long-term leases.

A potential buyer can take advantage of a special provision of the U.S. bankruptcy code, called Section 363, allowing it to sell assets and get out of leases and contractual obligations under the protection of the court. "A 363 sale short-circuits the whole process, and the debtor can sell assets free and clear of any liens, and thus get a cleaner title," says Rich Hynes, a professor of bankruptcy law at the University of Virginia School of Law.

Circuit City spokesman Bill Cimino wouldn't comment on the specifics of the strategic alternative process that the company is pursuing with investment bank Goldman Sachs (GS), but noted that a Chapter 11 filing was not something the company was considering. &quotWe have adequate liquidity,&quot says Cimino.

Wal-Mart Effect

The company says it is making progress toward returning to profitability in the second half of the year, through better sales of accessories and warranties and customer service improvements such as training sales reps to greet customers, ask the right questions, and make recommendations.

Some analysts and investors are doubtful, however. "Sure, the company has cash, but the question is can they return to profitability in this environment? The market is saying no," says Andy Hargreaves, an analyst at investment bank Pacific Crest Securities in Portland, Ore.

Circuit City has been in dire straits ever since prices plummeted 40% to 50% two years ago (BusinessWeek, 4/23/07) for large flat-panel TVs, which were the chain's highest-selling item. It is being clobbered by newer competitors like warehouse club Costco (COST) and discounter Wal-Mart (WMT), both of which have been aggressively promoting electronic goods.

If anything, Wal-Mart has stepped up its offering of various electronic offerings. On June 3 the company announced that it had increased its assortment of high-definition TVs by 58% and had introduced new models from Sharp. It increased floor space for social gaming and video players from Samsung and Panasonic that offer pictures in the latest crystal-clear Blu-ray technology.

"As the popular high-definition flat-panel TVs and iPods become more commoditized, it's all about price now," says McCoy of TNS Retail Forward. "Wal-Mart has an advantage because of its size and superior bargaining power."

Suitors sought

Adding to Circuit City's woes is the economic downturn and the fact that consumers have clamped down on spending. Circuit City reported a loss of $165 million its fiscal first quarter ended May 31 and said sales at stores open for at least a year, a key measure of a retailer's health, were down 12.2% in the quarter.

In May, Schoonover hired investment bank Goldman Sachs (BusinessWeek, 5/9/08) to review strategic alternatives. Circuit City is under immense pressure from shareholders who have bought in anticipation of a sale. In particular, activist shareholder Mark Wattles, who controls a 6.5% stake in Circuit City, wants the company sold.

In an interview a week ago, right after the Circuit City annual meeting, Wattles said that at least a couple of private equity firms were in talks (BusinessWeek, 6/24/08) to acquire the company and that an announcement would come within four weeks. Wattles also had three of his nominees elected to Circuit City's board of directors; they seem to have the directive to secure the best price for the company if it is sold.

Wattles didn't return calls for comment on the latest twist in Circuit City's fortunes. However, a Chapter 11 filing would probably not be in his best interest. The average purchase price for his 6.5% stake, or 11 million shares, is $4.11. Already, the stock is trading at half of that. Even if a buyer emerges who wants to reorganize Circuit City under Chapter 11, "It is rare that shareholders receive even a dime during a bankruptcy," says Hynes.

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