Argus Research--(Circuit City) Downgrade to SELL:
(Sold shares-Out)
CIRCUIT CITY (NYSE: CC, $5.22) ................................................................................................................... SELL
n We are downgrading our rating on CC shares to SELL in tandem with our lowered profit outlook, negative nearterm
credit trends, and the company’s competitive positioning longer term vis-à-vis Wal-Mart and Best Buy.
n CC reported 4Q EPS from continuing operations of $0.36 versus $0.67 as comps declined 6% and credit profits
fell 77%.
n Sales of digital satellite systems and wireless communications (higher margined products) remain soft.
n Full year EPS of $0.37 compare with our estimate of $0.50. We are lowering our EPS estimate for this year to $0.50
from $0.80.
ANALYSIS
INVESTMENT THESIS: We are downgrading the shares of Circuit City (NYSE: CC) to SELL. When we approach any
retailer, one of our most fundamental questions is, “What competitive advantage does the organization have and is it sustainable
in light of the growing competitive pressure emanating from retail leader, BUY-rated Wal-Mart (NYSE: WMT)?” As a retailer
hits any mass (in terms of size), this question becomes more fecund. A small niche player that specializes in inventory too esoteric
for Wal-Mart can garner success. By employing a niche strategy (à la Michael Porter) of entering a market to fill a niche need,
and from that base to expand into the mass market, the more likely one will enter Wal-Mart’s sphere. Moreover, Wal-Mart, as
gargantuan as it is, must continually broaden its merchandise categories to achieve the double-digit sales growth (and low to midsingle
digit comps) that are its goal. With its incredible IT, supply chain, and buying power Wal-Mart is slowly (and steadily)
assorting its stores to meet local needs. Last year Wal-Mart increased sales $26.7 billion, an amount larger than the annual sales
of all but a handful of US retailers. Over the past decade, industry observers have witnessed Wal-Mart’s prowess as it entered food
retailing, and the subsequent damage to multiple supermarket operators, the maturing of department stores and that sector’s
contraction, and more than a few mass merchant and discounter bankruptcies and/or industry exits.
Destination category killers such as Circuit City and Best Buy beat Wal-Mart on selection and service, but Wal-Mart
usually holds the price card. Wal-Mart’s merchandising strategy simply put is the 80/20 rule: stock the 20% of the merchandise
that fills the need for 80% of the public, and leave the complexity for others (thus niche opportunities remain). When the technology
requires explanation, Wal-Mart cedes the business to others, as assisted selling is not its forte. Over the past few years, the bulk
of new CE products have been digitized versions of merchandise the consumer already understands. Thus the digital cameras and
plasma screen TVs at Wal-Mart. Obviously this has hurt the specialists. Additionally, the CE category is an obvious fit for online
retailers.
Given Wal-Mart’s appetite and acumen and Best Buy’s plans for new store expansion, we think the longer-term prospects
for Circuit City are maturity, at best. The recent compensation changes among the CC sales force are likely to alienate the best
and create confusion among the rest, making near-term prospects questionable. The company’s reliance on credit is another cause
for alarm and confirms the increased competitive waters for the CE category. In the recent year, credit income declined $44 million
to $62.4 million, and represented 93% of pre-tax earnings from continuing operations (versus 51% in the previous year). The nearterm
credit outlook is murky.
The CC shares are at the low end of their 52-week range ($4 to $25). Nonetheless, in light of our lowered profit outlook,
the negative near-term credit trends, and the company’s competitive positioning longer term vis-à-vis Wal-Mart and Best Buy,
we are downgrading the CC shares to SELL An improved economy with improved consumer sentiment and increased spending
will benefit Circuit City. Meanwhile, the tasks ahead of CC management are substantial, and we remain on the sidelines regarding
the CC shares until we see traction on strategic initiatives.
4Q FINANCIALS: 4Q sales declined 5% (6% on a comp store basis), to $3.2 billion. Gross profit declined 6% to $763
million, or 23.9% of sales. Finance income declined 77%, to $7.7 million, and SG&A expense rose 3.9%, representing 20.3% of
sales. Net earnings from continuing operations declined 46.5%, to $75.3 million. On February 6, management implemented a
compensation change that penalized net results by $10 million, or $0.03 per share. Remodel and relocation expenses were $2.7
million ($0.01 per share) in the quarter and $47.9 million ($0.14 per share) for the fiscal year. Full year sales of $9.5 billion rose
5% (4% on a comp store basis), and EPS of $0.37 compares with $0.71 a year ago.
At market close on Friday, the SELL-rated CC shares traded at $5.22, down 0.05. (Marie Driscoll, CFA) |
