Description

Summary

Circuit City is a contrarian play on a stock that is down over 70% so far this year and currently sits at its 52 week low. It is in the midst of a multi-year turnaround, yet the market has essentially written off any possibility that the turnaround will be successful as evidenced by the precipitous share price decline and that fact that it is nearing cash value. Based on management’s comments it appears that the turnaround is on track to be successful, but is just taking longer than expected. Circuit City has $4.57 in cash and receivables (including a $0.24 tax refund expected this quarter) on its balance sheet representing 70% of its market value. Ex cash and equivalents, Circuit City trades at 2.8% of sales which is a historical low for the company.  Circuit City also trades at two thirds of book value and it hasn’t traded below book value since September 2003 when it traded as low as $4. These factors provide an adequate margin of safety that allows an investor a free call option on a successful turnaround. Circuit City has over $12bln in sales which represents significantly optionality should they be able to improve their operating margins and effect a profitable turnaround.

Thesis

“As the quarter started out we were in the middle of a tremendous amount of change. We had just come off going from ten to eight regions. We changed the management model in every store that we had, and then we started to change the labor model. So a way to think about that, if it didn't come out clearly, literally we had 40,000 people learning a new job. They may have had a similar job to their position, but they might have had a different area of responsibility. They had something new to learn. That created the distraction and that absolutely affected us early in the quarter, particularly in June and July as they were learning new roles and going to training centers and cascading about their learning to other people inside the business. That hurt our ability not only in conversion, as I stated earlier. It hurt our ability in attachments. We were-- hurt us with City Advantage (warranties), services, other things we typically attached for the consumer. What we saw, though, is we saw that as this change was getting behind us, and what we've learned from our regional learning centers (pilot programs) is it takes about 4-8 weeks for the change to settle in, and as the change was getting behind us month to month our stores began to stabilize. First our regional learning centers (pilot programs) which improved their performance every month of the quarter, then our divisional learning centers, and the rest of our chain is 4-8 weeks behind those. So we did see an improvement in performance over the course of the quarter. We have a long way to go. There's still a lot of people still learning new roles. But we have some history here that says that we'll be able to continue to improve in this quarter.”

Basically what management is saying is that the pilot programs for the changes they are instituting have shown to be working, but the majority of the stores are still in the transitional phase. The pilot programs certainly do not suggest that the turnaround will fail and management continues to state that it will be successful, but will just take longer than expected. In what appears to be irrational behavior, though, the stock has sold off to valuation levels that would suggest the turnaround is an abject failure and the company will end up liquidated. I believe this is a case of the market overly discounting uncertainty.  Circuit City currently trades at 0.66x book value versus a 5-year avg of 1.45x book value. It trades at 0.06x TEV/LTM sales versus a 5-year avg of 0.23x. As mentioned earlier, ex cash and receivables, it trades at a P/S of 0.028 versus a previous historical low of 0.10x. These extremely low multiples combined with 70% of the market cap in cash and equivalents suggests that there is enough margin of safety inherent in the shares to be able to bet on a successful turnaround. At these valuations, I believe shares in Circuit City are a high uncertainty, but low risk situation especially as management has noted that the majority of their stores remain free cash flow positive.

I believe Circuit City provides asymmetric risk/reward potential because of the limited downside risk suggested by the historically low multiples and significantly high return potential if they are able to successfully complete their turnaround and improve their operating margins. The market appears to be assigning zero probability to this occurrence, which is why the stock is currently a bargain in my opinion.

Assuming management’s turnaround is successful and they are able to match Best Buy’s operating margins of 5% (best case), there is over 500% upside potential from current levels. Assuming sales growth of 7% per year, a three year time horizon, and a 15x PE multiple at that time, Circuit City’s shares could be worth $39.26. Again the market is not assigning any value to the optionality of the turnaround despite that fact that many of the initiatives are still in the process of being implemented and pilot programs appear to be working.

Even if Circuit City is only able to get to a 3% EBT margin, the upside potential is still over 260%.

 The company currently has a huge number of initiatives ongoing of which the benefits have yet be reflected in the share price. Recent SG&A (headcount reduction) savings have been masked because of lowered margins due to the television issues as well as restructuring charges due to store closings. While, this may continue into FY 08 (continued IT and restructuring initiatives) once the store openings/closings slow, this improvement should finally become evident in the financial statements. It is instructive to compare the SG&A/Sales for Circuit City (22.9%) to Best Buy (18.8%). Given that there is over 400bps of possible improvement versus the nearest competitor and Circuit City is implementing a similar strategy (keep in mind CC’s new CEO used to work at BBY), it is reasonable to assume that Circuit City will be able to decrease their SG&A/Sales. Perhaps not to the same level as Best Buy, but a 100bps improvement would not be unreasonable. Should Circuit City be able to reduce its SG&A/Sales to 21.9% (only 1/4 of the difference with Best Buy), its EBT would increase by over 2000% and its EBT margins would reach 4.5%. This is an example of the trmendous operating leverage inherent in Circuit City which makes the upside potential of this investment quite significant.

 CEO Philip Schoonover used to work at Tweeter, Best Buy and Sony (supplier experience). While he has spent his entire career in consumer electronics, his experience at Best Buy was especially noteworthy as he was a key player in developing new initiatives there. His knowledge of Best Buy, gives confidence that Circuit City can follow the same roadmap to improving their stores, sales, and margins. Management’s goals and interests seem to be aligned with shareholders as their cash and stock bonuses are dependent on EPS and EBT margin targets. Schoonover holds 1m stock options with a strike price of $23.845. He also owns 500k shares outright. He is clearly incentivized to improve the margins and operating performance of Circuit City.

Anecdotal evidence that suggest higher valuation warranted

v     Circuit City trades significantly below a February 2005 $17 buyout offer by Highfields Capital Management. This offer was rejected by the board who stated that they could maximize shareholder value on their own. Highfields manager Jon Jacobson spoke about Circuit City in his interview with Value Investor Insight in February 2006. He said he invested in Circuit City because it was cheap and had optionality in correcting several years of bad management. He said he originally bought the shares at $9 when they had $6 per share in cash and receivables leaving the stub to trade at less than 10% of sales. The stock looks even cheaper today with same stub (ex cash and credit card receivables) trading at 2.8% of sales.

v     Circuit City has been an active acquirer of their own shares having bought back almost $1bln worth of shares since 2001 at an average price of around $16. In FY2007, Circuit City repurchased 10m shares at an average price of $23.69 and as recently as Q1FY08, they repurchased shares at an average price of $18.08. Given management’s commitment to the repurchase program, it is clear they saw value in the shares at levels significantly above the current price. However, Circuit City did not buy any shares back in the most recent quarter as they said they wanted to keep cash on hand given the debt market conditions. I think this move spooked investors who saw it as a more signal that the turnaround would not work.

v     Management at Best Buy is also acting Bullish.  Their CEO recently bought 500k shares at $43.86 and boosted their buyback program to 5.5bln signaling bullishness in future prospects. While it is not quite as simple as saying what’s good for Best Buy is good for Circuit City because, of course, Best Buy is a superior business with expansion opportunities in China and other advantages. However, some of the major sources of uncertainty with regards to Circuit City are the strength of the consumer and TV selling prices/margins. These issues would affect both Best Buy and Circuit City in a similar manner and Best Buy’s recent bullish actions can serve, by proxy, to alleviate some of the similar concerns with regards to Circuit City.

v     In addition, an interesting optionality exists due to the 2009 mandatory transition to digital television. Larry Haverty from Gabelli Asset Management  in the July 23^rd, 2007 issue of Barron’s called this, the “mother of all catalysts for Best Buy.” Haverty estimates that 200 million TV sets will become obsolete because of the new law and consumers will either have to purchase a new set or a converter. This should drive sales growth and margins not only for Best Buy, but also Circuit City. In fact, if this prediction becomes true, it could actually be more beneficial to Circuit City then Best Buy as Circuit City sells a greater percentage of TVs then does Best Buy. Also, currently only 10% of homes have a high definition TV and Circuit City CEO Paul Schoonover calls this a “massive opportunity.”

Conclusion

Bill Nygren was quoted in Outstanding Investor Digest saying that retail turnarounds always take longer than expected. It appears that this is the case with Circuit City and a large majority of holders and sell side analysts have essentially given up hope and thus the market price assigns a negligible probability of a successful turnaround. Circuit City has only recently begun several initiatives and we have not yet seen tangible results. Its operating margins are currently under 1% while its closest competitor has margins over 5%. Based on historically low multiples, it appears that Circuit City has a significant margin of safety. Given this margin of safety, there exists an asymmetric return matrix as the optionality of the turnaround and margin improvement suggest possible multiples of upside. In addition, knowledgeable and intelligent investors have valued Circuit City at higher levels in the past.

Catalyst