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<DAILY TROUBLE>
Friday, March 12, 1999

CompUSA
(NYSE: CPU)
Phone: 972-982-4000
Website: http://www.compusa.com
Price (3/11/99): $6


HOW DID IT FIND TROUBLE?

If you think about the declining average selling prices (ASPs) in the PC industry and the growing price competition from Internet e-tailers, the question really is, "How could the nation's top computer retailer possibly have avoided trouble?" If you've got a solution, I suggest you dial the above number and ask to speak to CEO James Halpin. I'm sure he'll want to talk.

CompUSA was trading in the mid-$30 region a year ago when the news started getting bad. Not only were under-$1,000 boxes becoming all the rage, but Compaq (NYSE: CPQ) had shipped far more PCs into the retail channel than it could sell. So already falling ASPs fell even faster as a price war to clear inventory ensued and investors feared that even giant chip maker Intel (Nasdaq: INTC) lacked a strategy for continued robust profits.

CompUSA had all this to deal with plus the rise of Internet-only software vendors like Egghead.com (Nasdaq: EGGS) and Beyond.com (Nasdaq: BYND) and a spate of catalog firms turned online retailers looking to gain market share by selling for less. CompUSA's first move was to consolidate its retail leadership by acquiring the money-losing Computer City chain from Tandy (NYSE: TAN). Though a smart move, the short-term result was a massive inventory liquidation at acquired stores followed by remodeling expenses.

A tough calendar 1998 ended with CompUSA reporting lower-than-expected Q2 results. Sales came in on target at $1.78 billion, up 22%, as both desktop and notebook unit sales soared by more than 50%. But ASPs for both categories plunged 20% year over year, dropping overall gross margins to 13.5% from 14.7%. As a result, EPS dipped to $0.17 from $0.36 a year ago. Even excluding the revamped Computer City stores, same-store sales declined by 4.7%.

While the former Computer City stores posted modest store-level operating profits, they're still generating just half the sales of a regular CompUSA superstore. The company boosted marketing spending to try to bridge that gap, but that just pushed operating expenses higher, to 9.6% of sales from 8.6% a year ago.

The mid-January launch of Onsale's (Nasdaq: ONSL) atCost site suggested that new computer merchandise will increasingly sell online at close to a zero gross margin. That raised the specter of merciless price competition that could especially hurt brick-and-mortar retailers.

Then on March 1, a warning of sluggish February sales from Compaq led International Data Corporation's senior analyst Roger Kay to argue that "the party's over." He told the Wall Street Journal that consumer PC revenue seems to have peaked and that the commercial sales peak could be just a few years away. This bleak outlook pushed CompUSA shares to their lowest level in three years.

Then the news got really ugly. Within days, Dell (Nasdaq: DELL) launched its Gigabuys.com website, selling 30,000 different PC accessory and peripheral items and promising stiffer online competition.

Two days later, CompUSA warned that it would miss estimates for the remainder of FY99. Rather than earning the expected $0.21 per share in Q3, the retailer now expects break-even results after backing out a nickel a share for its Web development and IT spending. Gross margins will drop to just over 13.0% from 13.5% in Q2 due partly to a high single digit percentage drop in same-store sales versus expectations of a decline of no more than 4.7%. The retailer now projects a Q4 loss rather than the $0.11 a share gain analysts had expected.

With that news, the stock plunged another $2 1/16.

BUSINESS DESCRIPTION

CompUSA is the nation's top retailer of personal computers and related products. After acquiring the Computer City chain last August, the firm now operates 210 CompUSA superstores in 79 U.S. cities.

The company also operates a build-to-order facility where it makes its own personal computers (CompUSA PC). It also runs a 200,000 square foot configuration center where it can custom configure 484 PCs with different software at the same time. This center has the capacity to ship 5,000 PCs a day.

Though retail computer sales still account for about 60% of the company's revenue, Q2 FY99 sales of $1.776 billion included $35 million in service revenue (up 50%) and $27 million in training revenue (up 27%). Corporate sales account for about 31% of total revenue.

While the company is investing in its website, which sells 180,000 different items, the bulk of its fast-growing direct sales ($83 million in Q2, up 48%) come from telephone orders.

Computer Retail Week reported that calendar 1998 sales by the top 100 computer merchandise retailers totaled $37.6 billion, or $29 billion excluding sales by mail order or new start-up firms. With its $5.75 billion tally, CompUSA claimed the #1 spot with a 19.8% share of the latter figure, topping the $3.93 billion for Best Buy (NYSE: BBY) and $2.9 billion for Office Depot (NYSE: ODP), its closest competitors.

Insiders own 6.9% of the stock.

FINANCIAL FACTS

Income Statement
12-month sales: $5,806.0 million
12-month income: $32.1 million*
12-month EPS: $0.36*
Profit Margin: 0.6%
Market Cap: $567 million
Enterprise Value: $410.7 million
(*Excludes non-recurring charge)

Balance Sheet

Cash: $402.9 million
Current Assets: $1,504.7 million
Current Liabilities: $1,163.5 million
Long-term Debt: $246.6 million

Ratios
Price-to-earnings: 16.6
Price-to-sales: 0.1
EV-to-sales: 0.07

HOW COULD YOU HAVE SEEN IT COMING?

With Advanced Micro Devices (NYSE: AMD) looking to grab market share by attacking the low-end market with its K-6 chip and Intel responding with its low-end Celeron chip, it soon became clear that the sub-$1,000 box wasn't just here to stay but might soon become the sub-$500 box. Plunging ASPs would surely drive unit growth, but it simply left less room for profits for all concerned.

Add in the boom in online auctions and straight e-tail sites selling computer merchandise and then mix in the explosive growth of direct sellers like Dell (Nasdaq: DELL) and Gateway (NYSE: GTW), and CompUSA was clearly facing serious challenges. One of the only bright spots was that, until last fall, CompUSA was the only national retailer selling Apple's (Nasdaq: AAPL) hot new line of Macs.

Heavy insider buying by ten CompUSA executives late last summer at prices ranging from $12.92 to $17.75 suggested a turnaround might be near. But that ultimately proved a major head fake.

WHERE TO FROM HERE?

With plans to add just 15 new stores during FY99, management has focused on improving the performance of the former Computer City stores. For example, corporate sales are running around $3 million a quarter at the average CompUSA store but just $0.7 million on average for the former Computer City stores. Implementation of a new enterprise resource planning (ERP) system should also make the business run more efficiently.

The recent earnings warning, though, could force management to become more aggressive in rethinking its business. E-tailers are pilfering some of the company's experienced PC customers while consumer electronics superstores like Best Buy (NYSE: BBY) appear to be stealing some novices.

The Internet presents the largest opportunity and most daunting challenge. To address it, CompUSA is separating its Direct business into a stand-alone company and pumping an additional $2 to $3 million a quarter specifically into the Internet operations. On February 11, it appointed R. Stephen Polley, formerly CEO of Interphase (Nasdaq: INPH), as Chair/CEO of CompUSA Direct. Its Q2 Internet sales grew 100%, and its redesigned website has won accolades for ease of use.

Perhaps most important, Direct looks prepared to compete on price. A report from Credit Suisse First Boston (CSFB) noted that a Palm III advertised in CompUSA stores for $369 was selling for $329 on its Web site and concluded that this price disparity is "a huge first step for the company."

Indeed it is, but customers don't want to pay more for a Palm III at the local CompUSA than they pay online. Increasingly, they won't. That leaves this retailer in a tough spot. Even slight pressure to gross margins compresses the bottom line. Yet, the future of e-tailing entails gross margins approaching zero.

As with every other retailer of commodity hard lines, CompUSA must answer a basic question: How can the brick and mortar stores somehow prove an asset rather than a liability? The company's management has yet to answer that question. While Direct, technical services, training, and CompUSA PC could continue to deliver strong growth, the stores have to create greater value.

Not long ago, I thought that CompUSA could ultimately thrive by being the biggest player in a very tough retail space. A high-volume, low-margin model seemed a viable course, but the volume just hasn't been high enough. In retrospect, it's hard to believe investors paid $35 a share for this stock just a year ago given the powerfully deflationary trends that would soon wreak havoc on its business.

CSFB puts the bear case valuation at $5.52 per share, assuming the Direct business is worth $898 million and that the stores are simply closed (with accompanying charges taken). We're not far from there now.

Bargain hunters may want to kick around some possibilities and listen in on management's next few conference calls looking for improved results at old Computer City stores, growth in Web sales, and a new strategy to leverage the store base into a competitive advantage. Today, though, CompUSA today looks more like a case study in how the Internet is changing retailing than as a viable investment candidate.

Related articles:
-- CompUSA Same-Store Same Story, 3/5/99
-- PC Sales Drive Online Gains, 1/8/99
-- CompUSA Drops Below Insiders Bargain Price, 10/8/98
-- CompUSA Gets Squeezed, 7/2/98
-- Market Feels Effects of Intel, 3/5/98

--
Louis Corrigan
(TMFSeymor@aol.com)

Make a Living Foolin' Around.

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