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Friday, April 23, 1999

The Good Guys, Inc.
(Nasdaq: GGUY)
Phone: 415-615-5000
Website: http://www.goodguys.com
Price (4/22/99): $3 1/8


Consumer electronics retailing is a notoriously tough business that requires hot products and a healthy economy to deliver real growth. But even then, prices are always coming down, putting a premium on tight inventory management and fast-turn merchandising skills that offer the main way to turn low profit margins into riches. It's a business where The Good Guys! have finished last -- or nearly so.

This San Francisco-based retailer was a potential turnaround story last June when its stock was in the mid-teens. It had just delivered a lower-than-expected March period loss thanks to a modest 2% gain in same-store sales.

While The Good Guys! were controlling expenses, however, gross margins actually declined to 25% from 25.3%, despite a growing influx of higher margin digital products, such as DVD, camcorders, and audio components. The inability to improve gross profit margins has ultimately torpedoed the stock.

For the December quarter, sales increased just 1% to $294 million as same-store sales actually declined by 2%. This during a period of retailer bliss, especially for larger rival Best Buy (NYSE: BBY). Earnings declined to $0.12 per share from $0.18, missing estimates by three cents per share. Gross margins dipped to 24.3% from 24.7%.

CEO Robert Gunst blamed the shortfall on "sluggish sales in the more commodity-oriented categories of home office, small screen television, portable audio, and stereo systems." Competitors were also pushing aggressive financing plans, and Good Guys was slow to respond.

Having rebounded from the fall mayhem's low of less than $3 to a high of $7 in January, the stock immediately turned back around on the December period sales figures. Preliminary March period results released April 8 had sales rising 5% but comp-stores sales up just 1%.

A week later, the company said Gunst would resign effective June 30. No replacement has been named. Gunst has been CEO since 1993. He will continue as a director. Some new blood is called for since the company itself now looks directionless. The stock price reflects those worries.


The Good Guys! is a consumer electronics retailer operating a total of 79 stores, 61 in California, 9 in Washington, 5 in Oregon, and 4 in Nevada.

The company has converted 11 of its stores to a new audio/video-enhanced Expo format with plans to remodel 5 more stores this year. Its Redondo Beach Expo, the first to be remodeled, showed improved first year sales but flat second year sales. In a joint venture with Tower Records, the company also operates five WOW multimedia stores.

In FY98, sales broke down into four general categories: video (41%), audio and cellular phones (30%), home office (17%), and other (12%). The video category has increased slightly in recent years as home office has declined.

Insiders own 9.3% of the stock. Major competitors include Best Buy and Circuit City (NYSE: CC).


Income Statement*
12-month sales: $932.4 million
12-month income: ($9.68 million)
12-month EPS: ($0.70)
Profit margins: N/A
Market Cap: $45.3 million
Enterprise Value: $32.1 million
(*As of December. Trailing 12-month revenue as of March is $942.4 million)

Balance Sheet
Cash: $13.2 million
Current Assets: $202.2 million
Current Liabilities: $167.5 million
Long-Term Debt: None

Price-to-earnings: N/A
Price-to-sales: 0.05
EV-to-sales: 0.03


A turnaround requires that a company deliver change and in some predictable fashion. Management must do more than cut losses or boost profits. It must show some ability to meet and beat the expectations it creates.

In that sense, the June quarter FY98 results released July 22 should have been a warning that Good Guys was still having troubles. Yes, sales jumped a nifty 7%, with comp-store sales up 6%, cutting the loss to $0.18 per share from $0.30 per share loss the year before. Yet that was reportedly $0.03 per share shy of the consensus estimate.

Although the company had managed to trim selling, general and administrative expenses by 150 basis points (1.5 percentage points), gross margins remained flat at 25.5%. Meanwhile, other industry players were experiencing rising gross margins due to tighter inventory management and strong sales of higher margin digital products. (Best Buy, for example, saw gross margins vault 280 basis points in its May period).

The flat gross margin, then, represented a remaining chink in a turnaround that had been partially built into the share price and was quickly knocked out of it.


Discount Store News has reported that at the February 10 shareowner meeting, Gunst said the company probably won't return to profitability this fiscal year (ending in September). That will make the fourth consecutive year of losses. The problem is that average per store sales have declined from $15 million a few years ago to $12 million.

Basically, it's time for a high-level management change. Cost cutting has helped, but the company has to improve store level sales and gross margins. Selling more performance contracts is one way to boost margins. Such contracts fell to 5% of sales last year from 5.7% in FY97. But with inventory turns down to 5.5 last year from 6.4 in FY95 (the last profitable year), new merchandising efforts are needed, too.

What makes Good Guys so appealing as a turnaround is that it's so beaten down. It trades at just 0.06 times sales (before backing out cash), about where Best Buy traded at its 1997 low. Today, Best Buy goes for 1.02 times sales after backing out its cash. Good Guys is now valued at just half its book value of $113.7 million (as of December).

Best Buy's success follows from a well-managed turnaround meeting up with favorable products and economic cycles. Even so, with just 2.2% net margins, its current price factors in its growing market dominance and rapidly improving financial health.

Still, if you assume Good Guys could improve net margins to just 1.5% (see FY95 results), earnings would rocket to over $14 million, or nearly $1.00 a share. Stick a P/E of 20 on that, back out the cash, and you get a potential target price of $21.

That's the logic fueling the turnaround hopes, but there's just no evidence that the company can produce such a reversal of fortune. The fact is, Best Buy's service plans rose to 3.7% of sales from just 2% in 1996. That's accounted for a significant amount of Best Buy's improving profits. And Good Guys targets a higher-end customer, and so already delivers much higher revenues (as a percent of sales) from such service contracts.

With its solid balance sheet, Good Guys represents a potential value play. But until there's evidence of consistent profits, value investors are likely to be repeatedly frustrated. This one's worth watching, but I wouldn't do more than watch at this point.

-- Louis Corrigan

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