<DAILY DOUBLE>
Thursday, July 8, 1999

Circuit City Stores-Circuit City Group
(NYSE: CC)
Phone: 804-527-4000
Website: http://www.circuitcity.com
Price (7/7/99): $100 5/8

HOW DID IT DOUBLE?

Someone's been buying a lot of computers. And washing machines. And cool digital electronics products like DirecTV, DVD players, and camcorders. Was it you?

If not you, then all of your neighbors. Sales at consumer electronics giant Circuit City have been booming for the last year as robust economic times and sky-high consumer confidence have encouraged an increasing number of Americans to enjoy the wired version of the good life. The company's investors have cheered as the shares have been digitized from the October low around $29 to the recent high over $100.

Circuit City's core electronics sales for FY99 (which ended in February) jumped 17% to $9.34 billion on an 8% increase in same-store sales, a key metric that compares sales at stores open for at least a year. Earnings for the company's core retail business soared 46% to $2.34 per share versus $1.60 during the soft FY98. Those gains came despite weakness during the first months of calendar '98 and the uncertainty caused by the stock market's plunge late last summer.

The first quarter FY 2000 numbers announced June 16 were even better, with sales in the seasonally weak quarter rising 15% to $2.2 billion on a 9% leap in same-store sales. Core earnings per share soared 65% to $0.39 per share from $0.24 a year ago. That crushed the Wall Street estimate of $0.23 per share.

With consumers reaching for more profitable new technologies and fully featured products, Circuit City saw its gross profit margin rise to 24.5% in Q1, up 30 basis points from 24.2% last year. Meanwhile, operating expenses dipped to 21.5% of sales from 21.8% thanks to leverage from the blistering gain in same-store sales. As a result, the core store business saw net margins leap 50% to 1.8% from 1.2% a year ago.

True, the company also announced in June that it was abandoning its proprietary DVD technology, known as DIVX, after investing more than $200 million in the project. Consumers had found the product offered added trouble with no added benefits. So Circuit City decided to cut its losses, taking a $114 million after-tax charge amounting to $1.12 per share. Yet, investors who never liked the company's DIVX gambit liked the fact Circuit City was bailing out of the business.

BUSINESS DESCRIPTION

Though headquartered in the sensible city of Richmond, Virginia, Circuit City has one of those slightly annoying capital structures that makes it necessary for an investor to look closely to know what she's getting.

Since February 1997, the businesses of parent company Circuit City Stores, Inc. have been tracked by two separate stocks: 1) Circuit City Group (NYSE: CC), the nation's number two specialty retailer of consumer electronics and one of the leading sellers of PCs, with 546 Circuit City Superstores, two consumer electronics-only stores, and 46 mall-based Circuit City Express stores, and 2) CarMax Group (NYSE: KMX), the nation's top used-car retailer, which operates 35 CarMax locations, including 30 used-car superstores and 20 new car franchises.

But the former retains majority ownership (76.6% of the 25.5 million common shares) in the latter. So buying into the consumer electronics retailer entails buying into CarMax. Also, Circuit City Group holds the parent's 75% stake in Digital Video Express, the now discontinued venture responsible for DIVX, and thus bears the brunt of the asset writedowns and restructuring expenses.

Among other things, this structure allowed the parent to raise outside capital for CarMax. The caveat, though, is that the owners of each tracking stock ultimately own merely a stake in the parent, which means that major troubles at CarMax would be visited on holders of Circuit City Group shares in more ways than one.

When looking at the company's press releases and financial statements, note that the data listed for Circuit City Stores, Inc. simply combine data for the consumer electronics unit and the CarMax unit, whose results are listed separately.

Insiders own 3.3% of the stock. July 15 is the distribution date for a 2-for-1 stock split.

FINANCIAL FACTS

Income Statement*
12-month sales: $9,624.4 million
12-month income: $237.0 million
12-month EPS: $2.36
Profit Margin: 2.46%
Market Cap: $10,237.6 million
(*Based on continuing operations, excluding charges, for the core consumer electronics stores and its intergroup interest in CarMax.)

Balance Sheet*
Cash: $62.9 million
Current Assets: $1,971.6 million
Current Liabilities: $977.0 million
Long-term Debt: $139.5 million
(*For the Circuit City Group alone)

Ratios
Price-to-earnings: 42.6
Price-to-sales: 1.06

HOW COULD YOU HAVE FOUND THIS DOUBLE?

From the middle of calendar 1995 through at least the end of 1997, the entire consumer electronics industry suffered through hard times. Average selling prices for computers plunged, leaving vendors racing to mark down inventories. Also, consumers were waiting for hot new digital products like DVD.

Circuit City's main rival, Best Buy (NYSE: BBY), saw its business and stock turn around first, signaling an improving environment for mega-stores that could sell in volume while controlling inventories.

Of course, a chunk of Best Buy's gains came courtesy of adopting Circuit City's aggressive practice of selling consumers high margin service warranties. Warranties have risen from about 1.9% of Best Buy's sales in FY97 to some 3.7% for FY99. Meanwhile, warranties have actually dipped from 6% of Circuit City's gross sales in FY97 to 5.4% in FY99, as falling product prices made it tougher to persuade consumers to pony up for the profitable warranties.

Nonetheless, the same digital developments that caused consumers to dance into Best Buy were benefiting Circuit City, something readily apparent from tracking the retailer's core same-store sales figures. Up against easy comparisons from the prior year's declines, the same-store sales figures vaulted 12% in May 1998, the first decisive year-over-year improvement and the first of a string of 14 straight months of strong comp-store gains.

Though the stock swooned with the broader market after hitting a high around $54 last July, the third quarter numbers confirmed that Circuit City's consumers had been unaffected by Wall Street's jitters. Sales for the November quarter shot up 18% on a 9% gain in same-store sales. With the stock around $37 when that news came out on December 4, Circuit City shares might have looked like a bargain.

WHERE TO FROM HERE?

DIVX is gone. That's one money-losing headache investors can now ignore. As for CarMax, well, it looks like this business will at least do no meaningful harm to Circuit City investors this year. Its first quarter sales increased 40% to $486 million despite a 3% decline in comp-store sales.

Massive promotions and price-cutting by new car dealers hurt CarMax's used car sales last year, but the company has made organizational changes to refine its cost structure. It's also acquired more new car franchises. Both efforts have helped CarMax benefit from a better selling environment this year. That's why Q1 gross margins improved to 12.8% from 11.5% a year ago while operating expenses declined to 11.5% of sales from 12.9% despite the lower same-store sales.

As a result, CarMax turned a slight profit in the first quarter, contributing $0.02 a share to Circuit City's results. Chair/CEO Richard Sharp has said CarMax's FY 2000 results should show a modest loss, or they may break even.

The CarMax business doesn't thrill me, and potential Circuit City investors ought to take a more detailed look. But Sharp's expectations suggest we can ignore CarMax for now.

Concentrating on the core continuing retail operations, then, we see that Circuit City trades at 42 times trailing earnings, or more than double its projected long-term growth rate of 18.2%. Analysts have been bumping up estimates, with the current FY 2000 consensus at $2.78 per share (high side: $3.05) and FY 2001 at $3.45 per share (high side: $3.75). So the stock carries a P/E of 33 to 36 on projected earnings for the year ending next February.

Circuit City will add a total of 35 new stores during FY 2000 and remodel 50. Better yet, the same-store sales comparisons will get more challenging, but not overly so. Comp-store sales rose 6% last June, 9% in July, and 4% in August. But those gains followed an overall 2% decline in same-store sales for Q2 FY98. Similarly, comps shot up 8% during the third quarter of FY99, but that followed a 3% dip the previous year.

Assuming consumer confidence holds up, Circuit City's recent momentum suggests the rest of the year should be strong. Although Best Buy has recently gained market share, the sector is increasingly dominated by these two giants, whose scale and efficiency produces nice profits from slim margins.

Best Buy remains a better managed enterprise given its success at boosting margins, growing cash while nearly eliminating debt, and trimming inventories relative to sales. Still, Circuit City is showing the same tendencies as it benefits from the strong sales gains. Inventories at the end of May were just 5.5% above the year-ago level despite the hearty 15% hike in overall sales. That's exactly what investors want to see.

Although I worry that all consumer electronics retailers could eventually be hurt by the growing numbers of e-tailers fighting price wars on the Web, Circuit City will itself enter the e-commerce fray when it relaunches its website later this month. The company will attempt to make an asset out of its brick and mortar stores by using them as a potential distribution network where online shoppers can pick up their merchandise.

Retailers on a roll often keep rolling, so Circuit City probably deserves to trade at a significant premium to its growth rate. This one's worth a closer look, especially if Greenspan and company cause retailers to shiver in coming months.

-- Louis Corrigan (TMFSeymor@aol.com)

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