Here at The Motley Fool, we believe individual investors should have the same access to information that Wall Street has. In that spirit, we've listened in on some investment bank conferences with major companies and are giving you the rundown. We call this feature "Fool on the Street."
"We are in the mid stages of our turnaround, and we believe we have ample upside."
That's how Dave Matthews, Circuit City's (NYSE: CC) EVP of merchandise and marketing, opened his presentation at the CIBC consumer growth conference.
He's right. The company is in turnaround mode. And there is a lot of upside if the company can improve its performance, as the stock is down more than 50% from its 52-week high. But that "if" is as big as the blue-and-yellow sign of competitor Best Buy (NYSE: BBY) that usually sits mockingly nearby.
In the presentation, Matthews lays the strategy cards out on the table to let the audience know how Circuit City plans to get there. I'll look at what he says and let you know why I think Circuit City has a long way to go before it starts creating value for shareholders.
A quick look back
They say a picture is worth a thousand words. The table below ought to be worth at least 100.
|
Sales
|
Gross Margin
|
Gross Profit
|
Operating Margin
|
Operating Profit
|
|
Circuit City
|
$12,319
|
23.2%
|
$2,860
|
0.4%
|
$53
|
|
Best Buy
|
$36,902
|
24.1%
|
$8,896
|
5.3%
|
$1,960
|
Data from Capital IQ. Results from last 12 months of performance. Dollars in millions.
Since I'm not going to write 100 words about this table, let me summarize what I see. Best Buy is considerably more powerful than Circuit City, since it generates higher margin percentages and absolute dollar amounts. So when I read the transcript of Matthews' presentation, I'd better read lots about how the company is working to become more profitable rather than how fast it wants to grow. That's because, right now, the company is not generating very good returns on its shareholders' capital.
The plan
Matthews outlines the renaissance using three key points. Cost-cutting is first. That's good. Retailers have to work as efficiently as possible, but there is only so much blood that can be squeezed from the cost-cutting stone. Fortunately, the next two items, the "four strategic pillars" and an improvement in merchandising, focus on "growth and profits."
I want to focus on the "four strategic pillars," corporate-speak for "four things we're going to try," on which Circuit City will build its growth platform. Those pillars are: "win in home entertainment, multichannel retailing, digital home services, real estate and concept development."
Multi-channel retailing is simply giving customers "more ways to shop Circuit City," be they stores, the Internet, contact centers, or firedog, its home services business. In two years, firedog has grown from no sales to $200 million. The real estate pillar is simply putting stores in the best locations possible and designing stores to be as inviting as possible. There's nothing that really jumps out at me from that list. They are all good things to do.
When talking about winning at home entertainment, Matthews commented that the "aim is to offer our customers superior value in the home entertainment category." Now, I have no problem with that vision. But the voice of my strategy professor, Ram Baliga, is echoing in my head. Ram always reminded us, "It's about value creation and value capture." Let me explain using Costco (Nasdaq: COST) as an example.
Costco creates lots of value by offering tremendous bargains and great products. It shares a great deal of this value with it customers by capping gross margins. This keeps customers happy and coming back for more. It captures lots of value by keeping SG&A costs as low as possible, by generating enormous store productivity ($937 per square foot in sales), and by raking in recurring membership fees from all those very happy customers. All the while, it generates about 13% returns on invested capital, adjusted for operating leases. Thus, it creates lots of value for customers and for shareholders.
The situation is not the same at Circuit City. According to Capital IQ, store sales productivity is actually higher at Circuit City than Best Buy. The problem is that Best Buy generates adjusted returns of 15.5%, compared with about 5% at Circuit City. So I'm nervous that management will continue to focus on creating lots of value for customers and not much for shareholders.
A needle in a haystack?
One saving grace that Matthews discussed was the notion of moving from "a complete focus on gross margin percent to one that balances margin rate with margin dollar pools and margin dollars per transaction."
That's an interesting comment, and one that balances being efficient with being powerful. In an interview, Bill Miller mentioned that one of the things he liked about Amazon.com (Nasdaq: AMZN) was that leader Jeff Bezos focused on running the company to generate maximum gross margin dollars -- to become powerful. Remember the table above, the one that shows Circuit City generating less gross profits and then not using them as effectively as Best Buy? If this were the brutal world of nature, Circuit City would be struggling to stay alive because it lacked power. But if it can truly work to maximize gross profits, returns on invested capital could rise if it uses those dollars wisely, rewarding both customers and shareholders.
The Foolish bottom line
The only way this ship is going to get turned around is if those returns on invested capital start accelerating. If the investments the company is making in the strategy Matthews described and the new stores don't raise returns, then they won't have created value. Without value creation, the only thing growing will be the queue for investors to sell their shares.
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Retail editor David Meier is a certified bargain hunter, in the stores and in the stock market. He does not own shares in any of the companies mentioned. The Motley Fool has a disclosure policy.
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