Dark Days Ahead for Best Buy and Circuit City?

In addition to the rush of snagging that quick-moving five- or 10-bagger, every Foolish investor wants to find that stock they can grow old with, their Coke and Buffett story.

Recently, I've heard people touting Best Buy (NYSE: BB  ) as a long-term growth play because of its freshly inked store-in-store agreement with Apple (NYSE: AAPL  ) and plans to expand into China.

I'm not so sure about this view. While both Best Buy and its rival Circuit City (NYSE: CC  ) are iconic American names, the electronics retailing industry's days of providing superior long-term growth opportunities for investors may well be over. It's possible that Circuit City in particular is the proverbial canary in the toxic coal mine and that its recent troubles are less of a short-term impairment, and more of an indicator that trouble is afoot for electronics retailers.

"The way you win the game isn't the price of the TV -- which is about the same for all retailers -- but the experience you give customers once they are in our stores." These comments, made in a recent Fortune magazine article by Best Buy's CEO Brad Anderson, underscore what may increasingly ail the segment. Pop in your eight track and flashback to the '70s. Electronics retailers were suffering from problems similar to car dealerships -- legions of irritated customers were fed up with pushy sales tactics and, worse, erratically rising prices put forth by local and regional players. Companies like Circuit City stepped in, established national operations, and passed the benefits of economies of scale on to consumers in the form of deeply discounted pricing. Back to the new millennium, and we have the CEO of the leading electronics retailer openly admitting that yellow tags are no cause for excitement because gone are the days of pricing power.

From televisions to stereos to DVD players, profit margins are moving closer to extinction. Margins have been squeezed so much that retailers are essentially getting paid to hold electronics equipment. Once a substantial source of revenue, electronics devices are now loss leaders used to upsell the customer on more profitable items like DVDs. Oddly enough, beyond service offerings like Circuit City's Firedog and Best Buy's GeekSquad, DVDs are one of the last profit margin frontiers for retailers. But even that party can't last forever.

We've gone over eroding pricing power. Maybe you're thinking that long term, things are going to get better and the electronics industry is going to come out with scores of new products. But Fool, beware -- these new products shouldn't be expected to magically contribute to improved margins. Unless these retailers can push inventory costs back to suppliers or come up with new value-added service offerings, electronics retailers will continue to look more like grocery stores than sophisticated high-margin operators.

Electronics and Moore's Law
If you can get over diminished pricing power, you still have Moore's Law to contend with. Moore's Law essentially says that the capacity of processors doubles roughly every 18 months, and it means that computer and electronics equipment will change more rapidly and, in many cases, will become increasingly complex. The law has numerous implications for electronics stores, but I'll go over two of them here: the disappearance of some high-margin products, and a steeper learning curve for electronics sales associates.

First, expect DVDs and the respectable margins they carry to increasingly go the way of CDs. For proof of this decline, look no further than Cisco's (Nasdaq: CSCO  ) announcement last week that its robust earnings were driven by a sharp rise in demand for online entertainment downloads. Second, Moore's Law and rapidly changing technology may have a hand in the decline of the service and expertise offered at electronics retailers. Indeed, in the company's most recent earnings call, Best Buy CEO Anderson admitted, "Along with that staggering increase in capability comes staggering increases in confusion." He went on to note that Moore's Law and accelerating technology has already caused a deterioration of customer satisfaction with the launch of Vista. It's quite possible that sales associates will find it increasingly difficult to master the rapidly changing base of complex products within electronics stores.

The customer experience and knowledgeable service is one of the last distinct features that the electronics retailing industry has to offer over retailers like Amazon.com (Nasdaq: AMZN  ) that dabble in everything from electronics to salt-and-pepper shakers. As that continues to erode, expect pure-play electronics retailers to feel the burn.

So where do you go from here?
By now you probably think I'm ready to strap on a sandwich board and proclaim that prices are falling and technology is coming on too fast -- the end of the world is coming! On the contrary, there's likely some gas left in both Best Buy and Circuit City for differing reasons.

With regards to Best Buy, I like that it trades at a forward P/E of just over 13. But I'm with the bear on the side of the Best Buy argument and think that consistently declining free cash flow and a late jump into China will prove problematic. Even in the case of Circuit City, despite its flaws, the company is flush with cash and relatively debt-free, making it a private equity or activist investing target if it falls much lower.

However, if you're looking longer term (more than five years), instead of trying to pick through the heap of companies in a declining industry, you can pass on opportunities altogether and wait for a no-brainer. I think if you're in the market for a retailer, both Wal-Mart (NYSE: WMT  ) and Target (NYSE: TGT  ) represent an opportunity to profit from any gains in electronics via a more diversified route. And both companies offer far better risk-return profiles. As a near-term plus, Target has activist investor Bill Ackman shaking the tree and hoping the real estate from under its stores and its credit card portfolio come loose.

With all the opportunities out there, investors don't have to worry about declining pricing power and margins and the unsure future that scores of rapidly changing products bring. While the electronics stores segment might do well in the near term, I think there are other industries out there that will produce more shocking longer-term returns.

For more Foolishness:

Best Buy and Amazon.com are both Motley Fool Stock Advisor selections. Wal-Mart is an Inside Value recommendation.

Fool contributor Rimmy Malhotra is a New York City-based money manager. He does not own shares in any of the companies mentioned. The Fool has a disclosure policy.


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