Tweeter Home Entertainment (NASDAQ:TWTR) appears to be making a comeback. After three straight years of losses, this haven for audiophiles finally surprised analysts with strong 10% same-store sales growth for the fourth quarter of 2005. With the stock trading at only 17% of sales, it's time to put Tweeter high on my list for undervalued cyclicals.

Too big, too fast, for too much
Tweeter has only itself to blame for its sorry performance over the past three years. The company added a humongous 84 stores between 2002 and 2004, settling down at 174. Too bad sales only grew 2% in the same period. Clearly, Tweeter misread the market for premium gizmos. As it snapped up stores in 2003 and 2004 -- sometimes in the same geographical market -- comps took a dive. Despite blasting off 10% in the fourth quarter of 2005, comps are up only 1% this year.

Net losses also stemmed from Tweeter's inability to keep selling costs under control. For all of its strengths in selling high-end equipment at high prices, it must endure high overheads. Its salesmen are highly skilled and provide better service than competitors do. On top of that, Tweeter has a program that automatically matches the lowest price advertised within 30 days, and it sends the customer a check for the difference -- even if the customer doesn't ask for it.

Even for the aficionados who buy expensive stereos, I guess there's nothing like the sweet sound of a cheap deal!

Ready for a turnaround
For all of its woes, Tweeter has several things going for it, especially its status as the first destination for audio and video gizmo buffs. Despite controlling less than 1% of the consumer electronics market, it commands a relatively high proportion of the new-product segment. Manufacturers have amply rewarded Tweeter with better margins, knowing they'd always get a good response from Tweeter's customers for new and high-end products. As a result, gross margins remained strong, increasing from 36% in 2001 to 40% in the first nine months of 2005.

High-definition TVs have been Tweeter's biggest seller for this quarter and the entire year. Their average price has dropped 16%, leading to a sales growth of 54%. The advent of lower-priced flat panels and plasma TVs has benefited the industry; perhaps Tweeter, with its strong brand loyalty, got the most out of a bumper quarter.

However, this is not strictly Tweeter's business model. It usually skims great margins out of new products, and with prices continuing to drop for HDTVs, does Tweeter really want to go where Motley Fool Stock Advisor pick Best Buy (NYSE:BBY) already is? Weren't Best Buy's high-end Magnolia audio stories-within-stores supposed to imitate Tweeter's success? I guess the lines are blurring.

On the other hand, I don't see the iPod experience taking much away from Tweeter. In fact, it could help sales. Though the hot gadget convinced customers that they didn't really have to spend a lot on audio, it also spawned a bunch of expensive accessories like docking systems and Bose speakers, which sell to Tweeter's core customers.

Tweeter has also made admirably tough decisions when necessary. Tweeter's 9% fourth-quarter sales jump resulted from fewer stores (around 160), indicating that closing 19 stores at a cost of $17 million was a sensible decision. I believe that more painful decisions lie ahead; obviously, growth at the cost of profits is not an option anymore.

A value worth watching
Judging by comparable companies, Tweeter appears to be undervalued at the moment. Tweeter has traditionally paid 30%-40% of revenues when it was acquiring profitable companies. Comparable price-to-sales ratios for profitable consumer electronic retailers are 29% for Circuit City (NYSE:CC), 70% for Best Buy, and 76% for Radio Shack (NYSE:RSH) -- though Radio Shack's bigger margins come from mobile phones, where Tweeter doesn't compete. At 17% of sales, Tweeter looks like a bargain.

Nonetheless, there are risks. Tweeter has seen its market slowly disappear to competitors like Best Buy, Circuit City, Target (NYSE:TGT), and Wal-Mart (NYSE:WMT). I'm not expecting margins to improve in a hurry, because Tweeter will have to be exceptionally adept at finding the optimum number of stores for a limited target market -- a difficult task. Furthermore, even expensive products can be sold cheaper online; protecting your turf from mass marketers and the Internet is not about one excellent quarter.

Still, I am enthusiastic about the company's sensible moves toward closing down unprofitable stores. Considerable customer loyalty, a well-entrenched premium market, and the good turnaround in comps this quarter all renew my optimism for a comeback -- which makes Tweeter's price, at 17% of sales, look very interesting. At the moment, I have a small investment in Tweeter. I may invest more once its fourth-quarter results are out.

Further Foolishness that goes up to 11:

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Fool contributor Bobby Shethia owns shares of Tweeter. He believes that some of its trebles are off bass. The Motley Fool is investors writing for investors.