It's extremely difficult to operate a smaller business alongside an industry behemoth like Best Buy (NYSE:BBY), unless the smaller business has a way to differentiate itself. For proof of this, you need look no further than Tweeter Home Entertainment (NASDAQ:TWTR), which showed some slight improvement in its fiscal fourth quarter, but is still unprofitable and operates in a fiercely competitive industry.

The good news for Tweeter is that same-store sales were up 10% and revenue was up 9%, despite the fact that the company had 18 fewer stores open in this year's fourth quarter than in the comparable quarter last year.

But that's just about where the good news ends. Gross margins were down slightly. And despite the lower store count and the lower operating costs associated with the reduction in sites, Tweeter's operating profitability was still a negative $19.4 million for the quarter and $65 million for full-year fiscal 2005. The company attributes $35 million of the operating loss this year to closing stores, which should be one-time costs. Another $25 million of the full-year operating loss is from tax adjustments.

For the full fiscal year, the company made some headway toward improving its cash performance. Its cash-conversion cycle shortened by seven days, down to 75 days from 82 days, an accomplishment largely driven by a nine-day improvement in the performance of its inventory cycle. That's a solid step, but there's still a long road to travel to get anywhere near Best Buy's 10-day cash-conversion cycle.

While I won't argue with the fact that Tweeter appears to be moving in the right direction, the company still hasn't entered profitable territory. Its balance sheet is burdened by $62.6 million in long-term debt and another $9.3 million in debt that is due in the next 12 months. In comparison to all of this debt, there's just $1.3 million in cash on the balance sheet.

Looking at the trailing 12 months, Tweeter has also generated negative free cash flow. In contrast, the company's free cash flow last year was positive. To complicate matters, Tweeter's Christmas quarter (ending Dec. 31), which is traditionally the best quarter for retailers, has been its worst quarter in terms of free cash flow over the past two years. This is primarily because of working capital increases in inventory and accounts receivable.

For the company to turn the corner on free cash flow this holiday season, it will need to continue to improve its inventory management and cash-conversion cycle. That's a tall order, considering Tweeter's dismal performance over its past two Christmas quarters.

Tweeter isn't alone in its struggle: Circuit City (NYSE:CC) has been scuffling for quite some time, too. Circuit City has the size to compete with Best Buy, but just like Tweeter, it lacks Best Buy's operational strength.

While I'm not a big fan of shopping at Best Buy, I do choose to go there over the competition, and that alone says something about the state of the industry. We go where we can get the best prices and customer service. Costco (NASDAQ:COST) and Wal-Mart (NYSE:WMT) can offer that on some electronics items, but Best Buy is still the only player in the industry that consistently does so -- not to mention its ability to offer a greater variety of items. Until these dynamics change, it's hard to see Best Buy's domination ending or the performance of smaller players like Tweeter substantially improving.

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Nathan Parmelee owns shares in Costco, but has no financial stake in any of the other companies mentioned. The Fool has an ironclad disclosure policy.