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Circuit City Stores, Inc. (CC)

Q1 FY2007 Earnings Conference Call

June 19, 2006 11:00 am ET

Executives

Bill Cimino – Director of Corporate Communications

Phil Schoonover – President, CEO

Danny Clark - Executive Vice President and President of Retail Stores

Michael Foss – EVP, CFO

Analysts

Daniel Binder - Buckingham Research Group

Bill Sims – Smith Barney Citigroup

Mitch Kaiser – Piper Jaffray & Co

Matthew Fassler - Goldman Sachs

Christopher Horvers - Bear Stearns & Co.

Colin McGranahan - Sanford C. Bernstein

Presentation

Operator

Good morning. My name is Toni and I will be your conference operator today. At this time I would like to welcome everyone to the Circuit City first quarter results conference call. (Operator instructions) Mr. Cimino, you may begin your conference.

Bill Cimino

Thank you, and good morning. We appreciate your participation in today’s call. I need to remind you that during the call, we may make some forward-looking statements which are subject to risks and uncertainties. We refer you to today’s release, the MD&A in our annual report on Form 10 K, and to our other SEC filings for additional discussion of these risks and uncertainties.

Let me also make sure that we have a common understanding of some of the terms we will use this morning. For the purposes of this call, when we refer to earnings or earnings per share, we’re referring to continuing operations unless otherwise noted. Earnings before taxes, or EBT, refers to earnings from continuing operations before income taxes. This is the profitability metric for which we have provided guidance. Net owned inventory refers to the difference between merchandise inventories and merchandise payable. Flat panel television refers to both LCD and plasma televisions. In the past we have referred to them as advanced televisions, or separately as LCD or plasma. A more industry-accepted term is flat panel television and we will maintain the industry standard.

Speaking on this call are Phil Schoonover, President and Chief Executive Officer, who will review first quarter performance and update you on the continuing efforts to improve the business; Danny Clark, Executive Vice President and President of Retail Stores, who will speak about the transformation efforts underway in our superstore business; and then Mike Foss, our Chief Financial Officer, who will review our financial performance and provide an update on the performance of the international segment.

And with that, I’ll turn the call over to Phil.

Phil Schoonover

Thank you, Bill. Good morning, everyone. Welcome to our first earnings call of the new fiscal year. It was good to see many of you last month at our analyst and investor conference in Nashua, New Hampshire. At that meeting, the senior leadership team talked about our confidence in building sustainable growth and mapped the progress on our journey.

You can see our progress from the press release issued this morning. We had domestic sales comps of 15.3% and total revenue growth of 17.5%. This is our best Q1 comp performance in at least the last three years. Earnings before tax margin, a positive 0.3% versus a loss before tax of 0.9% last year. Earnings of $0.03 per share driven by leverage on strong sales. This is also the first time that we’ve been profitable in Q1 in several years.

We continue to execute on our strategy, thanks to the hard work and engagement of our 46,000 associates. Sales were consistent throughout the quarter, strong each month. We recovered from last year’s weak PC performance, which contributed to relatively weaker revenue growth and stronger gross margin in last year’s first quarter.

We’re encouraged by the breadth of growth across product and service categories, all channels and regions in our business. While our store traffic, conversion and average ticket all increased, average ticket was the primary driver of growth in Q1. All of this leading to a profitable first quarter shows we’re making progress towards sustainable growth.

From a product perspective, we saw the strength in sales of flat panel TVs with triple-digit comp increases. Demand for HDTV in our stores remains very strong. Sales of larger screen sizes and high-definition 1080p product accelerated throughout the quarter, which served to increase total television average selling price as the quarter unfolded.

We’re excited about growth in home theater install, accessories and related products which enhanced the revenue margin on these transactions.

In PC hardware we experienced low double-digit comp increases, including growth in notebooks. We also had an improved trend in desktops versus Q4. You’ll recall that the first quarter last year we did not perform well in the PC business. Uncompetitive price points and poor in-stocks led to weak sales last year.

In portable audio, iPod and MP3 devices and related accessories, we had strong double-digit comp increases.

Finally, digital cameras and accessories also had strong double-digit comp increases.

We’re starting the deeper work of transformation of InterTAN. Like the U.S. transformation, we’re currently doing our value-targeting work to assess the opportunity and plan our approach. We’ve assigned new senior leadership in Canada. We will roll out the work in Canada as the year unfolds, and Mike Foss will provide you with more detail a little later.

At the analyst and investor conference, I talked about our focus on the roadmap for long-term sustainable growth at Circuit City and on the following areas of work in the near to midterm: capitalizing on our multi-channel strategies, PC services and home theater installation opportunities, refining our standard operating platform in the store, implementing supply chain improvements, continuing our merchandising and marketing transformation, and accelerating our real estate opportunities, prioritizing store-opening efforts in key markets.

As you know, multi channel strategy means three ways for our customers to shop: in store, on the web and by phone. We’re using the web and direct marketing to drive profitable customer traffic to our stores. This strategy is working and creating more opportunity for Circuit City while leading the growing consumer trend of shopping online and picking up in the store.

Our web sales were up 85% in the first quarter. The percentage of web originated sales picked up in our stores increased 300 basis points from last year. Leveraging our capabilities here, we’re poised to take advantage of this tremendous opportunity.

Let me explain how we think about this. Industry growth in web sales plus a shift from retail to the web is estimated to be a $17 billion transfer over the next five years, and we’re projecting $1 billion in sales through our web site this year.

Another way to our performance is enhancing our service offerings. This is estimated to be a $20 billion consumer market in CE and PC services by 2010. Our services growth was 175% in the first quarter. You will see continued refinement in scale of PC services as we learn from and expand our innovation work. Compared to last year, we now have a national footprint of in store, more in home, plus PC remote diagnostic services in time for our back to school PC selling season.

We continue to expand our home theater installation offering and we’re right on schedule to roll out an exciting new services and installation brand this fall, just in time for holiday.

We continue making progress with our merchandising, supply chain and marketing transformation. We’re still mining value from deeper process improvements, optimizing our assortments, enhancing promotional effectiveness, beginning the price-optimization work and growing our sourcing efforts, improving in stocks and transitions through our inventory management work.

As part of our goal to improve operational performance and execution, we continue to invest in IT systems upgrades which enable our transformation efforts. Merchandising system transformation is well underway and retail POS replacement is scheduled to pilot this summer.

On the subject of owned inventory, this quarter we had an increase in our domestic net owned inventory of $81 million. Let me take a moment to explain why: $234 million, or 15.1% more domestic inventory was on hand than last year, versus our sales growth of $371 million, or 17.5%.

We improved in stock levels across the board as well as increased flat panel TV, PC and digital imaging purchases to take advantage of a strong sales opportunity in Q1. However, this increase is not consistent with our overall strategic plan of reducing net owned inventories to zero over time, but was appropriate for Q1.

We do not believe at this time we have risk from excess inventory and we’re still expecting a $50 million to $100 million reduction in domestic net owned inventory from FY07.

As you know, product and service margin improvement was an area of significant focus in FY 2006 and continues to be this year. Q1 gross margin declined to 24.5% versus 25% last year. Our domestic merchandising margin was flat. The margin decline was driven by higher promotional financing costs and lower margin from our international segment and lower rate on the PC business while we increase revenues here.

We continue to expect product margin stabilization in the future based on improved merchandising, marketing, pricing and supply chain efforts as well as the work that we’re doing at InterTAN.

Overall SG&A rate in the first quarter decreased by a 174 basis points as we leveraged our payroll and rent expenses, improving our profitability in Q1.

Now, turning to the retail transformation, we made considerable progress through leading differently and by engaging our 46,000 associates. They continue to help us solve our biggest problems. Our retail leadership team has made a conscientious effort to re focus this organization on the consumer experience in our stores.

One of the learnings was to hold more and better-focused training events in advance of drive periods, preparing our associates for the key shopping seasons. I just returned from our back to school event. I saw the energy and passion of our store associates. We created a good teaching experience for our leaders, and I’m confident our stores will be better prepared for the important back to school drive period than we were last year. This is just one example of our engagement effort.

Another learning was we added team-based contests and rewards to focus our store team on results during these key drive periods. In a minute Danny will discuss some of our retail learnings in greater detail.

As we build a better customer experience, we see significant opportunity in improving our conversion rate. As we stated at the analyst conference, each 100 basis point improvement in conversion rate equals $320 million in revenue. This improves our revenue per transaction with the sale of high-margin services, accessories and other attachments.

Looking forward, we’re just beginning our work in the stores aimed at ‘team, simplify and grow’. Teaching our leaders to engage our associates and building teams, focusing the associates on creating a better customer experience, simplifying our processes to free up customer facing time, and we will use the continued learnings from innovation to drive growth going forward.

As many of you saw during our store tour in Nashua, New Hampshire, there’s some exciting things going on in our innovation work and it continues in earnest. A second round of innovation work is currently underway. We’re taking key learnings from our innovation test stores and will begin implementing this work in our stores later this year.

Just to mention a few examples:

In home entertainment: later this summer we will expand the home entertainment department with innovation learnings and our operating model in home electronics will be enhanced to create a better customer experience through associate-customer engagement.

In digital services we’ll grow PC services including an in home offering. We’ll expand our home theater installation offering and we’ll offer a new services brand beginning this fall.

In multi channel, better coordination across all Circuit City channels for our customers. An expanded assortment of products available online only and refining our in store pickup, leveraging this opportunity to better serve our customers by offering much-needed accessories and services.

Our innovation capability will be critical as we seek to drive growth. This is an enabler of our long-term strategy. We’re confident that our innovation capability will deliver a pipeline of growth, drive shareholder value as we move to the future, and de risk our investments while accelerating our speed of learning.

Again ‘team, simplify and grow’ are guides for the journey. The compass work provides strategic direction and structure to our work priorities and our long term vision, our true north star, remains. It’s all about helping you.

With all the efforts, we’re positioning Circuit City to take advantage of the strong digital television lifecycle, the shift of consumer shopping from stores to multiple channels and the large growth opportunity for profitable consumer services. We’re still early in our journey and we have a lot of opportunity ahead of us.

We continue to get asked about macro trends, so let me share our thoughts here. Obviously we’re concerned about the impact of higher energy costs, higher interest rates, slowing housing starts and some declining consumer confidence. We also monitor competitive trends like pricing and promotions, competitive store openings and the explosive growth on the web for the sale of CE products.

We watch the impact weekly, monthly and quarterly and prepare contingencies. We’ve installed processes to identify the impact of these trends and react accordingly if needed. At this time our results show that we have not seen a material impact from any of these macro trends.

Our team is on the right track and we feel confident that we’re on our way to creating profitable, sustainable growth.

Now I’ll turn the call over to Danny Clark, President of Retail Stores, who will provide you with further detail around our retail transformation and growth efforts.

Danny Clark

Thanks, Phil. As I discussed at our analyst conference in May, we have organized the retail work around ‘team, simplify and grow’. Today, I will give you an update on our progress.

First, team. We are continuing to engage our associates, building on their strengths and adding to their capabilities through large-scale leadership training camps. We have planned the year around four key drive periods: imaging, in May and June; back to school, in July and August; home entertainment in the fall and holiday.

We held our first event in March, designed to introduce and align our store directors to the work involved in making ‘team, simplify and grow’ a reality.

Our second event was held in April. This even prepared our sales managers to execute our key imaging strategies across the organization. Our vendors provided training on the technologies that were critical for success during the drive period. We created clear and compelling goals that each associate was accountable for and collaborated with our vendor partners on a contest that created in store energy.

These activities combined with improved in stock performance led to a successful imaging season and we have just completed our get up and go back to school event. I believe we are better prepared for the back to school season and I’m confident that we’ve dramatically improved the customer experience.

I am especially pleased with the collaboration that we have achieved among the retail, merchandising, marketing and direct teams. I also want to thank our vendors for their support of our teams. I believe this type of collaboration creates the best opportunity for continued business momentum.

Now, simplify. As we discussed during our analyst conference, simplify is about unleashing the capacity of our stores to better serve our customers. We have completed our test work in Dallas and are now moving to pilot these in 50 stores with a late summer scale of key processes.

Our test work includes improving efficiency in key store operating activities like truck receiving, store open/close, promotional tagging, CD/DVD stocking, warehouse visual management, product flow specialist and shelf stocking. This work will continue throughout the remainder of FY07 and into FY08.

Finally, growth. We continue to build our future on the foundation of FY06 by growing our home theater, PC and digital services, by improving our multi-channel retail experience and by rolling out early innovation learnings.

Services. In our service business we continue the work of building out the capability of the organization. To assist in leading this effort we have added a Vice President of Services Retail. His role will be to act as a strategic partner with our corporate resources and link those strategies with the retail operating rhythms, allowing us speed to benefit. Currently we have the capability to provide in store PC services in all of our stores, in home PC services in 100 markets with an additional 25 markets to be added next week, and home theater installation service in all of our markets.

We will continue to build our capabilities and improve our capacity as we move towards our brand launch in August. We have thoughtfully engineered a model that utilizes company-owned and third-party labor resources. This labor model allows us to be flexible and maximize growth and profits while tightly controlling costs.

Multi channel. We are excited by the growth of Xpick, or web-originated sales picked up in store and its ability to drive traffic to our stores. That’s important as we want consumers to experience the improvements we’re making.

Our stores have also begun to realize the benefits of extended assortments available on cc.com. As an example, our typical store carries 50 laptops. Our extended assortment takes us to 84. This allows us to further meet our consumer needs while optimizing our inventory.

Innovation. We are currently moving from lab to pilot on eight experiments in the domains of home entertainment, services and multi-channel, and we are on track to improve the home theater experience in more than 500 stores this fall and plan on holding a home theater event in August to help support our strategy.

We are confident in the future of these business efforts as we have aligned a robust bonus program that will provide monthly and annual incentives for our retail teams. In addition we will continue to co sponsor a vendor-supported contest during our key drive periods.

I would like to join Phil in thanking the 46,000 associates who helped achieve our first quarter results, and now I’ll turn the call over to Mike.

Michael Foss

I will walk through our first quarter performance. In addition I will cover several other items, including the recap of our common stock repurchase activity, our financial outlook for FY07 and a discussion about our Canadian subsidiary, InterTAN, and the changes that have taken place there.

Now, starting with the income statement. For the quarter, net sales increased 17.5% to $2.6 billion. Our domestic segment sales also grew by 17.5%, which was driven by two factors. First, very strong comp store sales growth of 15.3% and the impact of the addition of 18 net new Superstores over the past four quarters.

Our international segment sales grew by 16.1%, which was driven by four factors:

  1. Customer sales growth of 2.4% in local currency;
  2. We had strong growth in sales to our dealers;
  3. We added 15 net new stores over the past four quarters; and,
  4. Currency movements added an additional 9% of growth.

Now before moving off of sales I wanted to talk briefly about extended warranty net sales in our domestic segment. As you can see from the release, the percentage of domestic sales fell from 4.0% in last year’s first quarter to 3.7% in this year’s first quarter. As you know, the extended warranty net sales that we disclose publicly are revenues net of costs.

Our gross revenues increased during the quarter, while our costs rose due to some warranty plan enhancements as well as the introduction of some additional value-added product offerings such as accidental damage coverage. We will continue to improve our overall extended warranty offerings.

Now, turning to gross margin. For the quarter, consolidated gross profit margin decreased 57 basis points. Please remember that in the first quarter of last year, gross profit margins grew by approximately 142 basis points year to year, and was the highest gross margin rate of any of the quarters of last year.

The 57 basis point gross margin decline was driven by two basic factors: promotional financing costs and our international segment. Absent these two items, our gross margin rate would have been flat year to year. Now I’ll provide a little detail around these two impacts.

Promotional financing costs in the domestic segment impacted consolidated gross margins by about 31 basis points. This was driven by several factors. First, LIBOR rates were up almost 200 basis points versus the first quarter of last year. Second, the penetration rate of sales using promotional financing offers was up significantly year to year and finally, our average promotional financing term increased year-to­-year as well.

As we have said in the past, we will be competitive in our overall offers to our customers, including financing. During the first quarter we believe that on average, we were competitive in financing offer length in all areas other than the TV business.

In the TV business we saw some ramping back of promotional financing length at some of our major competitors and we did not follow suit. As you can see in the marketplace, we have reduced the length of our financing offers on TVs during the first part of June. We clearly believe there is additional margin opportunity here as we go forward.

The international segment caused a 25 basis point reduction in consolidated gross margin percentage year-to-year. Within the international segment, gross margins fell by 514 basis points. This continues the year to year impact we saw in the final three quarters of last year, when we saw year to year margin declines of around 300 basis points in the second quarter and 500 basis point reductions in the third and fourth quarters.

The decline this quarter was driven principally by three factors. First, we have continued to see the mix shift from the traditional higher-margin parts, batteries and accessories businesses into faster-growing, relatively lower gross margin product lines such as computers, digital cameras and our video business. Second, we have seen some margin declines in our communication products and third, we took some inventory markdowns late in the quarter to help with sell-through of some slower moving inventories.

Moving down the income statement, our first quarter consolidated selling, general and administrative expense rate improved 174 basis points from FY06. Our domestic segment expense rate improved by 134 basis points. This improvement reflects a number of puts and takes, including we demonstrated significant expense leverage this quarter due to strong revenue growth and good expense control. The leverage was particularly apparent in payroll, benefits, rent and occupancy expenses.

This leverage was partially offset by incremental investments in information systems, Circuit City Direct and innovation expenses as a percent of revenues, which cost us about 80 basis points during the quarter, and stock-based compensation expenses reflected in SG&A as a percentage of revenue increased about 16 basis points, primarily reflecting the introduction of the long-term incentive plan back in the second quarter of FY06.

The international segment drove a 40 basis point improvement in our consolidated SG&A rate. This was driven by the lack of brand transition costs that were incurred during the first quarter of last year, partly offset by increased rent and labor due to the addition of 15 net new stores in the past year, a small increase in advertising expense and increased depreciation due to the new signage that was rolled out in the second quarter of 2006.

The net result for the first quarter was net earnings from continuing operations of $5 million, or $0.03 per share, compared with a loss of $12 million, or $0.06 per share, last year.

As we stated in the press release, we adopted SFAS 123-R during the first quarter. This resulted in a non cash $1.8 million after-tax benefit during the quarter, bringing our total earnings to $0.04 per share.

Now turning to the balance sheet, at May 31 we had cash, cash equivalents and short-term investments of $634 million, down from $817 million at May 31, 2005. The year over year change reflects principally the use of $292 million to repurchase common stock during the past four quarters.

As Phil discussed, our domestic net owned inventory position increased $81 million year over year. The inventory level is higher to support our higher sales and improve our in stocks, and due to timing of our purchases, end of period merchandise payables did not grow as much as merchandise inventory.

Our goals for net owned inventory remained unchanged. We expect a $50 to $100 million domestic benefit this year and we believe that we can drive it to zero over a four-year period.

Now turning to our stock buyback program, during the first quarter we bought back 1.7 million shares for $50 million, or an average cost of $28.92 per share. We’ve now bought back a total of 49.6 million shares for $733 million, for an average cost of $14.79 per share. We have approximately $67 million for future share repurchases under our current Board authorization.

Now turning to our outlook for FY07, we provided a full list of FY07 expectations in this morning’s press release and they remain unchanged from our previous expectations of total sales growth of 7% to 11%, domestic comps to our sales growth between 5% and 7%, and earnings before tax margin of 2.0% to 2.4%, depreciation and amortization of approximately $180 million, up from approximately $164 million in FY06, and capital expenditures net of landlord reimbursements of approximately $280 million.

As we’ve discussed before, we are making significant incremental investments in information systems, Circuit City Direct and our innovation activities. These incremental expenses will total approximately 100 basis points as a percent of sales in FY07.

We believe that these investments will yield significant future benefits. While the impact of these incremental investments in the first quarter only impacted our expense rate by about 80 basis points, we believe the impact as a percent of revenues will be disproportionately large in the second and third quarters and will fall dramatically in the fourth quarter.

As a data point, we believe the incremental investments will impact the second quarter expense rate by between 150 and 170 basis points. In addition, in the second quarter we expect expenses to increase as we begin the store refresh work and start installing the expanded video department in more than 500 stores.

Finally, let me talk for a minute about InterTAN. Earlier this month we announced that Steve Pappas has joined us as President of Small Store. In this new role, Steve will have responsibility for operations in Canada. In addition he will lead our small store efforts in the United States, which we are currently exploring as part of our innovation efforts. Steve has great experience running large operations of small stores as well as starting up and growing a new retail concept. He has strong experience in wireless retail, which is both a significant challenge and significant opportunity for our international segment.

We have just begun a transformation journey in the international segment. This transformation effort this year is focused in four basic areas. First, a maniacal focus on process improvements. This work will be very similar to the type of work we have done in our domestic organization over the past 18 months or so. We are being assisted by a consulting firm to help us identify the pools of value that can be mined by implementing best practices and key functions across the company. We know we have significant opportunities in areas such as portfolio management, assortment planning, supply chain, advertising and promotional item effectiveness as well as conversion rates, to name a few.

The second major focus will be on driving significant leverage between our international and domestic organizations. We know there are significant synergies to be mined by having a tighter working relationship in areas such as sourcing, procurement, merchandising and vendor management, supply chain, services and the Internet. We will do a much better job on mining these synergies starting this year.

The third major focus area will be driving new growth area. For the international segment this year this will mean PC services and e commerce sales. We’ve rolled out the first wave of PC services to over 200 of our stores and plan to roll out to the majority of the remaining stores by the fall.

The final current focus area is employee engagement. We have clearly seen what the power of unleashing the strength of the entire employee base has done in the U.S. organization. We believe we have the same opportunity in Canada, and have just begun our journey.

For the international segment, we continue to anticipate a return to a significant level of profitability in FY07, albeit not to historical profit margin levels due to the product mix shifts.

In summary, from a total company perspective, we are pleased with this quarter’s performance. The team has done an outstanding job, but we also realize that we clearly have a long way to go to get to the level of operating performance that our associates, our shareholders and especially the management team expect from our company.

With that we will now open the call up to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Bill Sims with Citigroup.

Bill Sims – Smith Barney Citigroup

Thank you and good morning. Congratulations on an excellent quarter. Mike, my first question is to you. Can you give us an update on the operating margin performance of the bottom two deciles stores? Are those stores producing the same comp and margin improvement as the rest of the stores at a faster rate, and what are the main drivers of that improvement?

Michael Foss

I’m sorry, Bill. On the which stores? The . . .

Bill Sims – Smith Barney Citigroup

The bottom two deciles.

Michael Foss

Okay. Right, right. I don’t have a specific percentage to tell you. You’re talking about how we showed it at the analyst conference?

Bill Sims – Smith Barney Citigroup

Correct.

Michael Foss

I don’t have that level of detail with me here, Bill. I apologize for that.

Bill Sims – Smith Barney Citigroup

Can you just give us more color, then, on the overall rate of improvement? The number of stores that you’ve indicated that are underperforming have shrunk over the past year. Can you give us an idea of what is driving the drop in underperforming stores?

Michael Foss

Bill, let me make one comment first. Just given the strong sales performance we’ve seen in the first quarter and Phil’s comment that we saw that strength across regions and across markets that clearly, although I don’t have the specific percentage for you, I will pretty much guarantee you that we had very strong performance in those stores as well. As we demonstrated in – gave you the specific numbers for the fourth quarter, number one.

Number two is, I think Danny can comment on some of the actions that we’ve taken within the retail organization to drive this strong performance, things like ELITE teams and such.

Danny Clark

What you’re referring to is the work that we did with the ELITE teams last year, and we’ve continued to work with those folks this year. So think about ELITE team as just mobile, eight-plus management teams that can go out to the organization and help close the gap in performance.

You know last year we had a tremendous gap in our bottom-performing stores compared to our top-performing stores, and so Mike’s point is as we’ve lifted our overall business that gap has improved.

This year we’re focused on gap performance as it relates to services areas, PC services, home theater installation and opportunities that we have in the baskets inside the stores and we’ll be utilizing the ELITE teams against that work.

Bill Sims – Smith Barney Citigroup

My second question is, relative to your fourth quarter conference call, has your outlook for the flat panel display area from a pricing perspective and competitive standpoint changed at all?

Danny Clark

You know we’re seeing an increase in larger screen size and 1080p products. We’re bullish on availability. We’re hearing positive things about availability of flat panel TVs so our forecast is unchanged. It is a stake in the ground business for us and we pay very close attention to it.

Bill Sims – Smith Barney Citigroup

And from an overall price point perspective? Are you anticipating further price declines than initially anticipated or are you sticking with your original guidance?

Danny Clark

Yes. So we see some declines in price points of the flat panel television and, you know, any CE product has a life cycle. But as we shore up the sale of home theater installation, things like brackets and mounts and other accessories, our goal is to continue to increase the revenue per transaction by the end of the first quarter.

Bill Sims – Smith Barney Citigroup

Very good. Thank you.

Operator

Your next question comes from Daniel Binder with Buckingham Research Group.

Daniel Binder - Buckingham Research Group

Hi, it’s Dan Binder. A couple questions for you. I guess first, I’m a little bit curious about your thoughts on what you think drove the increased penetration of the credit promotions? Was it simply more attractive terms or do you think it’s saying something about the consumer and what they’re willing to do to get that new technology?

Phil Schoonover

Dan, this is Phil speaking. We made a commitment last year that we were going to be competitive in the marketplace with our financing promotions. If you look at where Circuit City was positioned versus other retailers of our products in the market, we were slightly more competitive on financing. The total promotion, we could debate with all on-sales and other value adds, but we feel with LIBOR forcing our rates from the bank up and just looking at the competitive landscape, this is an opportunity for us as we move forward and we’ve already adjusted our promotional schedule to reflect that.

Now at the same time there are other promotions that we run in balance, and we’ll get the most revenue out of our promotional dollar and we watch it as a science here. Promotional effectiveness is a big part of the transformation work in merchandising, marketing and supply chain.

Daniel Binder - Buckingham Research Group

Do you know offhand what percentage of your sales are being driven by the promotional offers week to week?

Phil Schoonover

Dan, we don’t. We won’t comment on what the percent of sales that were financed using promotional financing.

Daniel Binder - Buckingham Research Group

Okay, and the last question was just on audio, home audio. It just seems like given the sale of TVs being as robust as they are, there would be a bigger opportunity for perhaps better audio attachments and I’m just kind of wondering what you’re seeing there, why it may not be showing up as a stronger category.

Phil Schoonover

You know if you look at the two-year trend in home audio products it’s been declining at a double-digit rate for two years. We think we’ve seen some turn in performance but we do still think there’s a tremendous opportunity with audio attachments and this quarter the home theater experience that you saw in Nashua creates a vehicle for our associates to better serve the customers with a complete home theater experience.

So if we make those investments later this summer it’s really part of the rationalization is that significantly better penetration in audio products.

Daniel Binder - Buckingham Research Group

That sounds good. Can I sneak one more in? If we were to look at the web growth and the contribution to comps, it seems like maybe it probably added about 4 points to the comp. Do you think that’s reasonable?

Danny Clark

Dan, it’s probably within 100 basis points. It’s probably a little bit less than that.

Daniel Binder - Buckingham Research Group

Okay.

Danny Clark

Again remember, the majority of or more than half of the sales on the web are actually picked up in the store.

Daniel Binder - Buckingham Research Group

Okay.

Danny Clark

Thanks, Dan.

Daniel Binder - Buckingham Research Group

Thank you.

Operator

Your next question comes from Mitch Kaiser with Piper Jaffray.

Mitch Kaiser – Piper Jaffray & Co.

Good morning, guys. Nice quarter. I was wondering if you could comment about the supply environment. You know, AUO came out and said that demand for flat panel was weak and LG said the same thing, and then Samsung seems to say something that was completely contradictory to that. So I was wondering if I could get your perspective on that.

Michael Foss

Our flat panel TV business performed very well during the quarter, delivering the sixth consecutive quarter triple digit comps. I believe the manufacturers’ comments have largely been related to the computer business and overly aggressive forecasts rather than a downturn in U.S. flat panel high-definition TV business.

Obviously we monitor this business very carefully for inflection points and we have not seen any inflection points. You know, one of the things that’s going on, this is the biggest CE cycle ever. I think some of the forecasts that were originally put out there by second and third-tier manufacturers may have been a little overly aggressive. We watch the big four or five very, very closely and we have not seen a material move in their forecasts.

Mitch Kaiser – Piper Jaffray & Co.

Okay, and your expectation, then, for maybe January on the flat panel category? Obviously the price points are going to continue to come down but the demand should still be strong. Could we just get some perspective on that?

Michael Foss

Well again, there’s the sale of flat panel televisions. As Dan mentioned earlier, there’s an opportunity for us to reinvent the audio business with a true high-definition experience including the gaming cycle. It should help drive audio, and then there’s the sale of brackets and accessories and home theater installation. So this will be an engine that drives a basket of products and we’re expecting increases in our average transactions.

Mitch Kaiser – Piper Jaffray & Co.

Okay. Thank you.

Operator

Your next question comes from Matthew Fassler with Goldman Sachs.

Matthew Fassler - Goldman Sachs

Thanks a lot and good morning. Just a couple of follow up questions here. First of all, as you think about your sales guidance, you did a mid-teens comp in Q1. You continued to guide 5 to 7 for the rest of the year.

As we try to reconcile what you’ve done and the kind of forecast that you have -- and no one is blaming you for being that conservative and not raising early -- can you talk about how challenging you think those comparisons are?

Also, as we look at the evolution of the game cycle and look out towards Vista, how those play into your thinking on the top line?

Phil Schoonover

Matt, I think big picture, we’re up against the weakest quarter from last year. We took advantage of a great performance from the pc team and the store’s execution in that business. The comps do get stiffer as the year goes on and it’s very early in the game.

Matthew Fassler - Goldman Sachs

In terms of impact of gaming releases and Vista, do you expect those to be positives or negatives for you over the rest of the ’07 year?

Phil Schoonover

We’re very, very excited about the new game platforms. Great HD content, players that play HD movies is only good for our home theatre business and should drive up strong basket. We’re repositioning that product in our stores and are declaring it as a stake in the ground.

As far as the Vista launch, it has actually been pushed out beyond the holiday season. Anytime a new platform is introduced it typically stimulates the overall business over time, but can negatively impact a given period or quarter, and we’re happy that it’s beyond the holiday season now.

Matthew Fassler - Goldman Sachs

Understood. Second question, Mike, you spoke about the timing of expense investments. Does all of that show up in the corporate G&A line or the G&A line, if you will, or some of that also in the stores line just as you try to dissect the different expense components?

Mike Foss

More than half of it shows up in the G&A line, but there is some store expense.

Matthew Fassler - Goldman Sachs

Then finally, you did open the door to some color on June, talking about some changes that you’ve made to your promotional stance. It sounds like you’ve reduced the duration of some of your 0% offerings. Early read on what that’s done to sales, if that’s had an impact or just since you did mention the change to the tactic.

Mike Foss

Matt, it’s Mike. Obviously, we’re a couple of weeks into the quarter so I wouldn’t want to comment on the quarter.

Matthew Fassler - Goldman Sachs

Fair enough. Thanks a lot.

Phil Schoonover

Nice try, Matt. Next question, please.

Operator

Your next question comes from Chris Horvers from Bear, Stearns & Co.

Christopher Hovers - Bear Stearns

Good morning guys, great quarter as well.

Phil Schoonover

Thank you, Chris.

Christopher Hovers - Bear Stearns

Good morning, guys. Great quarter as well. As we think about, digging in on the warranty sales - Mike, you addressed that on the call, I’m sure you anticipated the question, but - could you give us a little more detail there? Is it that you’re feeling competitive pressure? There were always the questions of, well, Wal-Mart is rolling out warranties now and that’s going to hurt sales at Best Buy and Circuit City. What exactly is going on there and do you think that number picks up back to 4% as we look out at the balance of the year?

Phil Schoonover

We started looking at our warranty offerings over two years ago, felt that they weren’t different enough and they didn’t provide compelling enough consumer value. So revenue being up and margin being down is a reflection about the literal value we’re providing to the customer.

Things like the accidental damage plan is a compelling consumer offer, but it does cost us a little bit more. So over time here, as we build a services engine out, we want to provide better value and enhance our total basket to improve the profitability. There may be some trade-offs within that basket.

Overall the warranty business is very important to us and providing great consumer value is important to us, so we’re going to stay on track with these offerings.

Christopher Hovers - Bear Stearns

Then on the in-home PC services - you talked about having 100 markets and then 25 next week. Could you provide the breakdown of which is third-party and which is in-house?

Danny Clark

We do that based on the market, the size of the PC business in the market and what our penetration is. We have some markets where the services business performs better, so we don’t provide that by market, but we can look at that by market and understand what the best setup is for us.

What we’re very focused on is making sure that we control variable costs here and think about what is best for that individual market. So if you just think about this - if you spread out markets in the US and think about larger markets, we obviously probably control most of that because we have the scale to do that. In the smaller market it’s probably always going to be a third-party resource.

The other thing we did closely is we monitored the customer experience on both. We’re holding ourselves to very high standard on that. So even though we’re controlling cost and thinking about that, we’re also very focused on the customer experience.

Christopher Hovers - Bear Stearns

To refresh, I think as of the fourth quarter you had, was it 20 to 25 markets where it was actually in-house?

Danny Clark

I don’t have the actual numbers for the fourth quarter here, but as I said earlier in the call we have 100 markets up now. 25 more are coming next week and we are looking to complete that work later this summer.

Christopher Hovers - Bear Stearns

Then finally, how many markets in total are we talking about here for your store base?

Danny Clark

About 175 markets, in that range.

Christopher Hovers - Bear Stearns

Perfect, thank you.

Phil Schoonover

Thanks, Chris. Next caller, please.

Operator

Your next question comes from Colin McGranahan from Sanford Bernstein.

Colin McGranahan - Sanford Bernstein

Good morning. I wanted to focus on the gross margin line here, looking at a couple of different components. First, when you think about promotional financing, obviously if you look at LIBOR, that’s going to continue to be a headwind for you. Sounds like you may be slightly less competitive versus some of the more aggressive folks out there, but I would imagine your penetration rate will still be up year-over-year.

Talk about your financing compares; should we expect a similar kind of -20, -30 basis point impact on promotional financing through the year?

Mike Foss

Colin, its Mike. Let me talk for a minute. I think you jumped to the conclusion, maybe I didn’t word it appropriately, that we weren’t competitive in the first quarter. We clearly believe we were competitive in terms of our financing offerings in all categories other than the TV business where we generally longer than most of our major competitors. We’ve ramped that back a little bit as I said in the early particularly of June and made the comment, clearly we think there is additional opportunity in the quarter.

We do have some leverage on the length of financing. Clearly as you said, interest rates have been up and continue to be up; obviously a concern over incremental interest rate hikes, so that will be an impact to us all year long.

Again, as part of an overall competitive offering to customers, we were committed to having a competitive financing program. Can’t give you a specific percentage that it will impact second, third, or fourth quarters by, but we continue to manage financing as one aspect of our overall gross margin, or driving to a specific gross margin goal.

Colin McGranahan - Sanford Bernstein

That’s fair enough. Then on the warranties I would imagine this increased offering will continue to drive your cost up while your gross warranty revenues will also continue to rise. So we should expect something similar?

Mike Foss

Well, remember we made the comment that our merchandise margin which includes warranties was essentially flat during the quarter. The two impacts outside merchandise margins were the promotional financing and the international segment.

Phil Schoonover

This is during a quarter where we had some unusual growth of the lower margin PC business.

Colin McGranahan - Sanford Bernstein

In terms of what you report on a net warranty revenue basis, we should probably expect that to come down a little bit on a year-over-year basis because of the change in the offering?

Mike Foss

Again, some of the new offerings like the accidental damage we are going to continue and continue to push strongly within our chain because we think it’s a very compelling offering for customers. So elements like that will definitely continue.

Colin McGranahan - Sanford Bernstein

Finally, can you just comment on the gross margin rate of the TV category and any kind of color you could provide there would be helpful?

Phil Schoonover

I think when you look at the TV category, you have to take in the fact that it drives high margin services, accessories like brackets and cables and it pulls along with the audio business, like home theatre in a box or separate audio components. The way we look at it is, it’s above our average margin and including the basket, it is the major profit driver for the Company.

Colin McGranahan - Sanford Bernstein

Right. I would imagine that the services attach rate will increase as you roll out the new brand of product and you expand that capability. How will that impact - services, I’m assuming is a lower margin than the actual product margin, is that correct?

Phil Schoonover

Typically our services are at higher than product margin, so there are just a couple of ways to answer your question. Though the engagement work we are doing in our stores is aimed at a better customer experience in home theatre, which includes installation for those customers who need it, the complete basket of products, which includes brackets, accessories and the sale of audio products, the remerchandising in our stores in August will help. These are all above the Company’s average margin categories.

So the growth opportunity here is yes, the new service offerings, but there is also an absolute opportunity in attachment rates to better serve customers and create a better total experience in our stores.

Colin McGranahan - Sanford Bernstein

I understand that, but just to clarify - the home theatre install, you are saying is higher than the product margin?

Phil Schoonover

Oh, yes.

Bill Cimino

Thanks, Colin and operator we have time for one more question.

Operator

Your next question comes from Michael Baker with Deutsche Bank.

Michael Baker - Deutsche Bank

Hi, thanks. It sound that given your guidance that you’re basically on pace on your margins at the 2 to 2.4 EBT expectation, but can you comment where you are - the complexion of that gross margin relative to SG&A - is this where you expected to be after the first quarter?

Mike Foss

I think it’s relatively in line with what our expectations were.

Michael Baker - Deutsche Bank

So it sounds like you’re going to spend about $120 million in some of the things that we’ve talked about? You spend about $20 million this quarter again. That was the plan all along, for it to be more weighted to the second and third quarter?

Mike Foss

Yes, that is absolutely correct. Again, we expect so spend about 100 basis points in the various investment activities for the full year, but much more heavy as a percent of sales the second and third, and much less in the fourth.

Michael Baker - Deutsche Bank

Then one more while I have you. It looks like when I look at the weekly circulars, one area where you are getting much more promotional is on your DVDs, your new release DVDs, where you are now going through the last month, so $12.99 price point? How does that offset some of the margin opportunity in reducing the length of financing on the TVs? Are TVs just that much of a bigger portion that it has an outside impact?

Phil Schoonover

No, the package media business, specifically DVDs and CDs, is very important to our customers. Our heaviest spenders are also heavy media users, so we’ll continue to use this tool as the market comes down in price, we’ll bring our pricing down also.

We’re getting a little more refined around things like the genre’s of music and movies that move the needle the most. We’re certainly getting better at in-store merchandising to bring back some of our margins. In general, we will use this category as a traffic builder.

Michael Baker - Deutsche Bank

It wasn’t called out as a margin impact? Is that too small or just -- ?

Phil Schoonover

Basically in line with our expectations. We knew what we were going to do with this business.

Michael Baker - Deutsche Bank

Thank you very much.

Phil Schoonover

Thanks, Michael. Thanks, everybody.

Operator

This concludes today’s conference call.

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Source: Circuit City Stores, Inc. F1Q07 (Qtr Ending May 31, 2006) Earnings Conference Call Transcript (CC)
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