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Circuit City Stores, Inc. (CC)
F2Q08 Earnings Call
September 20, 2007 11:00 am ET

Executives

Bill Cimino - Director, Corporate Communications
Philip J. Schoonover - Chairman of the Board, President, Chief Executive Officer
Danny Clark - President of Retail
David L. Mathews - Executive Vice President - Merchandising, Services and Marketing
Bruce H. Besanko - Chief Financial Officer, Executive Vice President

Analysts

Danielle Fox - Merrill Lynch
Stephen Chick - J.P. Morgan
Bill Sims - Citigroup
Matthew Fassler - Goldman Sachs
Jack Murphy - William Blair & Company
Chris Horvers - Bear Stearns
Jonathan Cramer - Cowen and Company

Presentation

Operator

Good morning. My name is Selena and I will be your conference operator today. At this time, I would like to welcome everyone to the Circuit City second quarter results conference call. (Operator Instructions) I will now turn the call over to Mr. Bill Cimino, Director of Corporate Communications. Sir, you may begin. Sir, go ahead.

Bill Cimino

Good morning and thank you for joining us today. Before we begin, I need to remind you that during the call, we may make some forward-looking statements, which are subject to risks and uncertainties. I 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.

Speaking on this call are: Phil Schoonover, Chairman, President and Chief Executive Officer; Danny Clark, Executive Vice President of Multi-Channel Sales; Dave Mathews, Executive Vice President of Merchandising, Services and Marketing; and then Bruce Besanko, Executive Vice President and Chief Financial Officer.

With that, I will turn the call over to Phil.

Philip J. Schoonover

Thanks, Bill and good morning to all on the call this morning. Thank you for joining Circuit City's conference call. Before I start today, let me introduce our new Chief Financial Officer, Bruce Besanko. Bruce will play a key role in driving our transformation. He’ll provide an update on his initial areas of focus later in the call this morning. I am really pleased to have Bruce on board as we work through the challenges ahead.

Today, I’ll cover four topics. I’ll provide a summary of the quarter, update you on our multi-year turnaround, discuss our second half plans, and finally I’ll provide you with an update on InterTAN.

Turning to the first topic, an overview of the second quarter, you’ve seen our release and our disappointing results. At the end of our first quarter, we said that we expected continued disruption to our business. Our reorganization plans called for changes in nearly every part of our business in the second quarter. We are making solid progress on our multi-year turnaround plans, but obviously we are not satisfied with the financial results.

In particular, I am most disappointed in the drop in gross margin rate and will discuss our plans to address it later in the call.

We’ve introduced major disruption that caused distraction leading to execution problems in our domestic business. Just to remind you of the massive changes we are undertaking, first, sensing the changing macroeconomic business conditions and seeing the structural changes to the flat panel television business, we took action that will reduce selling, general and administrative expenses by $150 million this year and an estimated $200 million in next fiscal year. We touched almost every cost center of our business.

Second, we changed our retail standard operating platform to improve our in-store customer experience and rolled out new procedures to more than 650 stores. Associates learned new operating processes and received new scorecards to measure our performance. At the same time, store associates were adjusting to a new in-store management model and new district and regional support organizations -- an entirely new way to manage our store performance.

Third, the reorganization and streamlining at the store support center caused disruption to our overall performance as the merchandising, supply chain and marketing teams adjusted to the new leaner operating structure. At the same time, they learned new processes to support the introduction of our new merchandising systems.

During all of this change, we remained committed to delivering on our long-term strategic initiatives. In fact, Circuit City direct sales grew 20% in the second quarter on top of growth of 76% in last year’s second quarter.

Revenues from PC services and in home theater installation combined grew 22% on top of a 100% growth last year. We successfully opened nine new and four relocated stores in this quarter, including an entirely new concept for our 20K stores, and we finalized our plans to open approximately 45 total stores, 25 of which will be our latest retail concept in the second half.

The change to our business model requires us to consolidate our wins and asks 40,000 plus associates for more. I would like to personally thank everyone at Circuit City for their hard work and their passion that they brought to this phase of our journey.

Trends are improving. The year-over-year changes in net sales and comp store sales improved each month during the quarter, with August significantly better than June. Our associates did a wonderful job of embracing changes in a positive way, understanding why we needed to change and how the moves would improve their daily endeavors as well as improve the customer experience.

Since for the most part, the major store level changes are behind us, our associates are now focused on improving execution throughout our business.

Next, I’d like to update you on our multi-year turnaround. Our turnaround is not just people, process, or system changes, but we have a broader plan. As many of you know, our strategy goes beyond the big box concept pioneered by Circuit City in the ‘70s and ‘80s, to the next generation of entertainment and technology retailing. The shopping experience will be transformed into a true multi-channel experience, resulting in a strong web and call center presence, building loyalty and providing detailed information about products and services.

A significantly different and better in-store experience supporting the dual role of convenience for online shoppers and full service for customers buying solutions to complex consumer electronics needs. And our Firedog associates will then complete the experience with a suite of services in our stores or online, or even in the customer’s home.

In short, it’s the shopping journey book-ended with strong web presence at the beginning and our Firedog services after the sale that will offer Circuit City customers a unique value proposition.

We are building a new associate value proposition that will attract and retain the best teams to serve our customers. The opportunities and challenges before us are significant but our strategic goal is to reinvent the entertainment and technology retailing experience once again.

Next, an update on InterTAN. The new leadership team is solidly in place in Canada and gaining traction on their transformation efforts. InterTAN improved its pretax profit performance despite lower sales. We are continuing to explore strategic options to maximize shareholder value with this asset, but the current challenges in the credit markets, we do not expect any action regarding InterTAN will occur before the holidays.

Now, I will turn the call over to Danny Clark.

Danny Clark

Thanks, Phil and good morning. I will provide an update on the progress of our retail transformation work and its impact, including some initial results, our plans for the second half, as well as an update on the rollout of RPOS.

As Phil discussed in his comments, the early stages of retail transformation were complex in nature and required a significant amount of retail management time to implement. With that said, our transformation-specific activities are on schedule. This amount of change was dramatic and created a series of distractions in our stores, leading to a year-over-year decline in our conversion and attachment rates, including extended warranties but also impacting other areas of the basket.

We drove hard across the summer in order to get these changes behind us, allowing us to deliver improved execution in the all-important holiday selling season.

Let me first review our main retail transformation activities and then I’ll talk about our plans for the remainder of the year.

The overall purpose of this work has been to reallocate labor in order to improve the customer experience, improve sales and margins, and improve labor productivity. To that end, we implemented four fundamental changes.

First, we went from 10 to eight operating regions and changed the regional leadership team structure. This work was completed in Q1. Then, we changed the management model in all stores at the end of May. We created a new supervisor role that provides additional leadership to our associates on the sales floor while creating a clearer career path. This change was accompanied by an intense eight-week on-the-job training program that was fully executed by the end of July. At the same time, we rolled out new operating procedures across all stores, training 40,000 plus associates. This work was fully completed by mid-August.

With that work behind us, we began one of the most impactful changes; the creation of two to three customer focus areas allowing boundless selling. This is an important step as it allows our associates to move freely throughout their area, going to where there is a customer service need.

Our previous model contained six selling zones. This created customer service issues, as the zones were too narrow. Because the associate was trapped in a zone and unable to move to other customers close by, we were unable to effectively improve close rates or capitalize on the convergence of CE products. The implementation of these new customer focus areas is in process and training will be complete in September.

I want to thank our retail leadership for their diligent attention to this important work.

We have 65 stores which we call regional and district learning centers because they are used to roll out changes to our stores. Let me give some initial results on how the new operating model is working over the past four weeks. As a group, the learning centers are outperforming the control stores by more than 6% in sales per labor hour and more than 3% in total sales. We are also seeing improvements to store gross profit margin and average daily close rates.

Although the learning centers are four to eight weeks ahead of the rest of the chain, while accounting for the lower performance that goes with scaling changes across a large enterprise, we expect the remainder of the chain to show improvements once the associates have had time to adjust to the changes. We expect this to take 45 to 60 days.

Returning to our plans for the second half, we’ll have competitive extended warranty pricing that takes into account the current average selling price trends and offers a clear value proposition for our customers. We tested several plans in August and have made adjustments to our offers and pricing in response to our performance.

We have established specific goals for the back half of the year in other key basket offerings, including Firedog services, source, and other accessories. We will focus on closing the performance gaps among regions, districts and stores by using a combination of best practices, contest and accountability to quickly close these gaps.

We will focus on labor productivity to improve our conversion rates.

Now I will provide an update on our retail point of sale system, RPOS, which is actually much more than a cash register. It is a four wall system that supports store level inventory, scheduling and services, warranty sales and credit applications, as well as point of sale transactions.

We have rolled out RPOS to 134 stores, over 20% of the chain. As RPOS changes every store management system and keeping with the goal to eliminate distractions during the holiday selling season, we have paused our scale-up efforts, limiting new system implementation to new stores only.

We will complete the deployment of RPOS post holiday. This prudent pause will enable our stores to focus on crisp in-store execution.

Now I will turn the call over to Dave.

David L. Mathews

Thank you, Danny. Good morning. I’ll address two topics today. First, the performance of my merchandising, services and marketing teams during the second quarter, followed by the key areas of focus for the teams during the holiday selling season.

Starting with second quarter performance, as Phil mentioned, we imposed a significant amount of change on the organization during the second quarter, including forming new teams and organizing in new ways. The changes negatively impacted execution on a number of fronts, including pricing, assortment, category in-stock levels, and promotional effectiveness. I’ll talk about what we are doing in the second half of the year to address these changes in a few moments.

In terms of our performance in Q2 in key merchandise categories, PC sales were strong during the back-to-school selling season. Notebooks continue to drive the category. We approached the back-to-school selling season with an integrated selling plan and the team did a great job, despite all the challenges.

Flat panels are still driving the TV business. While tube and projection sales continue to fall off, large LCD sales were strong throughout the quarter. Following the disappointing first quarter TV performance, we were able to adjust our product assortment late in the quarter. Case in point -- sales of small and medium LCD TVs rebounded sharply in August.

With regard to Q2 domestic segment gross profit, the large year-over-year declines in gross profit can be attributed to two factors; year-over-year changes in our product mix, namely lower sales of warranties and a higher mix of PCs, which accounted for two-thirds of the margin decline; a year-over-year decline in gross margin rate within product categories, namely PCs and video, which accounted for the balance of the decline.

With regard to the holiday plan, cross-functional teams from our merchandising, services, marketing and channel areas are busy implementing detailed plans for the critical holiday selling season. The fiscal 2008 holiday plan was completed earlier than last year, with the aim of addressing the execution challenges that we experienced in the first half.

Our priorities for the second half include pricing, to improve our gross margin rate while improving sales performance, we will refine our pricing standard operating procedures, modify our pricing strategy for our promotional vehicles, move products to clearance pricing in a more timely manner, execute price moves based on learnings from our price elasticity models, tighten governance of markdowns at point of sale.

Solution and basket selling -- we will focus on driving margin per transaction by adopting a portfolio approach to margin generation. In other words, looking holistically at margin generated from devices, content, service, source, payment programs, et cetera.

We are also working with our retail partners to develop a detailed in-store plan, focused on attaching source, Circuit City Advantage, and Firedog services.

We are also taking steps to improve bulk-outs, end caps, and strike zones in our retail stores.

On the sourcing front, we are executing a sourcing plan that will deliver 80%-plus of annual benefit in the second half. We’ve nearly doubled our private label item count and greatly expanded our sourced category assortment. We’ve also enhanced our market intelligence by working directly with factories

In the inventory area, we are taking steps to ensure that weekly in-stock targets for regular and promotional items are achieved.

Finally, on the subject of promotional effectiveness, we aim to maximize the return on our marketing spend by employing a marketing portfolio approach to traffic, revenue and margin generation. We are also leveraging new marketing systems in the second half of the year.

Now let me turn the call over to Bruce.

Bruce H. Besanko

Thanks, Dave and good morning, everyone. I would like to cover three areas. First, I would like to share my initial observations on the company; second, I’ll provide a financial update; and finally, I’ll share some of my more immediate goals. Let me first begin with my initial observations.

When I first came to Circuit City, it was very apparent that significant change was underway. The implementation of the new retail management model and the new operating procedures in our stores are essential to improve overall productivity and in-store customer experiences, but clearly disruptive for the short-term.

Additionally, our POS, MST and other information technology upgrades will indeed be long-term wins for our customers and associates. The more modest rollout scheduled for RPOS, as well as completing the store level changes should help mitigate some of the short-term disruption.

It was also apparent that we needed to stabilize the financial performance quickly. I understand the urgency associated with that issue and work is already underway to do just that.

My final observation is that the company is now more focused on fewer bigger issues. By that I mean that it’s very easy to lose focus on the 20% of the changes that will deliver 80% of the benefits. We’ll make necessary changes but concentrate our efforts on those that will drive the most benefit in terms of margin, expense reduction, or return on invested capital.

In sum, my initial observation is the company needs to continue the foundational changes but it is equally important that we focus on only those change elements that will drive the greatest financial benefit and to appropriately pace change in light of our financial performance.

Let me now briefly review the financial performance for the quarter, starting first with the income statement.

Net sales decreased 6.2% to $2.64 billion. Domestic segment sales declined 6.3% to $2.51 billion. The domestic sales decline was primarily driven by comp store sales decline of 8%. The comparable store sales change improved in each successive period of the quarter across most regions. We experienced particular regional sales weakness in the Southeast region and California.

Our information technology and entertainment categories had positive comps, as did our web channel. Our international segment sales declined 3.9%, primarily reflecting the impact of the year-over-year net decrease of 57 locations and a comparable store sales decline of 4.4%.

Overall, we are pleased that we saw significant improvement in the domestic comparable store sales trend over the course of the quarter, though still negative, and that we’ve regained momentum in key product categories.

Consolidated gross profit margin declined by 313 basis points from last year. Domestic segment gross margin declined 331 basis points. While gross margin rates improve versus the prior year’s quarter in both audio and entertainment categories, we’re not satisfied with the overall rate decline. As Dave discussed, we have initiatives underway in pricing, sourcing, promotional effectiveness and solution selling that should benefit the domestic gross margin rate in the upcoming quarters. I will be intensely focused on helping the team achieve this result.

International segment gross profit rate remained essentially flat.

Consolidated SG&A expenses as a percentage of sales increased by 234 basis points. In the domestic segment, the key driver of the increase are the overall de-leveraging impact of lower sales, 133 basis points in occupancy costs due primarily to store openings, and 73 basis points in foundational improvements and information technology and services.

These unfavorable factors were partially offset by decreases in compensation and travel-related expenses that resulted from our expense reduction initiatives. The international segment’s expense-to-sales ratio remained relatively flat and did not impact the consolidated rate.

We remain on track to take out $150 million this year and $200 million for fiscal ’09, although we expect these savings will be partially offset by incremental expenses associated with our long-term strategic plans.

Our earnings before taxes as a percentage of sales declined to a loss of 4.8% of net sales this year, compared with earnings of 0.7% last year. The net result for the second quarter was a loss from continuing operations of $0.38 per share, compared with net earnings of $0.07 per share last year.

Turning to the balance sheet, at August 31st, we continued to have a very strong balance sheet, with cash, cash equivalents and short-term investments of $424 million, only $59 million of long-term debt, principally related to capital leases, and no short-term debt.

The cash and cash equivalents and short-term investments position is down $175 million from the $600 million we had at August 31, 2006. The year-over-year decline was principally driven by cash used to purchase PP&E of $320 million, and $194 million used to repurchase stock and to pay dividends.

These uses were partially offset by cash flow from operations, primarily the $143 million favorable decrease in net-owned inventory and cash provided by the issuance of common stock. We still expect a reduction of net-owned inventory at fiscal year-end of $100 million to $150 million compared to last year.

Consolidated merchandising inventories declined 1% compared with last year as we reduced inventories in our international segment. Merchandise payables increased primarily due to the timing of payments. As a result of the vendor settlement we held in June, we were able to standardize terms and conditions with more of our vendor partners.

Now turning to share repurchase activity, during the second quarter, we didn’t buy back any shares. To date, we’ve bought back a total of 60 million shares for $966 million, for an average cost of $16 per share. We have approximately $234 million for future share repurchases under our current board authorization.

We opted not to repurchase stock during the quarter for several reasons, including the desire to maintain a strong level of cash on the balance sheet as the business was undergoing a significant amount of change; the uncertain macroeconomic climate; and the desire to hold off major cash outlays during my initial transition period here at the company.

My initial view is that the minimum level of cash or cash equivalents for our business is in the range of $300 million, but given the uncertainty in the macroeconomic climate, we believe it is prudent to have a little more. We have ample liquidity from our existing cash flow to fund our multi-year turnaround, and keep in mind we still have a $500 million revolving credit facility available to us, and while we will not signal our future share repurchase plans, we have historically been aggressive buyers of our stock at current valuations.

Just a quick comment on the second half outlook, the company expects continued weakness in its third quarter results, with a net loss from continuing operations less than that of the second quarter. The improvement will result from stabilizing performance levels as the pace of change slows in both the stores and the store support center. The company expects to deliver a net profit for the fourth quarter and a full year net loss from continuing operations.

I would like to turn now to some of my near-term goals. My first and most immediate goal is to help the team stabilize the company’s financial performance. There are a number of initiatives underway to accomplish that goal and the sense of urgency is high.

Second, I’ll take an outside-in view of our four strategic pillars, pacing growth with the proper level of investment and in light of our current financial performance. The first one I’ll reevaluate is our real estate strategy. This evaluation will include timing of store openings based on the impact that the new stores have on the company’s P&L; second, prioritizing relocations over incremental store openings, and finally looking at the total quantity of new stores, including focusing the team on key strategic markets, those with the most market potential and upside, versus secondary and tertiary markets.

This reevaluation of the real estate strategy does not mean that we are moving away from our need to upgrade our real estate. Let me be really clear here -- we must and will significantly improve our real estate portfolio over time. However, it could mean modestly lowering the number of incremental store openings or shifting to a greater number of relocations in the near term.

I expect to complete the real estate strategy review this quarter and will update you on the next conference call.

In the interim, I want to provide you with some more detail surrounding our current real estate program and why we are excited about the 20,000 square foot format. In the first year, for similar trade areas, the 20K stores achieved the same dollar sales as the larger 30K stores, but on a four wall basis, the 20K format generated more gross margin dollars as a percentage of sales and a lower SG&A as a percentage of sales, delivering a much higher four wall EBIT and EBIT rate.

The cost to construct a 20K store will be lower than the 30K and our models reflect the stores reaching maturity after year two, so we expect additional improvement to the results of the sale increase will leverage the fixed costs. And by the way, the 20K stores as a portfolio generated a near 5% comp during the second quarter.

The third area I will focus on is our store productivity and non-waiver fixed cost structure. I hope to do this as part of our annual budget cycle. My initial observation is there appears to be additional opportunity to align our cost structure with our sales and margin performance. I plan to update you on this work by the end of the fiscal year. In the meantime, we are closely monitoring our expense and capital spending over the second half of the year.

Finally, I would like to take a look at the overall pace of change that the company is undertaking. While we are absolutely committed to growth, I would like to ensure the growth is appropriate, given our current financial performance and business conditions.

I look forward to meeting investors and analysts but want to also balance that time with the necessary time to reevaluate real estate and review our other strategic plans. We have a lot of work ahead of us. I do believe we’ve got the right team in place to first stabilize and then improve our financial performance.

With that, I would like to open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from Danielle Fox.

Danielle Fox - Merrill Lynch

Good afternoon. I was wondering if you could talk a little bit about the range of performance among your stores. Were they generally all loss making this quarter? And Bruce, it sounds like you are taking a close look at the real estate strategy. It sounds like a good idea to slow the pace of store openings. I’m wondering if there is this class of stores that is consistently underperforming, just why not close that bottom group of underperforming stores?

Bruce H. Besanko

Let me respond to the back half of your question first and then the front half. So in terms of store closures, we do look at the store performance on a -- you know, by store class. There wasn’t significant levels of difference among many of our store classes but for the 20K that I mentioned. That significantly outperformed the other store classes.

As part of the real estate analysis that we’ll undertake over the course of this quarter, we will look at our store closing criteria. We typically have been, have evaluated store closures routinely. We’ll continue to do that and to the extent that we may take another look at the attributes, we’ll certainly provide that.

As it relates to -- I think the first part of your question was more around regional performance or comp performance or store performance as it relates to regions. You know, the only trend that we really saw was in the West Coast, and in particular, California, and the Southeast, and those did under-perform relative to the other areas.

Danielle Fox - Merrill Lynch

I guess what I was thinking was maybe you have some much older stores that are persistent underperformers, so outside of some of the macro factors, some of the stores that maybe are just not responding as well to some of the initiatives that you are putting in place operationally. Are there some that are simply poorly located and a function of being old, for example?

Bruce H. Besanko

I think we understand the issues as it relates to the real estate portfolio in terms of some of the locations. What I would tell you is that whether the store was older or newer, these stores for the most part are all cash flow positive.

Danielle Fox - Merrill Lynch

Actually, that’s my final question, is just if -- you made some comments around the outlook for net owned inventory for the full year. What should we be looking for from a free cash flow perspective?

Bruce H. Besanko

I think overall, we are trying to stay away from the guidance, given the uncertainty in the -- both from a macro perspective as well as our own parochial changes, so I would prefer not to comment.

Danielle Fox - Merrill Lynch

Okay. Thank you very much.

Operator

The next question comes from the line of Stephen Chick.

Stephen Chick - J.P. Morgan

Thanks. I was wondering, maybe Bruce of Phil, if your comments about the sequential improvement in sales through the quarter, if you could get a little more granular with that, that sequential improvement, and also maybe comment on what you’ve seen post the quarter end.

Bruce H. Besanko

I’ll let Danny Clark answer the retail improvement.

Danny Clark

As stated in my dialog, Steve, that as the quarter started out, we were in the middle of a tremendous amount of change. We had just come off of going from 10 to eight regions. We changed the management model in every store that we had, and then we started the changes in the labor model, so a way to think about that, if it didn’t come out clearly, is that literally we had 40,000 people learning a new job. They may have had a similar job to their position but they might have had a different area of responsibility. They had something new to learn.

That created a distraction. That absolutely affected us early in the quarter, particularly in June and July, as they were learning new roles and going to training centers and cascading what they are learning to other people inside the business. That hurt our ability not only in conversion, as I stated earlier, it hurt our ability in attachments. We were hurt with City advantage, services, other things that we had typically attached for the consumer.

What we saw though is we saw that as this change was getting behind us, or what we’ve learned from our regional learning centers is it takes about four to eight weeks for the change to settle in and as the change was getting behind us month to month, our stores began to stabilize. First, our regional learning centers, which improved their performance every month of the quarter, then our divisional learning centers, and the rest of our chain is four to eight weeks behind those.

So we did see an improvement in performance over the course of the quarter. We have a long way to go. There are still a lot of people still learning new roles but we have some history here that says that we will be able to continue to improve in this quarter.

Bruce H. Besanko

Steve, this is Bruce; just another piece of color for you, if you look at August and compare it back to June, August sales performance was a factor better than June, so August was about half the decline rate of the month of June.

Stephen Chick - J.P. Morgan

Okay, and so now that we are kind of into September, are you seeing that continue into the current month?

Bruce H. Besanko

We’d prefer not to comment on September at this point.

Stephen Chick - J.P. Morgan

Okay, well, secondly, related to that then, did you also see, given that you had some favorable comments about the sequential improvement in flat panel sales as well, are we seeing extended warranty improvement along with the sales improvement that you are seeing sequentially? Do you know that?

Bruce H. Besanko

No, can we come back to you on that, Steve? We’ll have Bill follow-up with you. So you’re talking simply, just so we understand the question, attachment rate as well as share number of units because of the improvement in the hardware sales?

Stephen Chick - J.P. Morgan

Yeah, that and also, given that your warranty sales dollars were down year over year significantly, I would like to know if your comps are improving sequentially, are we also seeing a proportionate improvement in warranty sales since the profits there are so high? I guess that’s what I’m asking.

Bruce H. Besanko

Steve, we’ll come back to you after the call.

Stephen Chick - J.P. Morgan

Okay, and I guess the second thing, if I could, maybe for Phil; as we look at the enterprise value company that the equity market is assigning, it’s obviously at least to sales, very, very cheap from a retail perspective. I know you have somebody that you’ve retained to entertain your alternatives for Canada. I’m wondering if you can speak broadly about what kind of discussions are you having with your Board and is there a timeline that we are thinking about here? And when do you maybe have to think about something more strategic possibly for the whole company?

Philip J. Schoonover

Let’s review the series of events. We had a permanent change to the business model that Circuit City was disproportionately impacted by because of our strength in the video business last October through December.

We quickly deployed a team against the SG&A work, identified $150 million, and they handily have achieved materially taking that cost out. At the exact same time, we felt there was great opportunity in all of the fixed business buckets that Danny and Dave talked about. And what we made a decision to do is accelerate those changes, take our lumps here in the first half, and be ready for the all-important holiday selling season.

As far as the more strategic alternatives we have with the company, we have a massive opportunity to grow our share of the highly profitable flat panel television business baskets and we have execution issues and we also have strategic opportunities to improve that. So we think there is still a very big growth engine sitting out there as we move towards winning in home entertainment versus winning in flat panel televisions.

The second big bucket is that home services, digital home services, so Firedog as a brand, and all the services that sit underneath that, a growth engine for the company and we continue to progress there and we continue to make investments there.

Our fleet of real estate is aging. There’s over 400 stores that we would declare inefficient and typically in the wrong parts of town, and we continue to invest aggressively in making the right decisions to upgrade our real estate.

And so there’s opportunity on the fixed business side and there’s opportunity on the growth of the business side. With that said, the Board is squarely behind our strategic initiatives. They have supported our decision to accelerate this change and yes, the most difficult portions of that behind us in the first half and we continue to stay the course on our long-term strategy.

Circuit City has always and will always be open-minded to any strategic alternatives. As you know, there’s been two offers to take the company private in the nearer term, one’s with Carlos [Flem] and the other with Highfields. In both cases, the Board voted that the offers were not in line with optimizing shareholder value.

I don’t know how to speculate on anything and we wouldn’t speculate on anything other than that but we will handle any ideas that come forward responsibly.

Stephen Chick - J.P. Morgan

Okay, thanks. It seems like a lot to do and it seems like you are doing a lot of the right things, but I guess we’ll see how the holidays go. Thanks.

Operator

The next question comes from the line of Bill Sims.

Bill Sims - Citigroup

Thank you. Good morning. My question is for Phil. It seems like you have a lot of process improvement opportunities and you’ve had a lot of things underway for some time. You’ve also outlined some customer facing improvements that you are in the middle of implementing.

But it seems like a lot of the customer-facing improvements are just meant to make yourself more competitive versus putting yourself a step ahead of the competition. Do you have a clearly outlined strategy of what it takes to differentiate your business from the competition today, and what type of outline are we talking about in terms of implementing that strategy?

Philip J. Schoonover

It starts with our multi-channel and services strategy, so when we think about how we are different and better, we have a competitive web presence and one that is preferred by a great deal of customers. We have a Firedog services in the last mile, where many of our competitors do not offer in-store, in-home, online and telephone services. And those two book-ends we believe over time are more and more important to the customers. We think about the web as the new front door to CE retail and we think about the last 10 feet of the sale actually being done in the customer’s home.

What I would say is that we’ve, over the last 24 months, experimented in Boston and Florida, hundreds of experiments on the in-store customer experience. And we have a very firm set of understandings around what matters in the store and how that is different than yesterday.

We’ve touched on this but we’ve opened our first new format that takes the learnings from Boston and Florida and brings them to life in one store, and we call that our City store. It’s in Norfolk, Virginia. The 25 stores that will open in that same format the balance of this year have a different job and they actually do a different service for the customer. They have a very different employee value proposition and they actually make it convenient for the online customer to simply swing by and pick up and they make it easy for customers who need and understand complex digital products and services to touch, feel and compare.

We look at this as sort of a key to our differentiation. The box size is different, the job of the store is different, and the culture of our associates in the store is different. The customer service is very different in these stores.

We’ve been working on this for a long time. You’ve seen a lot of the experiments, Bill. This is that work.

So if I step back, we think that we need to emphasize the web experience because 70% of the high ticket, big ticket CE purchases begin their purchase online. We think we need to provide in-home services to further differentiate ourselves from our mass merchant and pure online competitors, and we think the job of the new store, as we upgrade our fleet, can be very different and in a way, we’re not tied to the legacy of brick and mortar as we upgrade this fleet.

So that’s the differentiated strategy over time.

Bill Sims - Citigroup

Phil, just one follow-up, if I may, on Firedog; has your current profitability challenges challenged your ability to build the Firedog brand? I haven’t seen a significant amount of television advertising out there. Firedog sales growth did fall back in the second quarter versus the first quarter. Where do you stand and how aggressive have you been in building the Firedog brand?

Philip J. Schoonover

You know, we’ve included Firedog in all of our standard vehicles, so our insert, our broadcast advertising, and online. And in real dollars, we’re spending more against the Firedog brand than ever. That is how I would answer your first question.

And obviously with the softening in the television business, home theater installation in particular, is not where we wanted it or where it should and could be. We had attachment issues in both home theater, install, and PC repair related to all the change and that’s just better management of profitable baskets.

Over time, we think Firedog is a differentiated offering. We think we can do a lot and a lot more with that capability and we plan to continue to invest. We grew the business 20% on top of 100% last year, so we are actually fairly satisfied with staying the course on that particular pillar producing financial results for the company.

Bill Sims - Citigroup

Thank you, Phil, and good luck.

Operator

The next question comes from the line of Matthew Fassler.

Matthew Fassler - Goldman Sachs

Thanks a lot and good morning to you. A couple of questions; first of all, I’m interested in the margin declines that you saw within the PC and video businesses, if you could speak to the drivers there.

David L. Mathews

As I mentioned in my earlier comments, two-thirds of the gross profit rate decline in the second quarter was actually due to product mix changes, roughly a third due to the rate decline within same categories.

We’ve got actually the plan that I mentioned, that we are really attacking for the second half of the year, is heavily focused on improving our gross profit rate. So on the mix side, solution selling, getting our basket back, getting in-stock levels right, bulk out, end caps, our promotional effectiveness in our marketing, and even getting our assortment right, all of those you could say are activities that are designed to attack the product mix issue that impacted gross profit rate.

On the actual rate declines, the pricing work that we are doing, the new SOPs, the markdown governance and our sourcing work are all designed to get our product rates up.

With regard to the TV category and PC category that you mentioned, we have on the TV side, we had some issues. You probably read a lot about tier one and tier three brands. We have been working hard to get our assortment right and make sure that we are winning not only in different price points, in different technologies, but also with different brands.

So our video team, our television team has actually made a lot of progress and I mentioned that in August, we actually were seeing improvement in small and medium LCD as an example, but the key thing in our TV business was we actually had unit challenges and ASP challenges early in the quarter, but do all the work of the team on assortment planning and getting our position right. We actually clawed back on units and we are now in the middle of attacking our basket strategy with a goal of getting profitability back up.

But the -- I’m actually pleased at where we are and coming back on a unit side, but we have some work to do on the basket side.

Matthew Fassler - Goldman Sachs

If we were to zone in on TV margins in the second quarter, you’re saying and as you disclosed, it would largely be a function of the basket. It sounds like maybe you were long some of the wrong product at the outset of the quarter and you had to clear that out.

David L. Mathews

Well, we had -- I mentioned this, actually, in our Q1 earnings call as well. When we looked at our TV business, we had assortment issues. We were under-indexed on small and medium LCD. We were under-indexed on some critical brands that we needed to increase our presence and all of those things have been addressed and our units have come back.

The basket, obviously, I mentioned our focus on solution selling and on margin per transaction, total ticket profitability, critical to executing that obviously it is our basket strategy, which is what we are attacking right now.

Danny Clark

I just want to really re-emphasize how much change we had going on in retail. We lost traction with City Advantage. Our Firedog services in the second quarter, we think we could have run them more. We lost some traction there. Those attachments are very important when you are driving something like the PC business and the TV business, and that absolutely impacted us.

For us, we are very focused and have tried to get as much of this work as we could this summer and we believe that being able to get the retail team back and focused on making presentations to consumers and providing better customer service is going to help those attachments go up, so those strategies have to go hand-in-hand. Dave’s team has to go work the back-end some of the things he just talked about related to pricing, marketing and brining customers in the stores and we have to do a better job executing in front of them.

Matthew Fassler - Goldman Sachs

If you think about the TV market a year ago, and it was I guess just passed this time last year that you started to see fallout and supply chain issues, how would you characterize the state of the supply chain this year versus where it was a year ago?

Philip J. Schoonover

I actually think we’re in pretty good shape, with the exception maybe of some spot cases. I think we are in good shape in the back-half of the year.

Matthew Fassler - Goldman Sachs

Finally, just on the real estate front, I understand that your new stores seem to be doing somewhat better, the 20Ks in particular. You are making a lot of long-term real estate commitments and committing a lot of CapEx at a moment in time when your earnings visibility is very tough and you’ve been putting up some tough numbers. And Bruce, I know you alluded to this in your prepared comments; how seriously have you thought about pulling back a bit on the store rollout to conserve some of that capital until the earnings visibility improves a bit and you know that some of that pressure is off?

Bruce H. Besanko

That’s a great question. Thank you for asking it. I would just tell you that we’ve got all options on the table. We’ll take a very planned, thoughtful look over the course of the next couple of months and then come back with a point of view. I think that’s what we are going to do. There are, as I said, there’s really no options that aren’t going to be considered.

Matthew Fassler - Goldman Sachs

Understood. Thanks so much.

Philip J. Schoonover

Matt, I would add just one comment here. I’ve asked Bruce to look at everything in the company and challenge it with an open set of eyes and a fresh set of eyes. Specifically with real estate, I think the total number to make sure that we preserve enough cash for tough economic headwinds or difficult competitive headwinds, is certainly a part of that work. But there is also a mix, you know, relos versus new store openings and something we didn’t discuss today but it’s the timing of these stores.

So for several months a year, most of our chain does not make money. New store openings have a two-year maturity cycle. I want Bruce to look carefully at the timing. I think we can do better on timing.

Matthew Fassler - Goldman Sachs

Understood. Thank you.

Operator

The next question comes from Jack Murphy.

Jack Murphy - William Blair & Company

Good morning. I have a question really about the SG&A but before I get to that, I just wanted to follow-up on an earlier question. On the lower attachment rate on warranties, is that a function of the falling ASPs in the flat panel TV business, or was it more the disruption of the new operating procedures? And if it is more falling ASPs, what is your view on attachment rates going forward as those ASPs continue to decline?

Danny Clark

It’s a function of both, so a little bit of a broken record here, but we had -- we distracted the people who were on the floor servicing the customers and took some of their time that they would use to, you know, it takes time to make a presentation on a warranty to a consumer so they can decide if they want to purchase it.

We saw declines outside of the TV category in the attachment rate, so that is -- we have three-year trends that we know. You can see as we started driving the changes through the system this summer, you can see the attachment rate starting to decline outside of TVs, so I’m kind of isolating that part of your question. So we clearly, and you can mark it when the events happen -- new store management structure, labor model changes, et cetera.

We also saw, and I want to -- you know, stabilization so that as the regional learning centers who were the first to go through these changes began to stabilize, you could also see those starting to improve which took -- it’s a little variability in that. It depends on how quick the store catches on. It takes about four to eight weeks.

The TV category has also had pressure because of ASP declines on the product, and one of the things that I said in my comments earlier on is that we did, we ran a lot of tests in August to learn what’s the right balance of features and benefits for the consumer, what the unit penetration at different price points, et cetera. We learned a lot in the month of August and we are always testing, by the way, so we always had to be thinking about where this is moving down the road but we feel pretty good about where our plans are set for the holidays.

So those things combined, so the distraction of going through the amount of change we’ve gone through plus the pressure on the TV attach, we had to look at the TV plans to make sure our value prop was right. We stabilized the operating model and the changes moving behind us more every single day, and we think we have our TV value prop right set for the fall, so we are optimistic that with focus, and that’s the key word, if I could just write one down for you, focus this fall that we can improve our execution.

Jack Murphy - William Blair & Company

If you were to control for all of the disruption, is it your sense that the TV warranty attachments would have still declined somewhat?

Danny Clark

I think TV would have been, we would had to have done the same thing we were doing in TV but if that was an isolated issue versus the extended warranty plans we sell throughout the store, that would have been easier for us to manage. We were trying to manage the change and then also recognizing the decline in ASP prices. We had to really understand where the extended warranty pricing should be and we ran several different experiments, we didn’t run one experiment, to learn what the best answer was for the company.

We looked at our performance against all of those and we think we are pretty close to the pin for the holiday.

Jack Murphy - William Blair & Company

Just turning to the SG&A initiatives to take out SG&A costs, on that $150 million and $200 million goals, could you just bring us up to date on where, how much of that you’ve actually taken out? And then, I believe Bruce made a comment that there would be some strategic spending offsetting that. Can you give us a better sense of net numbers, in any timeframe you want? Whether it’s four, 12 months or for the following year?

Bruce H. Besanko

Let me answer the back half of the question and then I’ll flip it over to Phil. In terms of the offsets, we have some ongoing growth initiatives and ongoing foundational issues in information technology that we are going to continue with. Now, I mentioned in my prepared remarks that we may look at the pacing of that but it’s those kinds of investments that may offset some of the savings.

Phil, in terms of some of the near-term activities that have helped us get to the $150 million to $200 million.

Philip J. Schoonover

The changes we’ve made to our regional district and store level structures saved us labor and actually improved labor productivity in the stores, a large number. We made changes here in the store support center to reduce layers, increase control and change workflows that saved us some further labor and headcount here in the store support center. And then we had several not-for-resale purchasing activities that we went through, all the travel and capital and our third-party expenses, and we had significant savings there.

We have made those decisions and they continue to hold and we’re not adding back in those areas. We think that there’s a larger number for next year. That’s why we say 150 this year, 200 next year because we’ve got a full year of benefits.

And more importantly, we’ve built a culture on the expense side to look at every expense and say if the customer is not willing to pay for it, let’s save that money and either invest it someplace else or take it to the bottom line. So we are continuing to look at our SG&A every day and we are scrutinizing it even closer, given our current results.

Bruce H. Besanko

Just to add one last comment for you in terms of the 150 this year, if I were to give you three broad buckets, I might suggest that the retail activity that Phil talked about is roughly on the order of $85 million to $90 million; IT activities are on the order of $15 million to $20 million -- I’m sorry, entertainment is $15 million to $20 million; and then the corporate areas are call it $45-ish million.

And then of course, we’ve outsourced our IT activities to IBM and there’s savings related to that.

Bill Cimino

Thanks, Jack. Operator, we need to take the next question, please.

Operator

The next question comes from Chris Horvers.

Chris Horvers - Bear Stearns

Thank you very much. I am going to follow-up on the previous question on the expense side. How much of that flowed through into 2Q and what is the incremental save in the back-half of that 140 of the 150 this year?

Bruce H. Besanko

I think we are not prepared to comment specifically on the quarter-to-quarter saves on this.

Philip J. Schoonover

If we talked about the implementation schedule though, we actually did most of the planning in the first quarter and began implementation in the last month of the first quarter. Most of the benefits will be in the second, third and fourth quarters.

Chris Horvers - Bear Stearns

And in some sense, ramping up as the implementations come through?

Philip J. Schoonover

You know, specifically the productivity from the stores would ramp up and that’s your biggest number, yes.

Chris Horvers - Bear Stearns

As you think about the past three or four quarters, it seems like your results have come in even below your what I would assume to be modest expectations, so aside from cutting back on the execution or the amount of change I’m putting through at the store level, what makes you think that that visibility into your earnings and sales in the back half is any more clear today than it was a quarter ago?

Bruce H. Besanko

The way that I’m thinking about it is that most of the change is now, as Danny had alluded to, most of the change is now behind us so the hard work during the second quarter and even toward, some of it in the first quarter, most of that is now behind us.

The way that we get visibility is through the RLC and the DLCs, the learning centers that Danny talked about, so we have absolutely clear visibility as to what is happening in that portfolio of stores, and so we can take those learnings and understand what an expectation might be as we look to the third and the fourth quarter.

Philip J. Schoonover

And I would comment that we have performed in several areas of the basket over time at much higher levels and we also have other benchmarks to understand what best practice looks like, other companies. So some of our expectations for the second half are rooted in performance that we’ve seen here at Circuit City and what the industry performs at.

We knew that this was going to be very choppy. It’s hard to define exactly what the net impact is going to be. We are doing the right things to get our standard operating platform in place and we are continuing to invest in the growth engines of the, you know, within the TV business and greater home entertainment business, the work that we are doing in services and the work we are doing in real estate.

I think we are doing the right things to grow the company long-term and we have taken our lumps in the first half on the operating model to get the near-term performance back.

Chris Horvers - Bear Stearns

Is there a way -- you said that comps improved throughout the quarter, June, July, August. There’s obviously a lot of seasonality there. You saw in overall broader retail, the consumer start to come back a bit here in August. Do you have market share data that shows you that you know what, maybe my market share loss decreased and then you can say well, yeah, we’re actually -- we’re fundamentally improving our position and it’s not just seasonality?

David L. Mathews

I actually only have NPD data through June, calendar June -- I’m sorry, Trackline through calendar June and NPD through July, so there is a lag which really prevents us from saying right through the end of the quarter what impact we had on -- hopefully positive but we don’t know yet -- on market share for August.

Chris Horvers - Bear Stearns

I just have one final question; as we think about the cash generation, which was pretty impressive here in 2Q versus 1Q, a lot of it was stretching payables and collecting on receivables. What are the levers that you have in the back half of the year to drive cash? Will inventory per foot overall come down, or is it just we’ll be continuing to stretch the payables?

Philip J. Schoonover

Let’s maybe balance our thoughts about the first half. There’s continued effort to have better inventory management processes, so that’s part of our merchandising transformation work and the suite of tools that we are deploying. Better forecasting, less safety stock, all of the work that we’ve done on vendor standardization at terms and payment conditions have led us to be able to have a different payables. The team did a very good job making sure that we paid for the product at the appropriate date but it’s a series of activities that led us to this inventory takeout.

In the second half, we’ll have more tools. We’ll have people settled down on execution and back in the groove on getting safety stock out of our system and providing improved customer levels of in-stock in the stores, which is really the way that we get to null net-owned inventory over time.

So I just want to maybe balance the comments; this is not a one-time thing. This is a journey, of which payables is part of the journey, getting our vendors on standard terms and conditions, which the vendor summit this summer was aimed at has helped that, and we have other things that we will deploy in the second half to continue to take our owned inventory down.

Bill Cimino

Operator, we have time for one more question, please.

Operator

Your final question comes from Jonathan Cramer.

Jonathan Cramer - Cowen and Company

Good morning. Just to follow on Chris’ question, could you give us a little more color on how, on your confidence for guidance? I know you had some broad strokes, and your expectations for the consumer backdrop as well?

Bruce H. Besanko

I’ll let Phil follow with a comment on the competitive and business conditions, but in terms of visibility to the second half, I think we’ve provided -- we’re trying not to provide any guidance. We did say that we would modestly see -- see modest improvements over the course of the third quarter, relative to the second quarter.

I really would prefer not to go any deeper than that because there is still a lot of uncertainty, both from a macro perspective but as we continue to roll out the change that we incurred in the second quarter, I want to be cautious here and not be specific because of the significant amount of change that we’ve had.

Philip J. Schoonover

As for our outlook for the second half, we saw the NRF came out with a 4% overall retail, which would be down from prior year. I think 4.8% was prior year. Directionally, we agree with that. We think the macro trends continue. Sub-prime mortgage issues are probably a bigger issue. We’re seeing some regional softness in California that we have seen before as leading indicators.

On the other hand, we had sort of several of our competitors point to the CE business as healthy and the trends within CE healthy, so we are sort of balancing our optimism with that backdrop.

We don’t think that anything other than a conservative approach for the second half is prudent, so we are continuing to watch our variable SG&A expenses and err on the side of being conservative there and we are continuing to watch our inventory levels.

I think, given the amount of change we are inducing, we are not fully completed and the choppiness says that we should be more conservative than we were last year, so I think that’s the way that I would sort of frame the approach we are taking.

Jonathan Cramer - Cowen and Company

Okay, good luck.

Bill Cimino

Thanks, Jonathon, and thanks everyone for participating in today’s call and for your questions. Before we conclude the call, I would like to remind you that a replay will be available by approximately 2:00 p.m. Eastern Daylight Time today and remain available through September 27th. Investors in the United States and Canada may access the recording at 1-800-642-1687, and other investors may dial area code 706-645-9291. The access code for the replay is 14906679. A replay of the call also will be available on the Circuit City investor information homepage at investor.circuitcity.com.

This concludes our call and thank you.

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Source: Circuit City F2Q08 (Qtr End 8/31/07) Earnings Call Transcript
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