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Circuit City Stores, Inc. (NYSE:CC)

F1Q09 Earnings Call

June 19, 2008 10:00 am ET

Executives

Bill Cimino - Director, Corporate Communications

Philip J. Schoonover - Chairman of the Board, President, Chief Executive Officer

John T. Harlow - Chief Operating Officer, Executive Vice President

Bruce H. Besanko - Chief Financial Officer, Executive Vice President

John J. Kelly - Chief Merchandising Officer, Senior Vice President

Analysts

Matthew Fassler - Goldman Sachs

Christopher Horvers - J.P. Morgan

Michael Baker - Deutsche Bank

Michael Lasser - Lehman Brothers

Scott Ciccarelli - RBC Capital Markets

Bill Armstrong - C.L. King & Associates

Gregory Melich - Morgan Stanley

Dan Binder - Jefferies & Company

Operator

Good morning. My name is Elizabeth 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) I will now turn the conference call over to Mr. Bill Cimino, Director of Corporate Communications. Sir, you may now begin your conference.

Bill Cimino

Good morning and thank you for joining us today. Before we begin, I need to remind you that during this call we may make forward-looking statements which are subject to risks and uncertainties. We refer you to today’s release, the MD&A in our most recently filed 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; John Harlow, Executive Vice President and Chief Operating Officer, and Bruce Besanko, Executive Vice President and Chief Financial Officer. Also available during the question-and-answer session will be Jeff Stone, Executive Vice President of New Business Development; and John Kelley, Senior Vice President and Chief Merchandising Officer.

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

Philip J. Schoonover

Thanks, Bill and good morning. Today I will discuss our first quarter results and update you on the progress towards our key priorities that position us for profitability in the longer term. Then, John Harlow, our Chief Operating Officer, will update you on the progress we are making in our turnaround plans and Bruce Besanko, our Chief Financial Officer, will discuss the financials and talk about recent corporate action.

I am very pleased to report to you that our first quarter results were above our guidance and the company is on track to deliver its financial guidance for the year. Fiscal year 2009 will be a year of very hard work and focus on execution, but we expect to improve our financial performance compared with fiscal year 2008 and set the stage to return to sustainable profitability in the future.

The first quarter saw continued improvement in the trends that began in the fourth quarter. Our hypothesis is that the trends had bottomed out, most of them in the August to October timeframe of last year. This continued to hold true.

We saw improvement in trends in nearly every category. The work is progressing well and we must maintain our focus in order to produce year-over-year improvement in our financial results. The hard work on the SG&A side of our results by our team has led to fundamental change in our operating model. We expect to build upon this progress in coming quarters. We are on the right track with the right strategies, the right talent and improved processes to execute a successful turnaround and position us for long-term profitable growth.

I want to put our first quarter results in the context of the full year plans. While we see it as our guidance toward the first quarter, we want to remain cautious regarding our outlook for the remainder of the year due to uncertainties about the macroeconomic climate. We continue to believe that our guidance is achievable and that we have the resources, including sufficient liquidity to drive our turnaround.

Turning to our long-term plans, we’ve made steady progress towards our four strategic growth pillars and other key goals.

First in home entertainment, last quarter we drove improvements in our baskets for flat panel televisions. In our first quarter, the baskets continued to grow sequentially and was the highest baskets result since a relatively strong Q1 performance in last year. Sales of flat panel televisions, particularly large LCDs, continue to grow strongly, increasing by high-single-digit percentage. Our total TV comp performance decreased by a single-digit percentage for the quarter but improved each month of the quarter and in May, TV comps were flat to last year.

Our year-over-year margin climb in TVs was much less than recent quarters, due to both better assortment optimization and some of the retail activities that John will speak about shortly.

The growth in flat panel televisions is being augmented by the strong growth in video-gaming hardware, software, and accessories. We are capitalizing on strong consumer interest in the new videogame platforms and the new social gaming products. And the business has long high margin tails through software and accessory sales.

Second, multi-channel -- the direct channel sales grew 3% this quarter, compared with 21% growth in last year’s first quarter. This growth rate is lower than what we have posted in past periods, driven primarily by a less aggressive promotional stance in categories such as PC hardware and televisions, as we seek to maximize gross profit.

The direct channel still remains a sales and comp driver for the company and recall that more than half of the sales volumes is picked up in our stores.

With more and more shoppers going online to research products, especially in the consumer electronics space, we know that building trust by offering reliable product information is good for customer loyalty. We see online community building as a key differentiator on our web offerings than that of our brick-and-mortar competitors.

To this end, we have renewed and expanded our relationships with Consumer Reports, the recognized gold standard for trustworthy, accurate, and objective product information. In the coming weeks, you’ll see even more of their helpful buyers’ guides on our web pages, along with great product information from Popular Photography and Sound and Vision magazines.

Third, let me talk about Firedog services. PC services and home theater installation revenues fell 16% for the first quarter. I want to remind you that Q1 of last year was the second-highest increase we’ve ever had in Firedog’s PC services and home theater installation revenues.

We achieved that increase with the launch of Microsoft Vista on the PC side and a popular home theater that was bundled with installation offer. We expect the comparisons to ease as we move through the year, ramp up our selling culture in the stores, and continue to refine our offerings and promotions.

Turning to our real estate and concept development work, we had 25 of our new The City stores at quarter end. In fiscal year 2009, we will continue to refine the model to improve our financial performance and differentiate the concept. We know that the concept works well with customers and they prefer the shopping experience. We are focused on improving our operating model in order to produce superior returns. Most of this work is in the entertainment area in our newest concept.

Regarding our exploration of strategic alternatives, we announced on May 9th that we have retained Goldman Sachs to assist us with exploring strategic alternatives for the company to enhance shareholder value. We also announced last fiscal year that we would explore strategic alternatives for our international segment, InterTAN. Both reviews are ongoing and may become inter-dependent. The management team and board of directors remain committed to enhancing value for our shareholders.

We are pleased that we were able to resolve the potential proxy contest with Wattles Capital Management prior to mailing definitive proxies, which enabled us to avoid the cost of an extended proxy battle, as well as eliminate more than a month of distraction. We believe this resolution serves the interests of all stakeholders.

Our primary focus in the second quarter and for the rest of the year will be to continue to increase our [sales] rate and attachments of higher margin accessories and services in order to improve our gross margin, execute on a retail strategy, and rebuild our selling culture while managing expenses.

Now let me turn the call over to John Harlow, who can update you on our store operations.

John T. Harlow

Good morning, everyone. I am excited to share with you the progress we have made for meaningfully improving our overall level of in-store execution and performance. We are doing this in part for better integration between the retail operators and the store support center, but primarily the progress is attributable to the hard work of our 40,000 associates.

We have only one agenda -- to provide an improved experience to our customers. Early in the quarter, we deployed staffing and service standards to support greeting our customers quickly and providing friendly service. We provided more effective training for all of our store associates from some of our best-in-class vendor partners.

Our stores, with the support of their field leadership teams, began to implement and execute against store specific plans that were developed in March.

We are gaining traction. Remember, every store associate across the company is learning new procedures and expectations. This takes time. For nearly 700 stores to see traction in 90 days shows the promise that we can do this. We will improve on this for the rest of the year and we expect the results to build.

Let me talk first about the actions we are taking to improve the customer experience and harness the financial outcomes of doing that successfully. Then I’ll share with you an update on the results we are seeing.

We provide our associates with tools and training to take better care of the customer and we are buttoning up operationally, which will show on the floor and behind the scenes. As we think about improving our performance through the customers’ lens, we are focusing on the first and last impressions that they will have in our stores.

On the customer service side, we’ve added policies and training for greeting, faster checkout, more prompt and friendly service throughout the stores. We are also focused on store readiness and merchandise presentation. We are upgrading our standards so that in-stocks are improved and the merchandise presentation is better. The SOPs, product [inaudible], and workload planning from the store support center are helping.

For customers who buy online and pick-up in the store, we are improving our execution of fulfilling and attaching to orders under our 24/24 pick-up guarantee.

In terms of rebuilding our selling culture, we focused our attention first on the biggest area of opportunity, home entertainment. In the first quarter, we made the following fundamental course corrections in home entertainment. We dedicated a supervisor in all stores and dedicated a sales manager in our top 200 sales stores. In April, we redeployed dedicated labor to the home entertainment department. As you will recall, last year we de-zoned our stores and found that dedicated home entertainment labor could be better trained and more effective in serving our customers.

We increased the amount and effectiveness of training for both products and selling skills for all home entertainment sales associates. This started in March and was vendor supported.

Sustainability for all of this will be delivered through our new team-based incentive to attract, retain talented sales associates and encourage collaboration and improved customer satisfaction. As of June 1, this change of team-based incentives was rolled out to our chain.

We tie this all together with our [talent] management and store operating focus. We have clarified and prioritized the role of our store leaders. Last year, as we implemented the SOP changes, we were out of balance between SOPs and selling focus. Now, our operations managers execute on SOPs, inventory and shrink. The sales manager focuses on rebuilding and sustaining the selling culture.

Also, performance management is being ramped. Stores make their store-specific plans and must execute and achieve their targets. We are providing them many more tools to evaluate and manage to individual performance and gap manage.

These efforts help us better take care of the customer and the results are encouraging. On the fourth quarter call, Phil provided you with some specific measures of progress towards rebuilding our selling culture and improving our customer service. Let me provides updates on those same metrics for the first quarter.

Our store close rate trend improved during the first quarter, with the gap to the prior year narrowing sequentially each month of the quarter. In fact, our May close rate was nearly flat to the prior year.

We measure how often we attach high margin accessories and services to the hardware units that we sell, and we were also seeing progress there. Remember that for the most, if not all of our [attach rate] measures, the first quarter of last year was our best performance of the year.

Here are three examples about this year’s performance; our PC services attachment rate held at similar rates to the fourth quarter as we anniversaried the benefits of the Vista launch last year. This rate is still 500 basis points above Q3 of last year and has been trending up in recent weeks.

Our home theater installation attachment rates was more volatile, but encouragingly March and May were both relatively in line with the overall fourth quarter trends, and April spiked up above last year.

Overall, the first quarter rate was 100 basis points better than the fourth quarter and 300 basis points better than Q3.

Finally, we continue to show an improved trend since November of 2007 in our warranty unit attachments and TV warranty attachments trended not only above FY08 levels but more than 100 basis points above FY07 levels as well.

We measure the total basket size of accessories and services that is attached to common hardware purchases. Both our flat panel TV and notebook baskets were approximately flat to our fourth quarter performance. Granted, this is down compared with last year’s relatively strong first quarter performance that we delivered prior to the operating changes that we made in our retail stores.

The flat panel TV basket value was higher for Q1 of this year than Q2, 3, or 4 of last year. Our store associates are performing better in this area and we believe the improvement will ramp as we move throughout the year.

We measure customer satisfaction in two ways; one, through third-party mystery shops; and second, through customer first scores. We saw another 250 basis point improvement in mystery shop scores from March to May, on top of a 600 basis point improvement we saw from when we started measuring in July to March.

Our customer first scores have been at or near three-year highs every month of the year. Admittedly, we have further to go in improving customer service in our stores but I am encouraged by the significant progress we have made.

To further demonstrate progress in this area, J.D. Power & Associates offers an additional third-party benchmark that measures average time to find associate assistance and demonstration of products. In March 2008, J.D. Power’s CE industry shop study showed that on both of these metrics, we compare favorably to our largest competitors while lagging some regional players. Therefore, we see further upside to this trend.

On the in-store pick-up side, more than 90% of our pick-up orders are ready within 15 minutes, which is a steady 40 percentage point improvement compared with August 2007. Clearly the percentage of orders ready in 24 minutes, which is our guaranteed time, is even higher. The accessory attachment rate has also improved significantly. On both measures, we are now consistent with our performance this time last year.

We are also becoming more operationally sound. We mentioned the pick-up in shrink we saw in the fourth quarter, which we are attacking. Regarding shrink, we have implemented targeted controls and improved staffing. Our goal remains to return to historic levels of performance. As an example, our in-store cycle count compliance and accuracy has seen good improvement, which allows us to quickly identify and better control potential shrink issues, should they arise.

So what does this all mean to the customer? The customer will be greeted and we will see a more attentive store workforce. Checkout will be quicker. The floor will be cleaner, better stocked, well signed, and generally easier to shop. The experience of home entertainment will be upgraded and will focus on multi-channel advantages and end-to-end solutions.

We will continue to improve our team as well. Mark Overgard joined Circuit City in May. Mark has more than 20 years experience in retail sales leadership. He will partner with Mark [Grayling] to oversee the Circuit City stores, Mark on the sales side of [EVREPs] and building the top line profitably, and Mark on the operations side to ensure operational excellence and expense control. We are excited to welcome Mark and look forward to his impact on rebuilding our selling culture.

Let me sum up our actions before I turn the call over to Bruce. We [planned] the work down to the individual store levels and now we are working on the plan. Focusing on fewer priorities this year creates fewer distractions so that we can replicate the greatly improved customer experience across all stores and product categories. Primarily, we will concentrate on our key store initiatives, minimize distractions and revisions, maximize drive times, and work to attract and retain the right people for our entire organization. We will focus on consistency with incremental improvements. We will deliver an improved in-store customer experience that supports significantly improved financial performance.

I am confident that we will see further traction on our execution initiatives in the second quarter with more visible contribution in the second half.

I want to thank our store teams for the great progress that they have made and their efforts to deliver improved customer experience, store standards, and top line improvements.

With that, I would like to turn the call over to Bruce Besanko, our Chief Financial Officer.

Bruce H. Besanko

Thanks, John and good morning, everyone. I would like to cover three areas; first I will review our first quarter financial performance, including analysis of the trends we saw in the quarter; second, I will update you on some recent corporate actions; and third, I will update you on some of the financial plans for fiscal 2009. Let me begin with a review of the financial performance of the first quarter, starting first with the income statement.

Net sales decreased 7.4% to $2.3 billion. Domestic segment sales declined 8.8% to $2.17 billion. Domestic sales decline was primarily driven by our comp store sales decline of 12.2%.

Let me provide more color around our domestic comp store sales trends. First from a product perspective, the category with by far the largest sales growth is large LCD televisions. Video-gaming products and analog-to-digital converter boxes also grew. All of these categories are within our home entertainment area.

We had broad-based weakness across most other categories, including other television technologies, information technology, audio, and music and movies.

Services anniversaried a very strong first quarter last year when we featured a strong home theater bundle offer and the launch of Vista.

We saw continued weakness across all regions of the country, though the strongest comp declines continued to be in Florida and California, and joined by Rocky Mountain. Similar to the prior quarter, the Northeast performed relatively better than the other regions.

As it relates to traffic, ticket, and close, because there’s a lot of seasonality to these metrics, we evaluate them on a monthly and quarterly basis as a percentage to last year. I’ll speak first about our store metrics.

Our first quarter average ticket was basically flat to last year. First quarter traffic declined from the prior year but the gap was much narrower than in the prior quarter. Trend-wise, March and May were stronger while April was weaker. We continue to believe that trends are primarily being driven by macroeconomic conditions, as well as a continued industry-wide decline in packaged media, which has historically been a traffic driver for us.

Close rate was down compared to the prior year but encouragingly, first quarter continued the fiscal 2008 fourth quarter improvement. May was the best month of the quarter and was nearly flat to last year. While it’s too early to know whether that trend will continue, we are encouraged that our efforts are starting to show some traction. Close rate is obviously one of the key metrics to measure execution and one we are intensely focused on.

For Circuit City Direct, increased traffic continues to be the primary driver of our sales growth. Average ticket declined on a year-over-year basis for the quarter.

Turning to our international segment, sales increased 23.6%, primarily reflecting the favorable impact of foreign currency exchange rates and a comparable store sales increase of 10.5% in local currency, partially offset by the impact of 25 net store closings in the last year.

Consolidated gross profit margin declined by 174 basis points from last year. Domestic segment gross margin declined 186 basis points. The decrease was primarily driven by a decrease in product margins. We saw negative mix shifts with imaging and notebook computers. Also for notebook computers, we had clearance activities, as well as an increase in the mix of sales of notebook computers.

Also contributing to the gross profit margin decrease was a decrease in extended warranty net sales. As we noted in today’s release, the year-over-year change in the gross margin rate was the smallest decline in five quarters, as we saw improved performance in the television category, primarily driven by assortment and promotional mix shifts within the category, as well as better retail execution. An increase in shrink also contributed to the gross margin decline. In the first quarter, we continued to book our shrink estimate at the same rate we realized for fiscal 2008. We will do so until we conduct physical inventory counts and as you know, reducing shrink is a major initiative for us.

International segment gross profit margins decreased 337 basis points. The decline resulted from an increased mix of sales from clearance product across many categories, as well as a mix shift from higher margin categories.

We continue to work on improving gross margins through optimizing our assortments, decreasing our markdowns, improving our pricing policies, and improving our advertising effectiveness.

In the first quarter, we saw some initial benefits, primarily from increased levels of sourcing, improved pricing governance, and reduced open box discount. We expect the contributions to build through the year as we fully implement the initiatives.

Consolidated SG&A expenses as a percentage of sales increased 573 basis points. The domestic segment’s expense-to-sales ratio increased 162 basis points compared with last year. The increase primarily reflects the overall deleveraging impact of lower sales as expenses were down in dollars. We had higher expenses related to new and relocated stores that increased by 124 basis points.

Partially offsetting these increases was a decrease of 81 basis points in compensation costs that resulted primarily from our expense reduction initiatives. We are pleased with the tight expense management and expect it to continue into the next quarter.

The international segment’s first quarter SG&A expense to sales ratio increased 171 basis points. In last year’s first quarter, we had a $7.5 million recovery that benefited the quarter. Excluding that, the expense ratio would have decreased as we did a great job of controlling expenses in the quarter.

For the quarter, we had a consolidated loss from continuing operations before taxes of $161.8 million compared to $82 million in the prior year. This performance was better than our guidance, due to better-than-planned expense controls. The net loss from continuing operations for the first quarter was $1 per share compared with $0.33 per share last year.

Now, turning to the balance sheet, between our current cash balance and the funding available to us through the amended credit facilities, we believe we have sufficient liquidity to sustain our multi-quarter turnaround plan. Cash, cash equivalents, and short-term investments were $92.2 million at quarter end. As compared to the same period last year, cash declined by $271.9 million, principally driven by purchases of PP&E, as well as cash used in operating activities.

We ended the quarter with $55 million in borrowings under our amended credit facility. This was less than we had originally planned. We expect to borrow as we build inventory for the holiday selling season, but by the end of the third quarter we should not have any borrowings against the facility except for the usual third quarter short-term borrowings for InterTAN.

In addition to the availability under the asset-backed facility, we expect to generate approximately $80 million in cash from a cash refund in the third quarter. Finally, with respect to InterTAN, while the board has not determined a course of action, the sale of InterTAN could add to our cash balances at the close of this year.

Consolidated merchandise inventory declined 3.4% from last year. Let me provide some details about our domestic segment inventories. They declined 5.7% even including the addition of 44 net new superstores.

Considering our sales decline and the weak economy, our team did a super job of keeping inventory levels in check. We are buying to trend, focusing on key items and carefully managing older inventories to clear them out in the most productive way.

In March, our in-stock levels jumped a bit as we carefully managed through some fiscal year-end product transitions. Our in-stocks have rebounded to a level that is improved over the prior year. Net owned inventory decreased nearly $84 million for the domestic segment and we are on track to deliver our annual net owned inventory reduction goal of $50 million to $100 million.

Let me touch on a couple of corporate actions now. While the asset-backed credit facility contained no financial covenants, we felt that if the company expects to borrow against the facility, that it makes sense to suspend our quarterly dividend. The company has taken a series of actions to maximize our cash position, including reducing its capital expenditure and raising the return on invested capital hurdle for all projects, and the board felt that it was appropriate to take that same approach to the dividend.

Next, as you may have seen, we filed a shelf registration statement with the SEC this morning. This filing will give us greater flexibility to respond to opportunities as they arise during our ongoing review of strategic alternatives. Please note that the filing does not indicate that the board has determined any course of action at this point.

Turning to the outlook, let me remind you of our financial guiding principles here in the company. First, we are focused on maximizing earnings before taxes, generating positive cash flow, and finally keeping investments focused with an increased return on invested capital hurdle rate to support our growth and maintain a heightened governance over capital, SG&A, and headcount spend. More specifically, for fiscal 2009, we still expect to deliver an improved pretax loss as a percentage of sales of 50 to 100 basis points compared with fiscal year 2008.

As a reminder, the domestic segment will incur no income tax expense or benefit in fiscal 2009 due to the company’s tax valuation allowance. Based on the current macro environment and current business trends, we expect our second quarter loss before income taxes to be slightly larger than our first quarter loss, due primarily to about $10 million in incremental pre-opening expenses related to new store openings and lease termination costs related to relocations.

We expect significant year-over-year improvement in loss before income taxes in the third quarter and an even more significant improvement in earnings before tax in the fourth quarter.

Let me provide some examples of why we have confidence in our improved second half outlook. First, our relentless focus on expense reductions and controls will continue to provide benefits for the balance of the year. Even more importantly, our stores’ close rates, probably our best proxy for in-store execution, continue to improve. Last year the close rate declined throughout the year, until we hit bottom in the third quarter. But the upward trend that we started in the fourth quarter of fiscal 2008 continued in this year’s first quarter.

Looking at the close rates sequentially since January 2008, the close rate has improved in three of the last four months and is up more than 10% over that period of time. Supported by training, strong management and financial incentives, we confidence that the close rate will continue to improve and allow us to achieve one of the key drivers of our financial guidance. This optimism is tempered by our concern about the weak traffic patterns, which we believe is symptomatic of a weaker economy and a shift away from packaged media.

We’ve built what we believe to be an appropriate level of conservatism into our forecast. John Harlow and the field organizations are creating a better performing sales team, so when the economic headwinds do subside, Circuit City will be in a great position to maximize results.

By the second half, our turnaround and store operating initiatives will have a more meaningful and positive impact on the business, having had more time to take effect. Beating first quarter’s estimates shows the positive impact that even a modest improvement in the operating initiatives can have on our financial results. We will also anniversary the disruption created from the implementation of these strategies last year.

Longer term, we believe our strategies position us for profitability and sustained growth.

Now I would like to turn the call back to Phil for his closing remarks.

Philip J. Schoonover

Thanks, Bruce. This was a quarter of steady progress. We are maintaining our focus despite issues during the quarter that could have distracted the team from achieving our goals. But we kept the amount changed to a focused minimum and stayed true to our plan and we are seeing them take hold.

We still have a long way to go but I am encouraged by what we’ve been able to accomplish in the quarter. In short, we are building a new Circuit City that will be much stronger when economic headwinds subside. Bill.

Bill Cimino

Thanks, Phil. As a reminder, we want to address as many questions as we can on the call, so pleased try to limit yourself to one question and one follow-up. We appreciate your cooperation in this matter. And with that, we’d like to open the call up to your questions. Operator.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Matt Fassler with Goldman Sachs.

Matthew Fassler - Goldman Sachs

I just want to ask you a couple of questions that revolve around capital structure -- consider it one question with a couple of components if we need to. Just very briefly, the role of the shelf and kind of why it [fouled out] and what role it could play over the course of the year. And then I guess related to that, you did dip into the line a bit. How deeply in would you expect to get with the profit forecast that you’ve laid out there?

Bruce H. Besanko

Here’s what I can tell you about the shelf registration; first, it’s a universal shelf, so it gives us great flexibility. It’s otherwise a very straightforward vanilla registration and as we previously disclosed, our board has authorized the management team to consider all strategic alternatives, which is exactly what we are doing with the universal shelf. It gives us maximum flexibility to respond to any strategic alternative that might arise, and as you know, the review continues and the board has not determined any course of action at this point.

As it relates to the cash balance and borrowings throughout the rest of the year, let me just refresh everyone. So we ended the quarter with $92 million of cash and short-term investments and $55 million in short-term borrowings against our $1.3 billion asset-backed facility. We expect modest double-digit borrowings again in the second quarter, just like in the first, and to have no borrowings by the end of the third quarter.

And we have further support of our liquidity through the $1.3 billion asset backed facility, which has no financial covenants. We expect to receive an $80 million income tax refund over the course of the back half of the year. We are on track to take out another $50 million to $100 million of net-owned inventory, of which 84 is already out here in the first quarter. We’ve eliminated the dividend, which this year will conserve about $20 million in cash and $26 million annually, and we’ve reduced our capital expenditures this year by close to 40% to 50%, or over $100 million.

So from that perspective, our liquidity is more than sound and more than sustainable for the turnaround plan.

Matthew Fassler - Goldman Sachs

Just to follow-up in terms of how you could deploy, just to kind of game it out -- is it a component of a poison pill strategy or would it be an alternative to seeking a sale of a piece of the company just to raise capital, even [if you have] a tough price?

Bruce H. Besanko

It’s less about a governance issue and more the latter.

Matthew Fassler - Goldman Sachs

Thanks so much.

Operator

Your next question comes from the line of Christopher Horvers with J.P. Morgan.

Christopher Horvers - J.P. Morgan

Good morning. Firstly, could you talk about your guidance and what you thought you saw as a lift from the stimulus checks and why you would think you could -- you show a lesser loss in the third quarter year over year? And then secondly, if you look in the SG&A detail, it seems like you cut back on store expenses, more significantly why we saw a rise in the overall G&A expense. So I’m just trying to compare that to your overall focus on customer service and re-engaging the workforce. Thank you.

Bruce H. Besanko

Let me answer the first part of the question on sort of the economy and what we are thinking about from an outlook perspective. I will also comment briefly on SG&A and then maybe John Harlow can talk a little bit about what we are doing in terms of the specific store activities as it relates to cost.

So the economy is tough. It’s not helping us right now but there’s at least two pieces of good news that I’d say. First, we’re in a solid growing industry, despite the economic headwinds, the CEA -- that’s the consumer electronics association -- is still forecasting a mid-single-digit growth this year.

Second, and as we’ve said previously, our issues are less about the macro environment, although it is affecting us, particularly in traffic. And it’s more about remediating the self-induced issues that we incurred last year. Those issues that we face are all fixable by us. And we are doing that. We are rebuilding our retail selling culture, as John Harlow had provided, as evidenced by the improvements in our close rates, our customer first scores, and our third-party mystery shop scores. We are fixing gross margin as evidenced by the improvements in our higher gross margin attachments. And as we said, Q1 saw the smallest decline in five quarters in our gross margin rate.

We are getting our disciplines back in inventory shrink and store initiated markdowns. Our compliance on shrink related activities, which will help our gross profit, have increased each month for the past four months and we beat our internal target in markdowns in Q1. And finally, as you noted, we’ve had great controls in terms of our expense structure, which is helping our bottom line performance.

As it relates specifically then to your question around the stimulus checks, we did see improvement in an overall weaker economy the first half. We saw some improvement, particularly in the latter part of April and running through May. We attribute that performance increase in part to the work that we’ve done and that John’s done with the field teams in terms of improving our store environment and customer service, and in combination with the tax stimulus checks. I’m sure that’s helped as well.

So from an outlook perspective, given all the work that we are doing and the traction that we expect to get, we are comfortable maintaining the guidance that we earlier talked about.

So then on to the second part of your question around SG&A, let me just kind of frame up where we’ve been on our journey with SG&A. Last year we reacted to compressing gross margins by developing plans to take out about $150 million of expenses in fiscal 2008, and we did that. We achieved actually more than that by about $50 million. We achieved $203 million in cost take-out versus our target. About half of that was store related and field related and the other half was in our corporate centers.

It’s important to realize that some of those costs were reinvested in our IT systems, such as our new point of sale system, as well as the growth initiatives that we have in consumer direct and our Firedog services.

All that said, the key elements of -- the key drivers of the savings this time around were the anniversarying -- we haven’t anniversaried all the cost take-out from last year. And second, we had tighter expense management throughout the company but including the corporate centers, such as the headcount and consulting spend. And so John, if you want to talk a little bit about some of the work that you’ve done around the store areas.

John T. Harlow

Sure. I think that, just to cover this in two parts, the reason I am so optimistic about the go-forward for Q2 and Q3, I think Bruce touched on how the consumer, how the work that we are doing on the top line and rebuilding the selling culture is resonating with the consumer. But frankly, the traction that we are seeing sequentially each month on a broad base of metrics, whether it’s close rate, attach, fundamentally improving our margin rate and better merchandising and having better in-stock in the store shows me that we will continue to see that trend improve, even with traffic that may be softer. So I think that’s all positive.

And as it relates to the store piece, candidly the numbers are better but they are not through reductions -- they are actually through better productivity levels behind the scenes at the store. I think I mentioned on earlier calls and this call as well that every store has built a specific plan to drive their behind-the-scenes and selling productivity, and that’s actually what’s given us the ability to improve the top line metrics, the customer satisfaction metric, as well as bring our SG&A or store labor productivity up, which is giving us some of the benefit that we are seeing today. That’s also coupled with measures that we have built in from our supply chain to better support the stores and workload planning from this building. I mentioned during the introductory comments that aligning this building and our supply chain to the stores is just giving us even better efficiencies to not only free up time to drive the selling side of the business, most importantly, but also to allow productivity at store level to continue to improve, and that will ramp up.

Christopher Horvers - J.P. Morgan

Just to clarify then, Bruce, perhaps you could say what drove the increase in G&A expense year over year?

Bruce H. Besanko

Well, we have a particular contract and one associated with our information technologies that began more toward the middle of the year rather than the beginning of the year, and so because we haven’t anniversaried that, you’d see an increase in G&A.

Philip J. Schoonover

Bruce, how much of that is new store openings?

Bruce H. Besanko

And that’s another piece of it, is that we do have some new store openings this year and that’s probably a double-digit millions of dollars of G&A expense.

Christopher Horvers - J.P. Morgan

Okay. That’s very helpful.

Philip J. Schoonover

Just one last thing -- on a go-forward basis, as I think you’ve seen, the first quarter is certainly the most difficult quarter on the two-year comps for us and so as we go through the year, the ability to sustain and build versus an area where we had slipped last year, we see that as being another level of our ability to deliver for Q2 and beyond.

Christopher Horvers - J.P. Morgan

Thanks very much.

Bill Cimino

Thanks, Chris. Operator, we’re ready for the next caller, please.

Operator

Your next question comes from the line of Michael Baker with Deutsche Bank.

Michael Baker - Deutsche Bank

Thanks, guys. So my question is just on the overall industry and what you are seeing on TVs. It sounds like TVs remain pretty strong, up high-single-digits. What does the supply in the market look like in terms of manufacturing? Or are you seeing more TVs come online in front of potential or hope for demand for the Olympics or anything along those lines? And then what could that mean for pricing and margins in the back half of the year for flat panel TVs?

John J. Kelly

I continue to see increased interest in flat panel, specifically large flat panel televisions, and in better technology, such as 1080 and 120 hertz, as well as plasma. So we are very bullish and optimistic about A, supply, we think the supply will be adequate and it will be in line with industry forecasts. And we continue to see consumer demand and consumer desire to purchase these products actually increasing as we go through the year with the Olympics and the holiday season coming, and the conversion to digital next February.

Michael Baker - Deutsche Bank

So you were up high-single-digits this quarter, which is a good number. I think it is down from the fourth quarter though but you expect that that increases through the year, partly because of the Olympics?

John J. Kelly

Yeah, and the holiday season. I consider the plan very doable and we are optimistic about what’s happening in this business.

John T. Harlow

The other piece of that I think it’s important to talk to is, as I mentioned earlier, the changes that we’ve made to fundamentally change how our home entertainment department delivers against not only the vision but to build the top line, all the changes related to management, supervision, training, and fundamentally the team-based incentives that I mentioned are -- we actually see that as being additive to the merchandising trends that are out there.

Michael Baker - Deutsche Bank

So market share, you guys think you can take back some market share because your in-store improved performance?

John T. Harlow

Yes, we do.

Michael Baker - Deutsche Bank

Okay.

Bill Cimino

And that was first John Kelly and then John Harlow on the call there.

Michael Baker - Deutsche Bank

All right. Thanks, Bill.

Bill Cimino

No problem. Operator, I think we’re ready for the next caller, please.

Operator

Your next question comes from the line of Michael Lasser with Lehman Brothers.

Michael Lasser - Lehman Brothers

It sounds like a lot of the focus has been on the in-store experience and you are pleased with some of the gains that you’ve made there with improving the close rate and the like. Can you talk a bit more about what you are doing to improve traffic and the draw rate? Because perhaps some of the improvements that you are witnessing are due to the declines in traffic and you are losing, you are moving closer to a core group of customers and as you lose out on some of those folks that have a lower propensity to purchase, that would cause the close rate to increase. So perhaps you could talk a little bit about the traffic.

John J. Kelly

Some of the things that we are doing to improve traffic in addition, we obviously had been using our movies and music departments to drive traffic. Now we’ve moved into some of the more commodity type of products, such as Flash media and other types of media, product-centric and PC accessories to drive traffic. You are seeing demand for that type of product as prices come down and it begins to [commodicize] the ability for us to use those products as traffic drivers, and use them out in front, the front covers and back covers of our task to drive people into the building to purchase these products, and we can use that to offset what we see as a decline in music and movies.

John T. Harlow

I think our plans and strategies this year focus on close rate and basket attach, and we expect in a tougher economy with declining industry trends in packaged media to actually see less traffic.

We mentioned a couple of times that our first quarter was our toughest comp. It was also our toughest traffic comp for the year last year, and we have aggressive promotional calendars throughout the year around all the holiday drive times, beginning with back-to-school later this summer.

But bottom line here is most of the changes we’ve made are in the home entertainment side of our store. That’s roughly half of our company’s revenue and more than half the company’s profit. We are focused on optimizing those customers from a revenue standpoint and from a profit standpoint.

Michael Lasser - Lehman Brothers

Okay, and as a real quick --

John T. Harlow

The other two drivers of traffic, obviously any Firedog services growth is virtually 100% comp store growth. I think we do very little outside of comp store, and then the web business drives traffic to our stores. And we had a disappointing performance in our web business. It wasn’t without some forethought. We left some computer business on the table intentionally that we just couldn’t see a way to make money on and there are some strategies as we move forward in the year to get our web business back up to historical comp rates. That is -- 50% of that web traffic ends up in our stores.

Michael Lasser - Lehman Brothers

Okay, and a real quick follow-up on the CapEx guidance; it was reduced by $10 million, but yet the store count for new store openings has not changed. Perhaps you can rectify where the difference is coming from?

Bruce H. Besanko

With respect to CapEx, we did take down our CapEx guidance. The reason for that is two-fold; we’ve been able to find efficiencies from a construction cost perspective in our real estate, which obviously helps and is accretive to our new store economics. And secondly, we are just being more prudent in terms of our overall capital expenditures in other areas of the business, including information technologies and other areas of the company.

So that said, we are committed to the profitable growth that we’ve outlined and our strategic pillars, including real estate, and so that’s the reason.

Michael Lasser - Lehman Brothers

Thanks and good luck.

Bill Cimino

Thanks. Operator, we’re ready for the next caller, please.

Operator

Your next question comes from the line of Scott Ciccarelli with RBC Capital Markets.

Scott Ciccarelli - RBC Capital Markets

I have a follow-up on the flat panel question; can you guys give us your outlook regarding pricing and margins in the second half, as capacity comes online? What do you think -- how do you think that’s going to play out in the second half here?

John J. Kelly

We are positioning ourselves to take advantage of just about any pricing or over-supply that the market has. Our inventories are really in line with being able to take advantage of that and our selling team is in line with being able to take advantage fully of that. We are nimble from an advertising perspective of being able to change ads. So no matter what happens from an industry standpoint, we are prepared to act quickly and move quickly on any opportunistic purchases that could occur due to an over-supply in the industry.

Scott Ciccarelli - RBC Capital Markets

So are you expecting an over-supply?

John J. Kelly

It’s possible. I don’t want to comment on what I expect, but we are preparing for any activity that could occur in that industry.

Scott Ciccarelli - RBC Capital Markets

But how do you manage that? I mean, obviously if you have pricing coming down, margins probably coming down, how do you manage that and still manage a second half rebound? I’m just trying to understand that better.

John J. Kelly

Well, we manage it through the proper inventory control and making sure that we are liquid so we can take advantage of those type of things.

Scott Ciccarelli - RBC Capital Markets

Okay.

Bruce H. Besanko

I would just add to that, Scott, that again the issues that we face are less about the broader macro environment and really the -- anything having to do with CE dynamics. We have sufficient traffic if we can close on it. We have sufficient opportunity in terms of gross margin, regardless of whether there may be an over-supply or an under-supply of televisions. There’s just lots of opportunity here for us to improve our performance here in the back-half, despite what may occur, either macro or from a CE perspective.

John T. Harlow

I would just like to add from the store perspective, obviously the value of making sure we continue to make progress on rebuilding the selling culture is the traffic that might be generated through margin changes in the business, we’re positioned through better attach, better close to offset and build on that margin. And so the team-based incentives and the work that’s been done Q1, Q2 well positions us to attach and build the profitability of the transactions, even if there’s some movement on the margin on the initial purchase.

Scott Ciccarelli - RBC Capital Markets

All right. Thank you.

Bill Cimino

Thanks, Scott. Operator, we’re ready for the next question, please.

Operator

Your next question comes from the line of Bill Armstrong with C.L. King & Associates.

Bill Armstrong - C.L. King & Associates

Good morning. So I guess I’m wondering, how do you improve your attachment rates going forward? What -- how are you going to be able to do that?

John T. Harlow

The selling culture discussion that we’ve been having most of the morning is how we do that. Some of the tools that I think I mentioned during the opening remarks, we’ve provided very specific in-store training as well as vendor training on products and frankly, coupling that with -- we have actually very specific performance tracking by associate. We work with every associate to not only continue to build their proficiency, to talk to them about where there may be gaps on how they attach and how they sell to customers, whether it’s services or accessories. We have very specific conversations around that, as well as on the merchandising end, we are collaborating to make sure that we sell bundles more effectively than we have in the past.

So adding all of that up allows us to not only sell more effectively but merchandise in a way that gets attach more rapidly than we have historically.

Philip J. Schoonover

John, do you want to talk about gap management at all and where we have stores that are performing well above the company average?

John T. Harlow

Sure. What we’ve done in terms of the management of not only the selling process but all the practices in our stores, we gap manage our stores in quartile, and so on a monthly basis we look at the top performing first and second quartile stores, and then roll those practices into the lower performing stores across the company. That not only gives us sustainability and improvement quarter over quarter but it allows the lower performing stores to try and implement new practices that will build attach, build margin, and build basket.

Bill Armstrong - C.L. King & Associates

And how will the team bonus build performance?

John T. Harlow

The team bonus that was put in place, we tried it in 50 stores and we actually saw a pretty significant improvement in not only the sales gross margin but basket, and so what we found is that the top performers who can earn anywhere from 25% to 40% higher levels of personal earnings by selling and attaching more effectively are also charged with training players who are either newer and bringing the bottom quartile sales teams to a different level.

So we are seeing performance in attach improving also by managing the performance on the team-based incentives in every store, and that’s now at scale across all stores.

Bill Armstrong - C.L. King & Associates

When was this incentive plan put in place?

John T. Harlow

June 1st. It was tested throughout the first quarter and gave us such immediate traction that we’ve rolled it to the chain and it’s again now in place, and we see that building through second quarter and third, frankly in great time for not only back-to-school but holiday selling.

Bruce H. Besanko

And Bill, just to add on to what John was saying, so just from an -- our biggest attachments come from the home entertainment area, and as John had indicated in his prepared remarks, we have a dedicated HE supervisor in all our stores now. We have a dedicated sales manager in our top 200 home entertainment sales stores. We have the team-based incentive that’s positioned around gross margin. We have increased -- in fact, we’ve quadrupled the level of sales training this year versus prior year. And so all of that together, particularly in the HE area where we have the highest levels of dollars associated with attachments, we feel will gain us traction here in the second half.

Bill Armstrong - C.L. King & Associates

So do you think we should see that attachment rate, that percentage rate starting to increase on a year-over-year basis, either in Q2 or in the second half of the year?

Bruce H. Besanko

We’ve actually seen some of the attachments already increase year over year, as John had alluded to -- and John, you can talk about this some more, but we have quartiled our stores and look at how they perform. We have half of our store base that have levels that are above prior year. And our home theater installation in Firedog, we’ve achieved over prior year’s and in fact over fiscal ‘07’s levels, which were even higher in several of the last -- in a few of the last several quarters here. So we are actually starting to do that already.

John T. Harlow

The sequential improvement that we’ve seen is showing us that we will be on track for Q2 and in the second half of the year, we’ll -- the traction continuing at the pace that it is today puts us in a place where by second half of the year, we are actually ahead of LY.

John J. Kelly

And to add to this is we are seeing sales of better merchandise and higher brands and better brands with this product. That’s allowing a basket -- those products tend to attach with a better basket, so the basket is actually higher when you sell the higher-end products. And we are seeing the consultants selling a higher-end product with this incentive.

Bill Cimino

Great, thanks, and Operator, we’re ready for the next call, please.

Operator

Your next question comes from the line of Gregory Melich with Morgan Stanley.

Gregory Melich - Morgan Stanley

A question on the attachments and warranties, I just want to make sure I’m getting this right; so the warranties and the service revenues from Firedog were both down more than total sales, but attachments were starting to at least improve sequentially. What’s the pricing strategy in the attachments? Has that changed? Is that why you might be seeing a higher rate versus what we are seeing dollars?

John T. Harlow

I’m sorry, Greg, are you talking about the pricing of the warranty itself or the attachments? I’m not sure which one you are referring to there.

Gregory Melich - Morgan Stanley

Either one. So basically whether it’s Firedog or warranties, have you changed your pricing strategy for those products?

Bruce H. Besanko

I’ll take that and then perhaps someone can add on, but with respect to the warranty pricing, just to refresh everyone, we made some changes in our pricing last summer. We took our price point down in the months of -- in the month of July and then took it back up slightly in the month of August and then later in the month of October. The two price increases in August and in October were not nearly to the levels of the original price but were up from where we had adjusted it in July.

As a consequence of that, as we look at unit attachments on our warranty programs, particularly for televisions, we are actually -- our unit penetration, that is, the ability to attach a warranty program given that new price structure to a television purchase is up versus prior year and it’s been up for most of the first quarter.

As it relates to Firedog pricing, I don’t believe we’ve had any meaningful or material changes in our Firedog prices.

Gregory Melich - Morgan Stanley

Okay, great. And then a follow-up on the capital structure -- Bruce, you mentioned the $55 million and by the end of the third quarter, you would expect that to be gone. During the quarter, what’s the working capital build need that you might take it up above that for some time?

Bruce H. Besanko

Yeah, we’ve not shared that. What I would tell you though is that our typical working capital peak is in the third quarter, typically in the -- sort of in the middle of the third quarter, sort of early to middle portion of the third quarter, which is pretty typical for a seasonal business like ours. Our borrowings are going to be certainly in the triple-digits, like they were last year during that peak. But as I said, we will have had -- we expect to have a zero balance by the end of the third quarter.

Gregory Melich - Morgan Stanley

Great. Thanks.

Bill Cimino

Thanks, Greg. Operator, I think we have time for one more call, please.

Operator

Yes, and your next question comes from the line of Dan Binder with Jefferies.

Dan Binder - Jefferies & Company

I was just wondering if you can just go back to the change in the -- what sounds like a hybrid compensation model for the home entertainment part of the store. Can you give us, in the 50 stores that you did test, any color around the improvement in comp-store sales, margin rate, the average employee increase in wages, close rates, things like that?

John T. Harlow

What I would say to you is that what we saw, and I won’t go into specific numbers in terms of the improvement, but it was significant enough over control groups that we believe that it would create enough margin impact to allow us to sustain not only the sales opportunity and the sales traction that we’ve seen year-to-date, but allow us to create up-side in the back-half of the year. And so rather than going into all of the specifics, the movement was as one would suspect in a 50-store test versus control. It had to be pretty significant for us to move in a 90-day timeframe to roll it to scale.

Dan Binder - Jefferies & Company

When you say upside --

Philip J. Schoonover

Also, you’re familiar with the company’s efforts in road shop. This is a very similar program to the program we’ve had in effect for a number of years in road shop, so we had the analog of team-based incentives in the company and then we had the coupling of poor performance last fall. This compensation program as well as the training and other activities has improved the home theater performance enough that we felt that this was a good direction for the company to go.

John T. Harlow

And the team-based component of it is creating a level of collaboration and it’s turned out to be very much customer-friendly as well as sales and financially friendly, so that’s why we’ve moved forward with it. And to Phil’s point, it’s not -- it’s fundamental change in the home entertainment department but it is similar to things we’ve done elsewhere in the company to build top line traction.

Dan Binder - Jefferies & Company

When you say upside in the back-half, you mean upside to your plan or upside to get to your plan?

John T. Harlow

Upside to get to our plan.

Dan Binder - Jefferies & Company

To get to your plan -- can we get an update on the POS systems? And then I was also wondering if you’d be willing to share the comp store sales by month for this quarter?

John T. Harlow

Sure. As it relates to the POS system, I think you know we’ve chosen to move at a deliberate pace on this to make sure that we minimize the disruption at the store level, and so we’ve continued to make sure that not only the POS but the back of the house work that’s done on the POS system is on-course. So to date, our plan is to continue to implement it in new stores and to continue to refine it in a group of stores. We are at about 200 stores today and then we will add a group more in the third quarter and the plan will be in the first half of next year to complete the chain, once we are satisfied that all of the -- not only the integration work but the infrastructure work is where we need it to be for scale.

As it relates to MST, we continue to be optimistic. The work, where we’ve gone so far with MST is we are actually in the later stages of implementation. We are about 80% of the way through and the work on the benefits from assortment and margin that we anticipated getting are taking hold at this point and the replenishment modules and core systems will be put in place over the next six to 12 months.

Bruce H. Besanko

As it relates to your second question around monthly comps, we’re not prepared to give you those at this point but what I would tell you is that in the early part of the quarter, about the first half of the quarter we saw comps that were similar to what we saw in the fourth quarter, and as I said earlier in the back half of April and moving in through May, there was a substantial change. We attribute that change in part to the traction that we are getting from our initiatives that John Harlow has outlined, but also the rebate checks. And so the comps as a consequence of that in May were better than the earlier trend.

Bill Cimino

Great. Thanks, Bruce and thanks, Dan, and thanks to everyone else 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 noon today and will remain available through June 26th. 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 48433262. A replay of the call will also be available on the Circuit City investor homepage at investor.circuitcity.com. This concludes our call and thank you.

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