Circuit City Stores, Inc. F4Q06 (Qtr Ending Feb 28, 2006) Earnings Conference Call Transcript (CC)

| About: Circuit City (CCTYQ)

Circuit City Stores, Inc. (NYSE:CC)

F4Q06 Earnings Conference Call

April 12, 2006, 11:00 a.m. EST

Executives

Bill Cimino - Director, Corporate Communications

Phil Shoonover - President & CEO

Doug Moore - Chief Merchandising Officer

Mike Foss - CFO

Fiona Dias - EVP

Analysts

Matthew Fassler - Goldman Sachs

Daniel Binder - Buckingham Research

Rex Henderson - Buckingham Research

Chris Horvers - Bear Stearns

Colin McGranahan - Sanford Bernstein

Steve Chick - J.P. Morgan

Alan Rifkin - Lehman Brothers

Mike Baker - Deutsche Bank

Operator

At this time I would like to welcome everyone to the Circuit City fourth quarter and fiscal year results conference call. (Operator Instructions) I will now turn the call over to Mr. Bill Cimino, Director of Corporate Communications of Circuit City Stores Inc. Sir, you may begin your conference.

Bill Cimino

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

Let me also make sure that we have a common understanding of some of the terms we will be using. For the purposes of this call, when we refer to earnings or earnings per share, we are referring to continuing operations unless otherwise noted. Earnings before taxes, or EBT, refers to earnings from continuing operations before income taxes. This is a profitability metric for which we have provided guidance. Finally, net owned inventory refers to the difference between merchandise inventory and merchandise payables.

As we noted in today's press release, we have reclassified some balance sheet items previously recorded in accounts payable in order to make this calculation more meaningful.

Speaking on today's call are Phil Shoonover, our President and Chief Executive Officer, who will review fiscal 2006 performance, discuss the changes in the management team and lay out some of the work for fiscal 2007; Doug Moore, our Chief Merchandising Officer, who will speak about the transformation efforts underway in the merchandising and supply chain organizations; and then Mike Foss, our Chief Financial Officer, who will review our financial performance, provide detailed guidance for FY '07 and give us updates on real estate and the international segment. With that, I will turn the call over to Phil.

Phil Shoonover

Thanks, Bill. Before I address the topics Bill highlighted, let me start by thanking our associates for their continued hard work and dedication. The combined efforts of our 43,000 associates helped Circuit City to deliver recorded fourth quarter sales and a 75% increase in fourth quarter earnings.

For fiscal year 2006, we achieved the top end of the fiscal 2006 EBT goal we set in January of 1.6% to 2.0%. This was 105 basis point improvement over the prior year. Thank you, team.

Today I would like to talk about four topics:

  1. The culture of engagement we're building with our associates.
  2. Our journey to improve our EBT margin.
  3. Our executive team and the initiatives they will lead in fiscal year 2007.
  4. An update on our innovation and strategy work.

A word about engagement. Engagement is the extent to which an associate is fully involved with and enthusiastic about their work. In order to build a culture of engagement, we are leading and managing differently by listening to our customers through our front-line associates and aligning compensation, recognition and rewards with key business outcomes; and, communicating more clearly with our associates so they understand how their work contributes to our strategies, expectations and business goals.

Circuit City's engagement index is primarily defined as a measure of associate satisfaction with Circuit City, a willingness to refer others to work here and a loyalty to staying at Circuit City. Through these efforts, our overall internal engagement score from our most recent survey improved by 22% year-over-year, which showed strong progress against top quartile benchmarks.

This cultural shift sets a firm foundation for future growth as associate engagement is paramount to improving how our customers are served by Circuit City and to increasing our customer loyalty, retention and conversion rates.

Next, I will talk about our journey to improve our EBT margin. The journey towards returning our EBT to respectable levels will take time and a lot of hard work; but looking back at the past three years, we can be proud of our accomplishments.

First, we undertook the difficult but necessary task of aligning our cost and expense structure with sales levels. Mike Foss continues to keep this task at the forefront of our goals. We understand that a company can't increase profitability over the long-term if we do not manage expenses.

Second, over the course of this past year, our gross profit margins stabilized and our sales growth allowed us to leverage our improved expense structure, particularly here in the fourth quarter. The 131% improvement in our earnings shows that our continuing efforts to enhance Circuit City's financial performance are taking hold. While our work is far from complete, we view our fiscal year 2006 EBT margin as the foundation on which to build.

Now looking forward on the journey. We expect fiscal 2007 will be a year of sizable growth in revenues as we capitalize on strong industry sales trends and improved execution. In order to support this future growth, fiscal year 2007 also will be a year of investments in process work, systems upgrade, innovation and in our real estate.

We are committed to a pay-as-you-go approach to investments, so the work underway should drive improvements to the Company's performance this year and beyond. Our expectation is to grow total sales by 7% to 11% and deliver an EBT margin of 2.0% to 2.4%.

Now about our leadership team and their key initiatives. In February we promoted Danny Clark, Fiona Dias, Doug Moore to Executive Vice President. They join Mike Foss and me on the executive leadership team.

Danny Clark, President of our Retail Stores, has been charged with transforming our store operations. In fiscal 2006, Danny focused his efforts on changing the way we lead. As a result of his team's work, we have already seen the power of engaging more than 40,000 associates to solve problems, provide higher levels of customer service and eliminate non-value-added activities.

In fiscal 2007 the bulk of our store efforts will be geared towards building a culture of associate engagement and simplifying store processes to increase the amount of focus that associates have available to devote to serving our customers. The combination of these two efforts should improve the customer experience and yield better execution in our stores.

Here is one quick example of a simplified process we are testing. We have reduced our standard operating procedure, or SOP, for unloading trucks to 21 pages to only two pages. By the way, the new SOP is so simple that it will be painted on the walls of our store warehouses for any new associate to read and understand.

Danny will also head up superstore concept development and scale some of the initial learnings from our Boston and South Florida tests. This work will also impact store openings, remodels and refreshes going forward.

Fiona Dias, Chief Marketing Officer, has been leading the integration of our brand marketing messages. Most of our branding messages revolve around three ways to shop: in our stores, on the Web and over the phone. We have seen the power of multi-channel marketing and building incremental customer traffic for the enterprise. While store traffic has declined slightly, we have experienced strong year-over-year growth in our Web and call center customer traffic.

In fiscal 2007 Fiona and the marketing team will continue to build our portfolio of brands and introduce a new services brand. We expect to unveil this new brand and our services strategy in the second half of this fiscal year.

Doug Moore, Chief Merchandising Officer, who is joining us on the call today, has been on point for continuing the transformation of our merchandising and supply chain organization. We have seen significant improvement in the working relationships with our vendors over the past 18 months and benefited from a portfolio management approach to our products and services.

We have also started the process to upgrade our merchandising systems to best-in-class. In fiscal 2007 the merchandising team will implement the system and processes that provide the capability to version our Sunday newspaper inserts aimed at gross margin enhancement. The supply chain team will focus on reducing net owned inventory and improving customer encountered in stock.

Most of you know Mike Foss, our CFO, who has been instrumental over the past couple of years in our journey to enhance profitability. In addition to his CFO duties, he also has responsibility for the real estate and business development departments.

We have recently expanded Mike's responsibilities to include our InterTAN operation in Canada. We are currently searching for a Senior Operations leader to replace Brian Levy who recently retired. This person will report in to Mike.

We have a strong team in place in Canada. They did a great job rebranding most of the stores last year to The Source by Circuit City. We believe there are significant profit improvement opportunities at InterTAN through implementing some of the transformation work we have done in the U.S.

In addition, we believe that we can leverage our strengths better by building a much tighter working relationship between the various factions at InterTAN and their U.S. counterparts.

Now I have discussed our executive leadership team. I would like to touch on some progress we have made in the areas of innovation we introduced in fiscal year 2006. To remind you, these are win in home entertainment, multi-channel integration and digital home services. Today I will update you on services.

We are very pleased with the progress we have made in PC services and the contribution this business is making to our fiscal year 2006 performance. Circuit City now has more than 1,600 PC service technicians in the U.S.

In addition to offering services in all of our superstores, we also provide in home PC service in more than 20 major markets. For customers who prefer, we offer online PC diagnostic and repair services. This program provides remote technical assistance to customers when and where they need it.

Our Boston and Florida test markets were learning from various offerings for home theater installation. We currently have installers employed by Circuit City in 13 markets to complement the third-party installers in the other markets. We believe that affordable, quality home theater installation is a critical competency for Circuit City to build.

Now I'm going to turn to our longer-term strategy. Last summer we started to develop a five-year plan for our Company's long-term growth. The project was undertaken by a cross-functional team of associates working with senior management aimed at creating a differentiated strategy and for our associates to rally around a sustainable long-term growth strategy for you, our investors and our Company.

The effort of involving associates at all levels of the organization and developing a strategic architecture was groundbreaking for Circuit City. As we begin implementation of this strategic framework, this broad involvement strengthens the feeling of ownership of the strategy. We will introduce more details about our strategic direction in the upcoming analyst conference.

I want to conclude my remarks as I begun, by thanking our associates for their hard work. I'm especially proud of the depth and breadth of our leadership team. As such, on this and future conference calls, I will ask other members of the senior management team to share with you their view of where we are going and where we have been.

Today you will hear from Doug Moore, our Executive Vice President and Chief Merchandising Officer. Doug.

Doug Moore

Thanks, Phil. Before I begin, I wanted to let you know that I have been with Circuit City for almost 16 years, and today I stand more confident in our future than I have ever been.

In my comments today, I will discuss some of the initiatives that we undertook in merchandising and supply chain to stabilize and improve our gross margins. It is important to note that our efforts in merchandising are only part of the solution. The structural improvements would not have taken hold as quickly or as effectively as they did without the great work that Danny Clark accomplished with the retail organization and the work Fiona Dias and her team did in bringing both quality traffic to Circuit City and by creating a winning multi-channel value proposition.

Much of our fiscal 2006 process work focused on utilizing cross- functional teams to improve our ability to make decisions and to drive desired business outcomes. Today I want to touch on five topics:

  1. portfolio management
  2. sourcing
  3. vendor collaboration
  4. inventory management
  5. product trend.

The sales growth and gross margin stabilization we delivered in fiscal 2006 and the gross margin improvement we posted in the fourth quarter are also indicative of portfolio management guiding our asset allocation.

As a reminder, assets include investments in inventory, advertising, promotions, labor, training space and assortment size. Some product and service categories such as flat panel televisions and MP3 players we consider stake in the ground categories. These products command a greater portion of our assets which allow Circuit City to compete at the highest levels in growing and emerging categories.

We have seen triple-digit growth in flat panel televisions and triple or very high double-digit growth in MP3 players every quarter since we implemented these filters. By putting all products and services in this portfolio structure, we have instilled discipline around our investments.

Let me now shift to another framework through which we are making merchandising and supply chain decisions. That is sourcing. When we discuss sourcing, we do not just mean private label products. While we may choose to go direct on some products, we do not intend to focus our resources on having a large selection of private label products in rapidly evolving categories. Branded manufacturers today create tremendous efficiencies and put significant promotional efforts behind new products, and therefore, it does not always make economic sense for the retailer to source directly. The risks can offset the cost benefits, especially for high-tech products.

Our sourcing efforts are focused on best sourcing, as in making the best supply choice at the time of purchase. Before placing a purchase order, we will run several scenarios across multiple vendors, including the options of private label and buying direct to make the best decision. This framework provides a higher probability of making the best business decision.

A third significant merchandising initiative is improved collaboration with our vendors, and we made progress on this front in fiscal 2006. As we have seen our overall sales levels grow and the process improvements take hold, many vendors have come to view us as a more significant retail partner.

We are working with our vendors to improve forecasting, promotions, in stock levels and other performance metrics. The work already accomplished to upgrade our processes will be enhanced in fiscal '07 as we begin to implement the first modules of our merchandise systems transformation.

Let me now share with you my thoughts about forecasting and inventory transition management. We have implemented new processes to better handle the transitions. For instance, we have improved our PC cycle transition since the second quarter last year and we especially saw significant improvement in the fourth quarter. We're holding people accountable for their forecasts and the transitions, and they are building a real competence in this area.

Let me now turn to our current inventory position. At the end of the fourth quarter, our net owned inventory position was $28 million higher than the prior year. Our total inventory position grew for two reasons.

  1. We had significant out of stocks in key product areas as we ended the fourth quarter last year, so our inventory position last year was unusually low. These product shortages carried into part of the first quarter.
  2. Through the portfolio management process I discussed earlier, we have made investments in inventory to support our sales growth and the strong sales so far this quarter both by increasing overall in stock levels and investing more heavily in stake in the ground and growing categories. Our commitment remains to reduce net owned inventory towards zero over time.

Finally, I want to talk about product category trends. We expect the recent strong growth of flat panel televisions, digital imaging, MP3 players and notebook computers to continue for the foreseeable future.

Now that the federal government set the deadline for the analog signal cutoff, we believe that more people will transition sooner to a digital television. This year additional HD content in the form of HD gaming, the launch of Blu-ray and HD DVD players and software will be available. All signs point to continued high consumer demand. Because our sales mix is heavily weighted to video, audio and related products, we are well positioned to take full advantage of this robust product cycle.

Flat panel televisions are also a key driver for our high margin services business as more and more customers will choose to have them installed. A key collaborative effort for our merchandise and retail marketing Circuit City Direct, our services and innovation teams will be to develop a strong home theater installation offering.

So to sum up:

  1. I'm confident that we have built the right merchandise and supply chain team.
  2. We have made progress against our goals, but we know we still have room to improve margin.
  3. We're excited about industry product trends and believe that we are positioned to win.

I look forward to updating you on progress in fiscal 2007, and with that I will turn the call over to Mike Foss.

Mike Foss

Great. Thanks, Doug. I will walk through our fourth quarter and fiscal year performance. In addition, I will cover several other topics, including a recap of our common stock repurchase activity, our financial outlook for fiscal 2007, an update about real estate and a discussion about our Canadian subsidiary, InterTAN, and the changes that have taken place there.

Starting with the income statement, for the quarter net sales increased 12.8% to $3.9 billion driven by strong domestic comparable store sales growth of 12.0%, as well as international comp store sales growth of 3.8% in local currency.

For the fiscal year, total sales increased 10.8% from the prior year to $11.6 billion, and consolidated comp store sales grew 8.2%.

For the quarter consolidated gross profit margin increased 26 basis points. The domestic segment gross margin increased by 56 basis points, primarily driven by two factors.

First, we had reduced markdowns compared with last year as we benefited from our supply chain initiatives to improve our inventory position and better manage product transitions. Second, partially offsetting the benefits were higher promotional financing costs driven by higher interest rates than last year.

In the fourth quarter, the international segment gross margin declined approximately 540 basis points, continuing the same product mix and margin rate trends we have seen for a couple of quarters. For the full fiscal year, consolidated gross margin remained relatively flat at 24.4%.

Moving down the income statement, our fourth quarter consolidated selling, general and administrative expense rate improved more than 200 basis points from fiscal '05. Our domestic segment expense rate improved by 217 basis points. There were a number of puts and takes that netted to this improvement, and they include the following.

First, approximately 132 basis points was driven by a reduction of a number of superstores we closed from 19 in each of the past two fiscal years to one in Q4 of fiscal 2006. Our overall improvement in performance, plus the implementation of lead teams in each region, kept all but one superstore above our hurdle rate for closure.

Second, approximately 72 basis points of the improvement was driven by leveraging payroll and benefits.

Third, approximately 39 basis points of improvement was driven by leveraging rent and occupancy expenses.

Finally, a reduction in relocation expense as we relocated only one store versus six last year, accounted for about 17 basis points of improvement.

Now partially offsetting these improvements was a 61 basis point increase in advertising spend as a percentage of sales.

The international segment SG&A rate improved by 73 basis points in the fourth quarter, driven by leverage on higher sales levels that more than offset increased advertising expenditures.

For the fiscal year, consolidated SG&A improved 122 basis points. The net result for the fourth quarter was net earnings from continuing operations of $147 million, or $0.84 per share, compared with $84 million or $0.44 per share last year.

For the fiscal year, our net earnings from continuing operations improved 131%. During the fourth quarter, we incurred a $7.8 million pretax hit as we reversed an estimate for non-redemption of the rewards feature on the Circuit City Rewards Credit Card. We originally estimated the percentage of redemption based on external benchmark data that ultimately we expect will be predictive of actual results.

Based on current guidance, however, we now believe that we should get gather additional data based on our own program's results before any estimate is recorded. So, at this point, we are assuming 100% redemption of all rewards points. At some point in the future, we will have an update to record an estimate for rewards non-redemption.

Now turning to the balance sheet, at February 28 we had cash, cash equivalents and short-term investments of $838 million, down from $1 billion at February 28 of 2005. The year-over-year change reflects principally the use of $338 million to repurchase common stock during the past four quarters.

Doug spoke earlier about the planned inventory increases that drove up our net owned inventory position at year end. The net capital expenditures for fiscal 2006 totaled approximately $216 million. We spent slightly more in the international segment and on MIS in stores than we had previously planned.

Turning to our stock buyback program, during the fourth quarter, we bought back 1.6 million shares for $40 million for an average cost of $24.40 per share. We have now bought back a total of 47.8 million shares for $683 million or an average cost of $14.27 per share. We have approximately $117 million for future share repurchases under our current board authorization.

Now turning to our outlook for fiscal year '07, we have slightly expanded the elements of our guidance for fiscal '07. This is meant to help you better understand the cash generation capability of the Company during the fiscal year. We provided a full list of fiscal year '07 expectations in this morning's press release. I will cover a few of the topics here.

Total sales growth is expected to be between 7% and 11%, Domestic comp store sales growth between 5% and 7%, and the EBT margin of between 2.0% and 2.4%. Depreciation and amortization of approximately $165 million, which is up from approximately $140 million in fiscal year '06. Capital expenditures net of landlord reimbursements of approximately $280 million.

While we're not giving specific guidance at this point with respect to improvements in net owned inventory for fiscal year '07, we are committed to driving material improvements in net owned inventory over each of the next several years.

In our current quarter, we have continued to see strong sales performance. This leads us to believe that we will have approximately breakeven earnings during the first fiscal quarter.

One quick comment related to our EBT margin guidance. You would normally expect greater profit leverage on a 7% to 11% sales gain than the 0 to 40 basis points year-to-year improvement our EBT margin guidance range provides. We are making significant incremental investments in MIS, innovation and in our direct channel, which is principally the web and call centers. These incremental expenses will negatively affect our fiscal year 2007 EBT margin by approximately 100 basis points. Clearly we expect to mine incremental sales and profit margin from these investments in future years.

Now turning to real estate, we have continued making progress on rebuilding our internal and external real estate teams and building a pipeline to accelerate our real estate revitalization. Just a quick data point showing the effect of the changes.

At our March 2005 real estate committee meeting, three sites were presented for approval and one was approved. This kind of performance was not atypical. One year later at our March 2006 real estate committee meeting, 23 sites were brought for review with a majority being approved after passing our high hurdle for selection. Our current expectation for the April committee meeting is that more than 30 sites will be brought for approval.

As we have discussed in past conference calls, the obstacle to quickly ramping up our real estate openings is that in many cases we are approving store sites that will not be owned for one to three or more years. Even though we are building up our pipeline and sites, we are only seeing modest improvement in the number of fiscal year '07 openings. We would expect more significant growth in fiscal year '08 and beyond.

We have also applied a portfolio filter to our markets, classifying each in terms of relative importance to the Company. In our stake in the ground markets, where it is vitally important that we win, we will make proportionately bigger investments, both in terms of new stores, as well as refreshing existing stores.

We will refresh the exterior and interior for consistent logos, colors, lighting and flooring. We will also do more work to the interior of some of our older store designs to bring a more open look and feel. Let me be clear, the store refresh is not as extensive as a remodeling activity as we did a few years ago, and we will not be attacking structural walls or ceilings. Instead of millions of dollars per location, the store refresh will be thousands of dollars per location. Costs associated with the work are included in the fiscal year 2007 outlook that we provided today.

Finally, let me talk for a minute about InterTAN. As part of a recent reorganization, I have resumed responsibility for our Canadian operations. I have also assumed the role of interim CEO of our Canadian subsidiary while we search for a Senior Operations leader for the Company to replace Brian Levy who has retired.

Clearly my duties as CFO remain the first priority, and I'm confident that our deep bench of talent on both sides of the border will help to ensure that we navigate this transition smoothly. I have spent significant time both at InterTAN and headquarters and out touring markets in several provinces. I have seen a dedicated, experienced, passionate group of employees who want to win.

We are laying out a first 100-day game plan, which will include some reorganization of the Company to derive greater responsibility and accountability, as well as better and faster decision-making; the implementation of some of the process transformation work that we have implemented in the U.S. over the last two years; a much deeper sharing and cooperation between InterTAN and its Circuit City teams to derive greater synergies than we have mined in the past; and finally, a focus on leveraging some of the great work done in the U.S. on identifying new sources of revenues such as services.

While we clearly face challenges in Canada, we believe that we have firmly established ourselves in the mind of Canadian consumers through our new brand. We anticipate a return to a significant level of profitability in fiscal year '07, albeit not at historical levels.

We will now open the call to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from Matthew Fassler, Goldman Sachs.

Matthew Fassler

Good morning. I would like to start out by asking you about the slightly longer-term investment profile. You outlined about 100 basis points of investments that you're looking to make against EBT in fiscal 2007.

As you think about your long-term plan for the systems perspective and marketing perspective, do you feel like that is the last layer of incremental investment, or do you see more in the upcoming years beyond that?

Mike Foss

Matt, it is Mike. Let me try and address that. In fiscal '07 -- we have talk in the past about our new point-of-sale system, which is coming online in fiscal '07. Obviously we have capitalized a lot of software, so we are going to start amortizing that investment in '07, and that's a multi-year amortization.

We have talked about our merchandising system transformation, which is we believe it is about a three-year journey, a significant investment there. As parts of the product come online, we will start amortizing that as well. We will make continuing efforts or continuing investments in MIS over a number of years to continue to give our team the tools necessary to compete effectively in this industry.

Then the final piece really is innovation and innovation-related activities. We incurred a fairly significant amount of year-to-year expense in the past fiscal year and we intend to grow that in fiscal year '07.

Again, as Phil pointed out in his part, we firmly believe in a pay-as-you-go methodology toward investments in all aspects of the business. So we need to drive continued improvement in operating margin performance while we make these investments.

Matthew Fassler

Got you. So what you essentially pointed to in your guidance today was earnings power, should you have chosen to pull back from these investments, to the 3% to 3.4% range. Is it your expectation that these investments raise the level beyond that, if you will?

Mike Foss

Well, clearly we expect to mine significant returns off these investments in future years.

Matthew Fassler

Just the second question relates to innovation. I think a lot of us have probably visited some of the stores that you have worked on in Boston and South Florida, and I'm interested in some of your initial takeaways in terms of results and learnings. Do they have broader applicability?

Phil Shoonover

Matt, this is Phil. Obviously the learnings in the arenas around home theater, both experience in the store, the associate engagement levels and then the installation services available, are critical to our long-term strategy. So, as we begin to plan on new store openings, our remodels and our refreshes, we will incorporate, with proof of concept, any and all of those changes. We will focus primarily on the learnings in the home theater businesses.

Matthew Fassler

Phil, is some of that likely to be seen at least at some level in fiscal '07?

Phil Shoonover

You will see it with the new store openings, any remodels we do this year and any refreshes we do. You will see it beginning there. Then the services strategy expansion, you will see it reflected in the architecture for our services strategy.

Operator

Our next question comes from Daniel Binder, Buckingham Research Group.

Daniel Binder - Buckingham Research

Just a couple of questions for you. First, on the relocation costs that you laid out of $34 million, how much of that is non-cash? Is that included in the 100 basis points of investment spending you were referring to earlier?

Mike Foss

Dan, it is Mike. As we have talked in the past, the relocation expense really is basically two pieces. It is accelerated write-off of any non-salvageable net book value on the store we close, which is a non-cash item. Secondly, we take an estimate -- assuming that particular site we have multiple years left on a lease, we will assume how long it will take for us to sublease that location and then what kind of rent we will get. So we take a second piece of the chart and the net present value of the difference between what we're going to pay and what we believe we can sublease the property for. That is a cash transaction, but that cash impact is spread over multiple years.

Daniel Binder - Buckingham Research

So if we look at the $34 million, is 20% of it or more non-cash?

Mike Foss

Off of the top of my head, I cannot give you a specific percentage for that. But the $34 million is really all store expenses, not just the relo piece of it, by the way.

Daniel Binder - Buckingham Research

I will follow up again on that. I was just wondering, is that number included in the 100 basis points that you talked about?

Mike Foss

No, that is not. The investments are essentially innovation and MIS spend and stuff like that. It does not include the incremental real estate spend.

Daniel Binder - Buckingham Research

Now if we look to fiscal year '08 given the stuff that you have in the pipe now, would you be willing to take a stab at what kind of relocation activity you would think we would see in fiscal year '08?

Mike Foss

Dan, unfortunately at this point, I'm not willing to give any projection, but clearly we don't find the level of activity we are doing in '07 to be acceptable. So we have to drive that substantially higher over the coming years.

Daniel Binder - Buckingham Research

Lastly, could you give us any more detail behind what looks to be about $125 million of reinvestment spending? Could you sort of break it down by major category?

Mike Foss

Again, the highest single piece is the incremental spend we are making in MIS. That is the biggest single piece of it. Obviously we are ramping up our growth in innovation as well.

Phil Shoonover

The MIS investments are retail, point-of-sale system and the merchandising systems.

Mike Foss

Remember some of that is the reflection of amortization of cash that we have previously incurred in the development of the applications.

Daniel Binder - Buckingham Research

I just wanted to touch on two other things. There has been a lot of concern about whether or not the consumer might slow in the back half of the year. How much flexibility do you have in terms of ratcheting down expenses if the sales don't necessarily hit that 5 to 7 level this year?

Phil Shoonover

Dan, this is Phil. We have a fairly sophisticated business rhythm now where we watch real-time trends both in sales and margin, and obviously we can impact demand if the consumer market is there. If we can't, there are several expenses on the back end that we can impact. The two largest expenses are our marketing costs and our labor costs.

I would also think that the impact to inventory is part of that dialogue. 12 times a year the senior team meets and 52 times a year the field and merchant team supply chain meet, and we constantly re-evaluate where we are against consumer demand.

Daniel Binder - Buckingham Research

Great. Thanks.

Operator

Our next question comes from Budd Bugatch, Raymond James.

Rex Henderson - Buckingham Research

Good morning and congratulations. Actually this is Rex Henderson filling in for Budd this morning. I had one housekeeping item and a couple of questions. First, the housekeeping item. The discontinued ops, can you give us a number on what the revenue impact of the discontinued ops is going to be for this coming year?

Mike Foss

In this coming year?

Rex Henderson - Buckingham Research

For fiscal '07?

Mike Foss

The revenue impact will be very small in fiscal year '07.

Rex Henderson - Buckingham Research

And what was it?

Mike Foss

I'm sorry, but I do not have a specific number for you. Remember, as we pointed out in the release, it really relates to two businesses that we've had, one of which has been divested totally and one that is for sale and it is relatively small, a very, very small piece of our revenues.

Rex Henderson - Buckingham Research

The second question is, can you give us some more color on the innovations and what you're learning at the stores in Boston and South Florida and what might roll out to the rest of the stores over the next year in terms of merchandising and marketing that you have learned in those stores?

Phil Shoonover

I think we have over 200 experiments underway in those two stores. Plus, we have done some things with our web experience and our catalog experience in addition to those to create a multi-channel experience for the customer. I think you are going to see three sets of learnings. One will be physical changes based on adjacencies, visual merchandising and the amount of square footage we dedicate to our products and services.

The second thing you will see is some changes to the way that we operate those stores both in how we recruit and retain people, how we train them on the specific skill set necessary and the sort of expectations we have around the way that our associates serve our customers.

Finally, there is a number of service offerings that we have tested in those stores that you will see in future iterations of new store openings, any physical resets we do to our existing stores -- we call them refreshes -- or any remodels. Most of that work will take place as we open new stores or as we do the remodels later on this year.

Rex Henderson - Buckingham Research

Secondly, the $151 million of CapEx for information systems, can you give us an idea of what kind of returns you expect from that in terms of a ROIC on that investment or in terms of areas where you expect to see changes of margin improvements in the future? How exactly will that impact your income statement over the next five years, rather than over the next year?

Mike Foss

You know, Rex, it is Mike. I will not comment on specifically the ROIC, but we approved the merchandising system transformation, which is the biggest multi-year spend that we have, and that has a very compelling return in how it will help the merchants out in terms of better margins on the products, how it will help our supply chain business and better inventory managing and help us get us to the goal of longer-term goal of zero net owned inventory. So there is a very compelling financial return for us, but I won't get into specific discussions about the percent ROIC.

Rex Henderson - Buckingham Research

Okay. Well, thank you very much and congratulations again.

Mike Foss

Thanks, Rex.

Operator

Our next question comes from Chris Horvers, Bear Stearns.

Mike Foss

Hi Chris.

Chris Horvers - Bear Stearns

Good afternoon, everyone. On the ReTech implementation or the merchandising system implementation, can you talk about what timeline that will be done over? Is it done in FY '08? What modules go live in FY '07, and which modules do you expect the highest margin benefit from?

Phil Shoonover

This is Phil, Chris. We are not going to disclose the exact rollout schedule. There are two basic philosophies. One is, there is a building block cadence you have to hit, so you have to have some of the foundational modules in before you can build upon those modules.

The second is we value targeted the outcomes of that implementation, and we prioritized the implementation based on sort of the pay-as-you-go mantra. It is about a three-year journey.

I think the way you guys should think about this, is the systems enable multiple years of continued mining of our operational efficiencies. Without those systems, years two and beyond become very difficult. So the low-hanging fruit was picked. The legal pads and calculators have been used, and now we need systems in process to get years two, three, four and five and beyond benefits from this.

That goes for ReTech, as well as some of the other systems we are implementing like Connect3, which gives us the ability to version our inserts for pricing promotion, market competitiveness and that should help us with margin.

Mike Foss

One point of clarification just to make sure we all understand, there are going to be modules that will be delivered over that three years. It is not that we don't mine any benefit until year three. We have, in fact, just rolled out one of the modules of ReTech and actually have it in live use today. So it's a multiple year journey. We expect to get benefits literally starting this year of that. But again, it is a very significant investment on the part of the Company.

Chris Horvers - Bear Stearns

So then the three-year journey started last year and the implementations will be done in FY '08?

Mike Foss

No, again, it will be done in each year of that journey because they are made up of many different modules, some of which we have already implemented. Some will be implemented over the course of this year and some over the next two years.

Chris Horvers - Bear Stearns

Any update on the replacement point-of-sale system?

Mike Foss

Our POS system as we call it will be going live this year, and we would expect to roll out the majority of it, if not all of it, this year.

Chris Horvers - Bear Stearns

Finally, you have historically talked about the performance of relocated stores or maybe answer it in terms of what the comp would be without the relocations?

Mike Foss

Yes. As an example, relocations we have seen a minor improvement in the ROIC in the first year of relocations and the sales lift is approximately within 100 basis points of the same. So overall we're very happy with the profitability of our relocation and our incremental stores.

Chris Horvers - Bear Stearns

Thank you.

Mike Foss

Thank you, Chris.

Operator

Our next question comes from Colin McGranahan, Sanford Bernstein.

Colin McGranahan - Sanford Bernstein

Good morning. A couple of questions. First, focusing on the advertising expense, the 61 basis points of deleverage, was there anything that made fiscal '06 advertising abnormally high? If you can talk about what changes drove the increased dollar amount and what kind of benefit you saw from that, and how we should think about advertising expense going forward? That is the first question.

Fiona Dias

This is Fiona Dias, let me take that. There were two components that drove the marketing higher year-over-year. The first was the rebranding effort that we did with our InterTAN operation, and that was largely a one-time expense as we were trying to rebrand two new brand names to The Source. So that I think you can say happened one time and will not be repeated to that extent in years to come.

With respect to the Circuit City brand, we did spend incrementally year-over-year. A lot of that went into some of the programs we have talked about before like our catalog program and our Internet marketing that we do. The results of that are fairly evident from the growth that we have driven in our web-originated sales, and I would expect that as we continue to grow those businesses, we will make appropriate investments to drive that.

Colin McGranahan - Sanford Bernstein

Okay. The second question for Mike. Can you talk about the gross margin outlook in Canada? How far are you into the mix away from wireless, and what is driving the gross margin pressure there?

Mike Foss

Well, again, as we touched a little bit on in the discussion, we're going through kind of a transformation in InterTAN or in Canada where you are seeing some of the traditional higher margin items like parts, batteries and accessories becoming a relatively smaller piece of their mix. You are seeing very high growth in things like digital cameras and personal electronics and such which carry lower margins in it.

So you saw that change start to happen about two to three quarters ago, and there are elements that we can do to continue to try and improve gross margin, and we're working on those. Clearly services will be a significant component of our future in Canada, but we are not happy with the gross margin. There are activities going on throughout the organization, and then also through leveraging our friends in the U.S., we would expect to be able to make some decent progress on gross profit margin as we progress through the year.

Colin McGranahan - Sanford Bernstein

Okay, Mike. Let me be much more direct. At what point does that gross margin business in domestic -- you are at 22 -- you have not quite split that difference at 35, 36 in '06 -- does it end up closer to domestic, or does it stabilize at 35, 36?

Mike Foss

I will not get into projection of where the gross margin will stabilize. Clearly we're doing everything we can to try and improve the gross profit margin of the Corporation. It will not be anything like a domestic superstore gross margin.

Colin McGranahan - Sanford Bernstein

Final question just following up on ReTech, what is the total cost over three years on CapEx? And of the $150 million in MIS spending in '07, how much of that is specifically related to the merchandising system, and how much of that is actually being amortized this year versus the total cost that will hit being amortized as the modules are implemented over the next three years?

Phil Shoonover

Again, we will not get into a discussion of the specific dollar amount over the three-year period, but you're not talking about millions. You are talking about hundreds of millions as is a traditional -- if you talk to any retailer -- that is ReTech. Again, as we develop the module and implement the module, we start the amortization of the expense related to that module. So that will layer over multiple years before we're starting fully amortizing all aspects of the investment we're making.

Colin McGranahan - Sanford Bernstein

Average depreciation life is three to five years?

Mike Foss

For software development, it is generally seven years.

Operator

Our next question comes from Steve Chick, J.P. Morgan.

Steve Chick - J.P. Morgan

Mike, I want to make sure I heard you correctly. Your depreciation and amortization for the year I think you said came in at $140 million. Is that down for the quarter then year-over-year?

Mike Foss

I don't have that in front of me, Steve, but if you call, we will get you the number.

Steve Chick - J.P. Morgan

Okay. Yes, I just wondered because it looks like it was flat to up for the first three quarters, and it implies it might be down in the fourth quarter. So I guess I was wondering if there was something that might be in there.

And then the second thing, the $216 million of your capital spending, it looks like you were year-to-date through Q3 $214 million. Is that about right? You did not spend much in capital for the fourth quarter?

Mike Foss

Steve, I'm going to defer here for a second. If you call, we will get you that detail.

Steve Chick - J.P. Morgan

Yes, we can talk about it offline. It was just something that stuck out. With your stock buyback for the quarter, it was 40 million at a $25 average price. It was a little lower than what you have done all year. Was that a function of stock price or what your cash outlook was for the quarter? How do you think about that?

Mike Foss

You know, it is a number of factors. But remember probably the most important one is the fact that the Company follows the same trading window that insiders of the Company follow. So there are certain points where we can be in the market and certain points where we cannot be in the market.

In the fourth quarter, we have the shortest window of any quarter because of the fact that we announce December sales in early January, the window is basically from a couple of days after that to kind of the end of the month. So it is the shortest trading window.

Steve Chick - J.P. Morgan

Okay, that is right. Thanks.

Operator

Our next question comes from Alan Rifkin, Lehman Brothers.

Alan Rifkin - Lehman Brothers

A couple of questions, if I may. Phil, you mentioned that you believe you have better vendor relationships with the vendor community in the past couple of quarters. I was wondering if maybe you could provide a little bit of color as to your prognosis as to whether or not those improved relationships will in 2006 yield better buying on your part and hence greater gross merchandise margins?

Phil Shoonover

Yes, I think there are several things that our vendors can do for us, and I'm going to let Doug color commentary here a little bit. When you think about the best sourcing strategies that Doug laid out, we're going to require support from our vendors on those mission-critical best sourcing strategies. We have also worked at getting up new products and new product lines at Circuit City, which our vendors can help us with.

In addition to that, our level of in stock and our owned inventory requires very close coordination and partnership with our vendors. So almost all our key merchandising strategies pivot on those critical relationships.

Doug, if you're still on the line here, I would like you to talk a little bit about the vendor survey and how we measure this.

Doug Moore

Doug Moore here. We took stock in our position with our vendors about a year ago when we were woefully deficient in a number of key areas just in basic business processes and practices, and they revolve around things as basic as forecasting, collaboration, buyer expertise, industry knowledge, etc. We significantly moved up on all of those calibrations. In fact, we will talk a little more at the analyst conference about some of those results because they are, frankly, quite good.

So I think actually in terms of cost it is more about if you manage your transitions better, you buy differently, and you can count on us to sell more. Generally the math will collectively be a lot better. So that is really where it is. Cost is a moving target, and it varies category to category and vendor to vendor. So I really would not comment precisely on that part of it, but we're making progress in the other parts that contribute to losing margin or gaining margin.

Alan Rifkin - Lehman Brothers

Okay. Thank you very much. Mike, you had mentioned that one of the contributing factors to your improved gross margin was lower markdowns, and I am maybe wondering if you could provide some color as to what you think the promotional environment will be in 2006 and maybe even an early read on the '06 holiday season?

Mike Foss

I will not talk about our expectations for the future. We did see a little bit of lessening in the promotional environment in the fourth quarter and a little bit of lessening of financing terms in the fourth quarter.

Alan Rifkin - Lehman Brothers

Okay. And your expectation for advertising as a percent of revenues in '06 versus '05?

Mike Foss

Again, I won't at this point give out a future-looking guidance on something like advertising for competitive reasons. Alan, I apologize for that.

Phil Shoonover

You know, Alan, maybe we can answer part of that question. This is Phil. I think our philosophy in promotional funding is that we will invest where we get a return so that that gets measured gets repeated. We built a pretty robust set of processes and measurements around promotional effectiveness both for the actual ad dollars spent and then for things like markdowns or value-adds like financing. And if a promotion is not producing a return, we don't keep running it. Those that produce a return, we do more of.

I think as far as the promotional environment this year goes, while it may be fair to say some of the retail promotions stabilized, the online promotions were as competitive as ever. I think the byline here is expect Circuit City to compete, and we will compete aggressively in some businesses, and we will harvest some other businesses. The portfolio is designed to blend out, and we make commitments and we plan to figure out a way to live up to them.

Alan Rifkin - Lehman Brothers

Fair enough. Maybe I will ask it another way. Without the rebranding effort up in Canada to The Source from InterTAN, would you folks have gotten leverage on the advertising line in Q4?

Phil Shoonover

Remember, Alan, in the fourth quarter, there was minimal, if any, rebranding-related activities. Most of that activity happened in the first three quarters of last fiscal year.

Alan Rifkin - Lehman Brothers

Okay. Well, thank you very much.

Phil Shoonover

We have time for one more question.

Operator

Our next question comes from Mike Baker, Deutsche Bank.

Mike Baker - Deutsche Bank

I just wanted to follow-up on your services business. So it sounds like there are some new things going on there. Is that moving away from the IQ Crew?

And then as part of the question, I was just wondering is that that accretive to margins? Did that contribute in '06, or are you still in the investment phase? And what about '07? Is it still an investment stage, or does it contribute to margins in '07?

Mike Foss

Okay. So our overall service strategy includes PC services, which are a material part of the improvement in profitability for Circuit City, and we plan to expand those PCs services. I want to separate that from the brand IQ Crew. We mentioned in my portion of the call that we are going to introduce a new services brand. The basic growth category for us in the area we're spending most of our R&D dollars today in is the home theater installation business.

PC services are very important to us. We plan to aggressively grow those PCs services both in-store and in-home, and we plan to expand those service offerings into Canada. Those are profitable service offerings. As we are learning from our Boston and Florida experiments and our existing home installation infrastructure, we will aggressively grow our home theater services capabilities.

Mike Baker - Deutsche Bank

So that will be a different brand it sounds like than the IQ Crew? Is that the way I could understand it?

Phil Shoonover

Yes, we have not announced our exact brand position, but we do plan to introduce a new services brand.

Mike Baker - Deutsche Bank

So it sounds like your 13 markets where you do -- where you in-source the home theater and then the rest of the markets you outsource the home theater installation, it sounds like from your comments that the in-source part is more profitable for you, and that is what you're going to be rolling out?

Phil Shoonover

I think the outcome of our services initiative has to be high-quality installations at affordable prices for the transformation to digital television that we want to take advantage of. So we will find the most efficient and effective way to deliver those services. Sometimes it will be first-party and sometimes it will be third-party services. It is very difficult to rationalize in-house services in secondary and rural markets. So I think we will continue to use outside partners as a blend with our internal partners.

The other thing we have learned about this is in some types of services the best way to provide customer value and quality is to control those services directly.

Mike Baker - Deutsche Bank

Okay. Thanks. And then while I have you, I will try one more. The margin outlook for next year and then even longer-term, does most of that improve or come on gross margin or most of SG&A, or is that -- you're not giving that kind of color?

Mike Foss

Yes, at this point, Michael, we won't be giving that color. Rest assured that we're trying to attack every line on the P&L.

Mike Baker - Deutsche Bank

Right. I just thought I would ask, though. Thanks a lot.

Operator

Sir, do you have any closing remarks?

Phil Shoonover

No, I think I will thank everybody for participating in the call, and we look forward to talking with them soon.

Operator

Thank you for participating in today's Circuit City fourth quarter and fiscal year results. You may disconnect at this time.

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