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Circuit City Stores, Inc. (NYSE:CC)

Q2 2009 Earnings Call

September 29, 2008 10:00 am ET

Executives

Bill Cimino - Director, Corporate Communications

James Marcum – Acting President & CEO

John Harlow – EVP & COO

Bruce Besanko – EVP & CFO

Analysts

Colin McGranahan - Sanford Bernstein & Co.

Scott Ciccarelli - RBC Capital Markets

Dan Binder - Jefferies & Company

David Strasser - Banc of America Securities

Michael Lasser – Barclay’s Capital

Matthew Fassler - Goldman Sachs

Michael Baker - Deutsche Bank

Anthony Chukumba - FTN Midwest

Brian Nagel - UBS

Operator

Good morning. At this time, I would like to welcome everyone to the Circuit City second quarter results conference call. (Operator Instructions) I will now turn the conference call over to Mr. Bill Cimino, Director of Corporate Communications. Sir, you may begin.

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. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors.

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.

Any forward-looking statements represent our views only as of today, and should not be relied upon as representing our views as of any subsequent date. While we may elect to update forward-looking statements we specifically disclaim any obligation to do so.

On today’s call, we may make reference to some non-GAAP measures, specifically adjusted loss from continuing operations before income taxes, adjusted net loss from continuing operations and adjusted net loss from continuing operations per diluted share all of which exclude the impacts of the asset impairment charges that were recorded in the second quarter.

These measures as adjusted are not measures of performance that are defined by GAAP and are not to be considered a substitute for our results as prepared in accordance with GAAP. A reconciliation of these non-GAAP measures to the most directly comparable GAAP measure has been provided in today’s press release, which is available on our Investor website at www.investor.circuitcity.com and has also been furnished to the SEC on Form 8-K.

Speaking on this call are James Marcum , Vice Chairman and Acting President and Chief Executive Officer; Bruce Besanko, Executive Vice President and Chief Financial Officer and John Harlow, Executive Vice President and Chief Operating Officer. Also available during the question-and-answer session will be Jeff Stone and John Kelley.

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

James Marcum

Thanks, Bill and good morning. As you know I joined the company as Vice Chairman in August to accelerate progress on our turnaround. In the time since I have joined the team, I have been impressed by the team’s desire to return the brand and the business to a place of strength and leadership.

It is my mission to direct that energy towards improving our operations and strengthening our market position in order to accelerate our turnaround and deliver improved results for all of our stakeholders.

As many of you know in May of this year, the company announced it was exploring strategic alternatives. We started a review that was not limited to any particular option, we have thus far concluded that while we will always explore strategic options as part of our [fiduciary] responsibility given market conditions its prudent to focus internally on improving the company’s performance in order to operate as a standalone business.

To that end we are now undertaking a comprehensive review of all aspects of our business to determine the best methods of delivering substantially improved financial performance and maximizing shareholder value.

This new management team has been working together very closely to determine the appropriate actions we need to take and we are fully aligned in our current approach. We are committed to making the necessary decisions to put Circuit City squarely on the path towards a profitable future and to deliver the best experience for our customers as they shop in our stores, on our website and by phone.

We have a lot to cover today on our call, so I would now like to turn this call over to Bruce Besanko to review the second quarter.

Bruce Besanko

Thanks James and good morning everyone. There’s three topics that I’d like to review with you today, first our financial performance for the second quarter; second our key operational metrics; and third our thoughts on our fiscal 2009 outlook. Let me begin the second quarter review with the income statement.

Net sales decreased 9.6% to $2.4 billion. Domestic segment sales declined 10.6% to $2.2 billion. The domestic sales decline was primarily driven by our comp sales decline of 14.4%. Let me provide more color around our domestic comp sales trends.

First from a product perspective large LCD televisions continue to be our largest sales driver. Digital television converter box sales are also very strong for us and so are social gaming products. Offsetting these areas of strength was broad based weakness across most other categories. In some areas such as Notebook PCs we utilized a less impressive pricing strategy in order to improve the gross margin.

As it relates to traffic, ticket and close I’ll speak first about our store metrics. Close rate trend improved sequentially though it declined by a low single-digit percentage to last year’s rate. Our second quarter average ticket was nearly flat to last year which is also an improvement in trend. The strongest average ticket performance coincided with the strong basket improvements we saw in August.

The largest driver of our performance was a double-digit decline in traffic from last year. We believe the factors contributing to the traffic decline include the economic environment, competitor store openings, and weakening in our brand relevance and a significant decline in music and movie unit sales.

For Circuit City direct we continue to see strong increases in traffic while average ticket declined on a year-over-year basis for the quarter. Turning to our international segment sales increased 11.2% primarily reflecting a comp sales increase of 11.2% in local currency as well as the favorable impact of foreign currency exchange rates partially offset by the impact of 28 net store closings in the last 12 months.

Sales growth was strongest in navigation, video game and computers and related software and wireless. Consolidated gross profit margin increased by 63 basis points from last year. On the domestic side gross margin rate increased 74 basis points. Year-over-year change in the domestic gross margin rate was the first year-over-year increase in 10 quarters.

I couldn’t be more pleased and I’d like to personally thank our merchandising teams for their great work.

The increase was driven by improvements in the product margins of televisions and related products and PC hardware. We also have favorable mix shifts in those product categories. For example the decrease in PC sales. We believe our initiatives in the home entertainment area, things like team-based incentive, dedicated supervisors and labor and enhanced training benefited gross margin by approximately 75 basis points.

Warranty had a slight positive contribution to gross margin as sales were flat to last year on a percentage to sales basis and we took costs out to improve our margin. Also contributing to the improvement was a decrease in shrink at 12 basis points. As you remember in the fourth quarter of last year we saw an uptick in our shrink above our historical levels. This hurt gross margin disproportionately in the fourth quarter as we recorded the higher rate for the quarter and some catch-up for earlier periods.

In the first quarter of this fiscal year we accrued for shrink at the fiscal [2000] rate which was slightly below the fourth quarter rate. In the second quarter we completed a physical inventory in a representative sample of our stores and our results were significantly improved over the fourth quarter physical inventory results.

In fact we adjusted our accrual rate down by about 20% for the first six months of fiscal 2009. The impact of the second quarter includes a benefit from that first quarter catch-up. In the second quarter we also saw some benefits from improved pricing governance and reduced markdowns as well as clearance and open box discounts.

We expect these contributions to build through the year as we fully implement the initiative. International segment gross profit margin decreased 408 basis points. The decrease primarily resulted from margin rate declines in commoditizing categories such as tech related media and navigation products, a mix shift reflecting stronger sales growth in the lower margin categories such as video gaming, navigation and computers, and targeted clearance activities particularly in the end of life computers and portable audio.

Consolidated SG&A expenses as a percentage of sales increased by 230 basis points while SG&A expenses in dollars declined from last year. The domestic segments expense to sales ratio increased 271 basis points compared with last year. The increase primarily reflects the overall deleveraging impact of lower sales, 182 basis point increase in expenses related to the 76 new and relocated Superstores that have opened during the past 12 months, and a 67 basis point increase in marketing expense.

The increase was partially offset by a 26 basis point decrease in consulting and other professional services. The international segment SG&A expense to sales ratio decreased 583 basis points from the prior year’s rate primarily due to a benefit of $4.3 million related to goodwill and the leveraging impact of higher sales.

This segment also had lower advertising and consulting expenses. To sum up the international segment performance the team did a terrific job with growing sales and managing expenses to offset the declines in gross profit margin.

Let me speak for a moment about our continued cost control. We continue to identify areas to better control or reduce expenses for our domestic segment. We’re leaving no stone unturned both in our store support center and in the field to reduce or eliminate non-value added expenses.

The reductions identified are not large individually but certainly add up to a meaningful contribution in the aggregate. Now let me turn to the asset impairment charges. We recorded $73 million of non-cash asset impairment charges during the second quarter. Due to our financial performance and our initiation of the comprehensive review of our business we were required to [test] long lived assets for impairment under GAAP as of the end of the quarter.

Based on information available at August 31, 2008 we have evaluated the carrying value of each of our stores’ property and equipment which would include things like fixtures, equipment and leasehold improvements. We determined that the carrying value of the fixed assets at some of our domestic segment Superstores would likely not be recovered through the estimated future cash flows considering our assumptions about the lives of those assets.

For those stores, we wrote the assets down to their estimated fair value. For the quarter our adjusted pre-tax loss of $162.7 million excludes the non-cash asset impairment charges. On a GAAP basis we had a consolidated loss from continuing operations before income taxes of $235.7 million compared to $128 million in the prior year.

The adjusted results exceeded our guidance which didn’t anticipate the non-cash asset impairment charges do the significantly better gross margin performance and also additional SG&A expense controls and reductions. The net loss from continuing operations for the second quarter was $1.00 per share excluding the non-cash impairment charges and $1.45 per share on a GAAP basis compared with $0.38 per share last year.

Now turning to the balance sheet, cash, cash equivalent and short-term investments were $92.5 million quarter-end. As compared to the same period last year, cash declined by $331.9 million principally driven by the net loss in purchases of property and equipment. These declines were partially offset by net proceeds from short-term borrowings.

We ended the quarter with $215 million in borrowings under our amended credit facility. Our borrowings in the second quarter were higher then we had expected due primarily to higher then expected net owned inventory.

I wanted to update you on the status of the approximately $80 million tax refund that we hope to receive in the third quarter. While we still expect to receive the refund we’re in the process of appealing an unexpected and frankly disappointing administrative issue that complicates the refund process.

We expect to receive the refund when these issues are resolved but we cannot predict the timing of that resolution.

Consolidated merchandising inventories declined 17.7% from last year compared with the consolidated sales decline of nearly 10%. Domestically our inventory and supply chain teams and our merchants kept inventories roughly in line with our sales trends.

Sales softness that we experienced in the quarter slowed turns leaving the slightly higher net owned inventory and a decrease in payables. While we’ve been aggressively managing inventory to sales, we need to ensure that we are improving in-stocks where necessary to support the sales.

To conclude my review of the financials let me say that while these results are clearly not acceptable, they do demonstrate some initial progress that resulted in part from the work of our associates in the field to rebuild our service culture and from our corporate support teams to provide compelling and effective offers and tools.

Now I’d like to briefly review some of our key performance metrics from the second quarter. These results also demonstrate that we’re gaining solid steady traction toward our objectives; not far enough, not fast enough, but solid steady progress.

As I mentioned earlier our store close rate trend improved. The year-over-year [GAAP] for the quarter is the narrowest it’s been in two years however there is much more progress we can make in this area even given the economic headwinds we face.

We’re also seeing progress in attachment rates for high margin accessories and services related to our hardware units that we sell. Our PC services attachment rate moved ahead of both fiscal 2008 and fiscal 2007 for the quarter though revenues declined along with hardware units.

For home theater installation attachments the rate exceeded last year in two of the three months of the quarter. And our warranty unit attachments held steady with the first quarter and TV warranty attachments continue to exceed last year. In August we began to anniversary the impact of price reductions that we started testing last year.

For the total basket size in dollars of the accessories and services that we attach to our hardware sales, both our flat panel TV and Notebook PC baskets grew significantly compared with the first quarter. For the two prior years the second quarter basket was below the first.

Our Notebook PC basket exceeded last year for the month of August and our flat panel TV basket grew above last year for the quarter. In addition our mystery shop and customer first scores are improving slightly. We shared with you last quarter that mystery shop scores had improved 800 basis points from July, 2007 through May, 2008.

The scores also improved another 140 basis points through August. However we still have significant customer service issues in our stores that simply must be improved, [wanting to] substantially raise the bar for our associates and James and John will both speak to this shortly.

On the in-store pickup side our percentage of orders ready within 15 minutes which is less time then our guarantee, remains solidly in the 90s. The in-store accessory attachment rate to web orders also continues to increase significantly.

Finally as I mentioned earlier we made progress toward our goal to return shrink levels back to historical levels of performance. To realize this much progress in only six months is quite an achievement and I want to thank our asset protection and store associates for their terrific efforts here.

We still have a long way to go to reach our goal but I’m heartened by the progress so far. Now turning to our outlook, today we withdrew our previous guidance for fiscal 2009 results given the initiatives underway and the comprehensive review of the business that we’re undertaking.

Let me be clear though, our financial priorities haven’t changed. We remain focused on gross margin rate improvement and management of expenses and investments in fiscal 2009. We’ll continue to keep you informed of our progress in our key operational initiatives during the second half of fiscal 2009.

I’d like to now turn the call back over to James to offer more details behind our priorities going forward.

James Marcum

Thank you Bruce, I have to say that the fact that our adjusted pre-tax results for the second quarter were ahead of expectations does not mask the fact that our actions to date have not been sufficient to reverse our overall business results.

We realize the performance of this company is unacceptable to all of our stakeholders and that it is imperative that we take the right steps to accelerate our turnaround. For context the past several years have been difficult for this company.

To that point the company has operated through a number of shifting market paradigms such as intensified online competition, declining prices for consumer electronics, and the entry of mass retailers into the CE market.

These shifts have created some difficult challenges for our business. But with that said, we’ve also tried to implement too many disparate initiatives and at times have not focused on the right things given the challenges facing our company and the industry. In fact, in many cases we believe our past actions have impacted our business negatively.

I have observed since joining Circuit City that there are fundamental principals of retail which we need to execute more affectively. We must get back to the basics and make no mistake; this is all about our customers.

Our management team has spent a good deal of time reviewing plans from the past and identifying what has worked and what has not. So far we’ve identified four areas of the business which need to be improved to drive traffic to our stores and increase the company’s profitability.

The first is customer experience, we need to dramatically strengthen the Circuit City brand, gain back the trust of our customers and rebuild our selling culture. We also need to raise the general standards we set for customer service and the type of overall in-store experience that we deliver.

Next is execution, we need to raise our in-store visual and merchandising standards. This includes improving our in-stock positions particularly on key items and ensuring that they are coordinated with our advertising circulars. This also includes communication to our customers through compelling signage, appealing visual merchandising and improving our ability to educate our customers on the exciting products we sell.

With respect to our culture, we need to re-instill our service culture through better training, tools, support and incentives so that we can improve our customer experience.

And lastly our stores, we are going to focus on the productivity and assortments of our core stores. As a first step in making improvements in some of these areas and in particular to better position our company for the holiday selling season, we announced today that we have integrated The City leadership into the core retail operation.

This will enable us to incorporate some of our learning’s from the City and share best practices from both store concepts across the chain. John is going to provide some more details about this move and the leadership in a moment.

In addition we know that our current store base does not support the customer or associate experience that we are committed to delivering in the future and we recognize that we cannot grow our way to success without first fixing our core business.

As a result we expect to dramatically reduce our store openings beginning next year. Other then fulfilling existing commitments which are limited, we would not expect to open new stores in fiscal 2010 so that we can focus on improving the execution in our existing stores.

It’s important to note that the areas of the business that we must improve require both immediate and longer term focus. We have been working hard to identify critical elements that can be positively impacted for this holiday season.

John will speak to those in detail in a moment, but to share some top level highlights our activities for the holiday selling season will be driven by the following simple initiatives which we also identified in our release this morning.

The first is focus on easily implemented tactics to enhance the customer shopping experience; improve the company’s in-stock position on key items and advertized products; upgrade in-store signage and visual merchandising; and to finalize the chain-wide rollout of Simple to Shop in home entertainment; and then lastly launching new marketing brand campaigns supported by relevant traffic driving offerings.

Looking ahead we will continue to scrutinize and examine our business. This will include a review of the productivity of all of our assets and we will be ready to make the difficult decisions that are necessary to accelerate our turnaround, improve both our operational and financial performance and to deliver shareholder value.

Overall the process to accelerate our turnaround will not be completed over night. Rather it will continue to evolve as we reach certain milestones and develop appropriate next steps. Let me emphasize our goals to do all of this with the long-term interest of Circuit City, our vendors, our customers, and our shareholders in mind.

As Bruce said, our team will provide additional updates as we move forward. Let me now turn over the call to John Harlow who will speak to the specific initiatives that we are going to take in the second half. Those initiatives are focused on improving traffic trends, customer service and our financial results and then lastly, to deliver a successful holiday selling period.

John Harlow

Thank James, good morning everyone. As Bruce and James noted, we are not satisfied with our recent operation or financial performance. We recognize that there are problems in our business; however our team is energized and highly motivated to take the steps necessary to turn around our business.

James spoke in broader terms about some of the areas we need to improve. I’d like to outline some of the specific initiatives we are implementing now for the holiday season to help us prepare and execute during the critical holiday selling period.

First, our customers have told us that we are not as helpful as we should be. So we will significantly elevate the service standards in our stores. For example, customers will experience quicker, warmer greetings as they enter the store, and faster more efficient checkouts.

To do this, we are implementing more rigorous training programs and launching a holiday training camp and a program focused on particular tactics for bringing the first and last impressions initiative to life.

Second we will also increase our in-stock levels on key items and advertised products and improve our merchandising standards. The number one reason that our surveyed customers cite for leaving our store without a purchase relates to the product being out of stock.

We recognize this is an improvement area for improvement and a key performance metric that we are measuring.

Third, we will upgrade our in-store signage and visual merchandising to better communicate our value proposition to our customers in a clear compelling way.

Fourth, because home entertainment or HE is our most important business, we are continuing our work there to give our associates the tools they need to create the best experience possible. As a reminder, we created a team-based HE incentive program and implemented a new training program for the associates in that department earlier this year.

The results of all this work contributed approximately 75 basis points to gross margin and positioned us to finalize the rollout across the chain this month of a new home entertainment experience that we’re calling Simple to Shop.

Simple to Shop is an exciting customer friendly setup of the home entertainment department. It is a new way to sell HE that will set us apart from our competition. We are making the shopping experience simple for our customers and simple for our associates by addressing our customers most frequently asked questions through more tangible demonstrations of the whole home theater experience in five simple steps.

In addition to the new Simple to Shop selling process we have upgraded the HE merchandising offerings to highlight our commitment to providing the best home theater experience. We’ve added the leading worldwide manufacturer of load speakers, Klipsch. We are also upgrading our end caps to take full advantage of showcasing the high definition Blue-Ray experience.

These changes will help our associates provide the products, services and experience that our customers are asking for.

Finally we will launch a new marketing campaign focused on the brands that not only drive traffic into our stores and reinforce the commitments that we’re making to our customers. While we won’t provide specific details about the campaign for competitive reasons, our intention is to highlight the compelling offers that we have and support the campaign with consistent in-store messaging.

One other item I want to discuss today is the retail leadership alignment that James mentioned earlier. The leadership integration of The City and core retail leadership will enable us to bring learning’s from our The City concept to our Circuit City Superstores and apply best practices from both concepts.

By doing so we can bring many of the cultural, visual presentation, and customer interaction aspects of The City to create a better customer experience in our Circuit City stores. Jeff Stone now has responsibility for our retail sales and stores’ organization.

Jeff is well known for his experience in building tweeter home entertainment groups customer center culture and high levels of service. He will lead the dramatic steps that we need to take to improve the customer experience this holiday season and in the future.

His first priorities will be to instill appropriate accountability and performance standards for all of our domestic Superstores. In addition our Regional Vice Presidents, sales training, retail operations, and sales development will also report to Jeff.

He will also continue to oversee firedog services. Brian [Leech] who led the creation and has been overseeing the development and refinement of The City concept will lead the sales training organization of Circuit City.

He and his team will facilitate rebuilding the customer focus culture and improving the customer experience in all of our stores.

We believe that implementing these initiatives will help insure a significantly improved store experience for the 2008 holiday season and will serve as a strong message to our customers that Circuit City is committed to customer service, convenience, consistency, and integrated solutions.

Before we take your questions, I would just like to emphasize that we are focusing on fewer priorities with fewer distractions. We are focused on consistency with incremental improvement. We will rebuild our selling culture as we deliver an improved in-store customer experience that supports significantly improved financial performance over the longer term.

As we continue to build traction in our operational initiatives we will continue our focus on building trust and relationships with our customers and associates.

I am confident that the clarity, focus and engagement of our store teams will bring this to life.

We are now ready for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Colin McGranahan - Sanford Bernstein & Co.

Colin McGranahan - Sanford Bernstein & Co.

It looked like there was actually some evidence of some progress in store there, with better close rates, but it looks like the challenge here has shifted a bit with the double-digit decline in traffic. I was curious your comments around damaged brand relevance and given that in the second quarter you actually had some benefit from the tax stimulus how do you plan to address the traffic issue coming into what I think most of us are expecting to be a pretty challenging holiday season. Is it just messaging on advertising, could you talk a bit more about initiatives to drive traffic, and what you think you can do to try to change the brand relevance perception in the near to medium term.

Bruce Besanko

Traffic is indeed a problem as we said; we had low double-digit declines this quarter which are somewhat worse then what we saw in the first quarter. We need to continue to improve the customer experience in the stores. We do intend to launch a new marketing campaign relatively shortly that we believe will help bring some relevance back to the brand, but you’re right we are challenged with the relevancy of the brand.

John Harlow

Really the marketing plans that we have for the back half of the year and again I won’t go into them specifically, I believe will create very important distinctions in terms of offerings that are much more customer-relevant as a starting point and candidly we know that from an execution perspective we haven’t done a strong enough job calling out what we do well. So in addition to the 24-24 promise and guarantees that we have, two-day home theater installation, all of the value propositions that we offer to customers, we know we haven’t called them out as meaningfully and my belief is as we do that, and marry that up with a very different customer experience, customers will notice that and that will help hedge against some of the economic headwinds that are out there.

John Kelly

I believe that during the holiday season we’ll have some very compelling offers to offer our customer during this period that will also be able to enhance our traffic during this period.

Colin McGranahan - Sanford Bernstein & Co.

It sounds like maybe you’re not going to get that tax rebate in the third quarter and you’re not sure when, and obviously there was a deterioration in the payables coverage ratio and inventory, can you talk about what you’re funding outlook looks like and where you think you might be on net debt through the year?

Bruce Besanko

So just to refresh everyone, we ended the quarter with $91 million in cash and about $215 million in short-term borrowings against our $1.3 billion asset backed facility. To further support our liquidity in addition to the $1.3 billion credit facility which as everyone should know has no financial covenants; we also suspended our dividend last quarter which this year will conserve about $20 million in cash.

You mentioned that $80 million tax receivable we believe the government understands that they owe that money to us; the question is when it might occur. So we do have the $80 million tax receivable that we expect to get to us. And we’ve reduced finally our CapEx this year by about $100 million from the prior year. We expect to reduce it significantly for next year as well. There’s not likely to be very little store growth next year.

From a liquidity perspective the key issue for us is our vendors. We continue to do everything we can to ensure the continued support from our vendors particularly our largest vendors and as we’ve said before the majority of these vendors want to see Circuit City succeed and to prosper and we maintain very good relationships with them.

We have open and transparent dialogues with them on an ongoing basis and when they express concerns we try to address them. As it relates specifically then to an outlook in terms of liquidity what I would say is that we do expect to have some borrowings at the end of the third quarter principally driven by the fact that there is close proximity between Black Friday and the end of our fiscal quarter but beyond that we’ve withdrawn guidance. So I won’t comment any further on liquidity.

Operator

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

Scott Ciccarelli - RBC Capital Markets

Can you give us any color regarding the health of the ongoing vendor relationships, you said most want you to succeed but were they aware of the current earnings report that you were going to put out today and any other color regarding their relationships?

Bruce Besanko

As I mentioned we have very transparent dialogues with our vendors particularly the larger vendors. We routinely speak with them, certainly, in some cases on a daily basis but certainly on a weekly basis. For the most part we keep them in the loop in terms of our performance and the ongoing turnaround. They want to see Circuit City succeed because we’re in many cases the number two, number three or number four channels for them in consumer electronics.

They want to see us succeed and they’ve so far for the most part have been supportive of the turnaround.

John Kelly

Also one of the things that we represent to the vendor community is a wide assortment of consumer electronics products that enhance their profitability also so I think there’s even more desire to success rate for Circuit City then you’ve seen in the past and I believe that from all the dialogue I’ve had with most of the major vendors in the last couple of weeks, even going back further to the last 90 days is everybody wants to see a healthy Circuit City have a very prominent place in the market going forward.

Scott Ciccarelli - RBC Capital Markets

Can you remind us what your borrowing terms are on the inventory and receivables, how much against each can you borrow?

Bruce Besanko

The facility is against, principally into the inventory and some small amount of receivables on our balance sheet and we have full capacity to borrow against that inventory capped at $1.3 billion less some thresholds required by the bank.

Scott Ciccarelli - RBC Capital Markets

Its 100 cents on the dollar on the inventory?

Bruce Besanko

I don’t want to comment specifically but there is a haircut that’s made and its pretty standard in the market and so ours is relatively standard.

Operator

Your next question comes from the line of Dan Binder - Jefferies & Company

Dan Binder - Jefferies & Company

A lot of your expense management has been pretty aggressive and allowed you to modestly exceed some of the goals that you set so far on the pre-tax line, as you look at the business do you view this as having gotten to a point where the cost cutting has actually starved the business to some extent and that we’ll need to see some of that spending go back up to support some of the initiatives that you’re talking about on training and in-store service?

John Harlow

As we look at it and I look at how we’re approaching SG&A there are a couple of fronts. We have been very specific about how we, with store labor being the largest bucket, how we allocate store labor and on a go forward basis we will continue to allocate it to really be able to deliver against our goals. Most of the SG&A savings has come truly behind the scenes from efficiencies upstream whether it be in the supply chain or from this building. And candidly I see us as we continue to narrow and focus the scope of what we go after as a business being able to continue to find SG&A opportunities without negatively impacting store experience.

Dan Binder - Jefferies & Company

You talked about one of your focuses being on getting in-stocks up, what should we expect for inventory growth as we get to Q3 and if you can even look out as far as Q4, what would your expectation be on inventory growth and are the vendors in a position to commit at this point to your goals of getting higher in stocks?

Bruce Besanko

In terms of inventory build, so far we’ve had no issues in terms of building the inventory that we need for the holiday and I’m not anticipating any issues on a go forward basis. We feel like the vendors will continue to provide us the support that we need to move through the holiday selling season and are optimistic in terms of our in-stock.

John Harlow

As I look back on the second quarter I would start by saying we didn’t execute anywhere near to the level that we’re capable of executing and we have put in place very specific initiatives to not only make sure that our key item in stock and our add in stock and not only our top stores or the top categories are in stock much more effectively then we have been. We did experience a dip in the quarter more internally focused. Quite frankly there were some things that we didn’t execute as well as we should have but on a go forward basis the very specific actions being taken are on priority SKUs, add, etc. where the customer will be looking for product and for us to be in stock, I’m confident we’ll be able to deliver against that.

James Marcum

I think you’re points are very well taken and right on. My personal sense since I’ve been inside the company, it’s not as much as expense as it is the inventory and truth be known we have aggressively managed. It has left us vulnerable where you’ve had some SKUs perform extremely well, its left us very vulnerable to be able to keep and maintain and in-stock position especially when you’re talking about advertised product.

So we will be looking hard as we go into the holiday season. Now with that said, I still think we would expect to have inventory levels in line with the sales performance at that point.

Operator

Your next question comes from the line of David Strasser - Banc of America Securities

David Strasser - Banc of America Securities

[inaudible] a lot changes to the business heading into the holiday, at what point do you stop and say we, what’s your drop dead date so that you can actually just focus 100% on selling and there’s not too much change in the business?

John Harlow

We missed the beginning but let me try to capture what I think was the essence of your question, a couple of things. We have set up really October 15 as the end of where we introduce new change to the stores. The changes that we referenced are actually already starting to take shape and are in place.

Candidly they are, if you remember at the beginning of the year we talked about an initiative referred to as our core four which was about putting in place fundamentals around customer service, rebuilding the selling culture and improving merchandise execution standards. Really the work we’re doing right now is additive to that and is not significant change other then from the standpoint of the in-store service experience. That primary focus will be the biggest difference and I would tell you that we’re building on a base over the next couple of weeks to make sure that we land the holiday season.

David Strasser - Banc of America Securities

As you look at some of the changes you’re going to make, has there been a thought about bringing back in some way, shape or form a commission structure? Or at least some sort of incentive structure from the service standpoint?

John Harlow

As you probably know we had refined in the home entertainment category a new compensation structure which was really geared on the overall team performance in home entertainment and that’s actually helped us deliver some very strong results. Candidly as we compliment that with the Simple to Shop initiative that I mentioned in HE, I see this as being something we continue to be able to build toward. As it relates a broader look on compensation and commission, that’s not part of what we’re looking at. We believe that there’s enough strength that comes from what we’re doing today coupled with raising the bar on customer service and customer experience in the store, it’ll send a different message and build back traffic and customer confidence.

I would look at this as we’re raising the bar, not creating a new bar.

Operator

Your next question comes from the line of Michael Lasser – Barclay’s Capital

Michael Lasser – Barclay’s Capital

Can you talk a bit more about the vendors and are they seeing any increases in the rate at which they have to pay for factoring receivables from you and is that a concern such that it could cut off any inventory flow?

Bruce Besanko

Anything that would impact our suppliers’ ability or willingness to ship to us would obviously be a concern to us. But what I would say is that we continue to do everything in our power to ensure that those vendors that supply us can continue to supply us and we spend a great deal of time both John Kelly and I, along with James now, with those vendors talking through the turnaround plan, talking through our results, talking through our expectations, and I won’t comment on any particular vendor, but I would say I’ve been very pleased that so many vendors have remained supportive of the turnaround, particularly given the macro environment and the softness in their own businesses.

So at this point I’m pleased with the support that we’ve gotten from our suppliers.

James Marcum

In the last couple of weeks I’ve gotten the opportunity to reach out to most of the top 25 vendors and have very lengthy conversations and transparent conversations with everything the company is doing and about Circuit City and those types of things, and it’s clear that the vendors do view us as relevant. They do view us as having a reason for being. They are very supportive of where we are. They are actually very happy with a number of the initiatives we’re talking about here today, and the speed at which we’re moving. So I think if anything, those vendors comprise the majority of our revenue. That’s been very encouraging to me.

Michael Lasser – Barclay’s Capital

It wasn’t really clear to me whether or not they’re seeing it become more expensive to do business because clearly there’s a willingness to do business but their ability may be impacted if the rate at which they have to pay to factor the receivables becomes [prohibitably] expensive. Hopefully you can address that point. And then is there any thought on the outlook to be able to extend credit or is there any change in the ability to extend credit to customers through the private label credit card? Are you seeing any change in terms with, through Citi at this point and can you effectively use that as a tool to lure customers back into the store?

Bruce Besanko

Its actually not Citi, JP Morgan Chase bank owns our credit card receivables since we sold our bank a few years ago and our relationship with Chase remains strong in my view. We renewed the agreement as you may know back in November which was attractive for us because it allowed us to reduce costs and at the same time lengthen some of our financing offers.

In fact we’ve been even more competitive recently with our offers and we’ve increased our term length in the second quarter by about seven months compared to the prior year. In terms of activity with Chase, they continue to approve the FICO rates and bans as they have been and they’ve remained relatively constant over time. So there’s really been no, as far as I know, no material change in terms of the financing offers that we’ve made other then to lengthen the term to be competitive.

You asked again about the vendors and what I would say is that to the extent that there has been areas of concern as it relates to the vendors and the factors, I can’t comment as to whether or not these vendors are able to get factors or if they’re able to get insurance, what I can say is that to the extent that I know about it, what I try to do is to facilitate with them on behalf of them with those providers to see if there are opportunities out in the marketplace to get them that insurance or factoring if possible.

So we’re doing everything we can to try to help them during this difficult time both broadly in a retail sector but certainly with our financial performance.

Operator

Your next question comes from the line of Matthew Fassler - Goldman Sachs

Matthew Fassler - Goldman Sachs

As we think about the payables ratio we understand that as traffic slowed you did pull back on purchasing, how should we understand doing the math on how much of the decline in the payables ratio relates to the pace of purchasing versus perhaps changes in vendor terms?

Bruce Besanko

Recall that our comp store sales declined by about 14%, our inventories decreased about 18% and our merchandise payables decreased somewhere over 30%. The primary driver of the decrease in payables is that our weaker sales performance resulted in slower inventory turns. In fact the bucket of inventory greater then 90 days has grown and vendors are typically paid in less then 90 days.

Additionally given the weaker back to school drive time we slowed our inventory receipts particularly during the back part of August in response to the weaker sales which further decreased payables. So the change in the vendor terms didn’t have a material, any change in vendor terms didn’t have a material impact on our payables for the second quarter.

Matthew Fassler - Goldman Sachs

On the credit facility one point of clarification, that $1.3 billion is against your gross inventory correct, not your net owned inventory?

Bruce Besanko

Correct. It’s against gross.

Matthew Fassler - Goldman Sachs

You talked about the haircut off the asset backed facility being of customary size if you could give us some ballpark since it’s not clear what’s customary, at least to me?

Bruce Besanko

I’ve seen it anywhere between 10% to 20% is sort of pretty customary.

Matthew Fassler - Goldman Sachs

You talked about your physical inventories having yielded better results how big of an impact did that have on your [grosses] this year? How much did your shrink accrual decline and how much of the gross margin improvement did that represent?

Bruce Besanko

Roughly our accrual change amounted to about a 20% reduction in the accrual rate for the second quarter. Let me step back on shrink because it was an important component of the gross margin result. Our inventory shrink is typically been very good as it relates to hard line retailers and we see absolutely no reason why we can’t continue to best-in-class performance that we’ve seen previously. But as you know last year we took our eye off the ball and experienced that sharp increase in shrink which was particularly felt in the second half of last year.

The good news though is that we’re fixing it. We completed a physical inventory and a representative sample of our stores and our results were significantly improved over the fourth quarter fiscal inventory results. In fact, it was about a 20% lower accrual rate then the full year fiscal 2008 rate. We’ve actually conducted some additional inventories here in the month of September and the results are consistent with what we saw in August.

I just wanted to say one more time to our Loss Prevention folks and our field folks you have done a great job in terms of bringing the shrink back to more normal levels.

James Marcum

On the credit facility because you’re asking about advance rates and what’s normal, I think the only thing to point out is that we ended the quarter with about $200 the facility is $1.3 billion, by the time we get into our peak periods, we will have close to $2 billion of inventory which is serving as collateral for that asset backed facility. So there is this pretty significant overcollateralization if that is of a concern to you.

Operator

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

Michael Baker - Deutsche Bank

Could you address flat panel television, ASPs what you saw this quarter, what you’re seeing in the channel in terms of inventory supply is loose or tight and then therefore what you expect to occur in terms of television, ASPs and margins in the back half of the year?

John Kelly

We’ve seen for the last few quarters, we’ve seen the average ASP decline a little bit in television both in small and medium and the large LCD and plasma in the high single to low double-digit price range but as a matter of policy I don’t want to give any forward view on ASP forecasts looking into the holiday season. From a standpoint of our inventory, we’re poised and ready to take advantage of just about anything that comes down and simple speaking we’re ready if anything were to come our way.

Michael Baker - Deutsche Bank

So then anything significant in terms of the size of TV? Are people still opting for the larger TVs or in a tough economic environment are you seeing any leveling off on the increase in inches per TV?

John Kelly

We’re seeing large LCD and plasma, we’re still seeing the demand being significantly high and as ASPs find they’re getting into a sweet spot which is more available from a lower price standpoint to the average customer then it has in previous years.

Operator

Your next question comes from the line of Anthony Chukumba - FTN Midwest

Anthony Chukumba - FTN Midwest

In relation to the strategic options and putting that on the back burner, does that also pertain to your international operations? Are those not for sale at this time as well, or are you still exploring strategic alternatives in regard to the international operations?

James Marcum

Frankly all options are on the table with respect to all of our assets and our strategic alternatives. So the answer to that is we have not precluded anything of that sort.

Anthony Chukumba - FTN Midwest

You talked about slowing down store openings significantly particularly next fiscal year, what is your stance in terms of store closings? In other words, is there potential that you close a significant number of stores given that you’re now sort of cutting back on the store openings?

Bruce Besanko

As you probably know in the past we’ve periodically closed stores either because of performance or because of the brand or for other business reasons and we’re likely to do so again in the future. We’re undertaking a comprehensive review of the business in order to identify and execute against ways to dramatically improve the overall financial position of the company and to preserve and maximize shareholder value and as part of that review, all options will be on the table.

And as I said, we intend to be transparent as it relates to the review over the course of the back half of the year and we’ll keep our investors, analysts, and other partners informed as to the progress during the second half.

Operator

Your final question comes from the line of Brian Nagel - UBS

Brian Nagel - UBS

With respect to gross margins, you actually showed some progress in the quarter, what are you seeing in terms of the pricing environment competitively, if there’s been any change in that, has the macro environment turned more challenging?

Bruce Besanko

As you’d indicated we had seen good improvement in terms of our gross margin just to refresh, we had consolidated gross margin improved by about 63 basis points and on the domestic segment it improved 74 basis points which was the first time in 10 quarters that we saw year-over-year increase. And the increase was really across the board, it was improvements in product margins, improvement in mix, warranty had a slight positive contribution and as I mentioned we also had a decrease in shrink.

The initiatives that we’ve talked about previously as well particularly in the HE area, things like the team-based incentive program, the dedicated supervisors and labor, the enhanced training have also benefited gross margin.

John Kelly

From a competitive standpoint I continue to see competition being very difficult, very tough and going into Black Friday I expect it to be a very, a lot of promotional activity and it will continue on through the holiday season I believe this year based on the real macro situation and people’s top line being effected.

James Marcum

With all of that said, we believe we still have opportunities within our own margin. We’ve been a company that absolutely has built a multi channel strategy and I believe we’ve done a phenomenal job in developing our web business but with that said, we have ourselves created some internal I would say some pricing, I don’t want to say conflicts, but we have an opportunity as we go forward to really look at our relationships between our web and in store pricing and opportunity to eliminate some of the confusion.

So it should benefit us as we move forward.

Brian Nagel - UBS

Regarding SG&A, how should we think about what you expect for staffing levels in your stores this holiday season compared to what we say in the last holiday season?

John Harlow

We have a very specific scheduling approach that we use that aligns staff to customer traffic sales levels and so you should expect a better in store experience, that is our commitment not only from the management team, but store management team and the staffing that will be put in place and is put in place for the front end of the store and the selling floor will be to deliver against that commitment. The work that we’ve done as it relates to SG&A and staffing again is largely behind the scenes so where we will be cost competitive if you will because we have very strong scheduling practices and we’ll be expense competitive because we’ve done a lot of work behind the scenes where the customer won’t see that cost to be as lean as possible.

James Marcum

With that said, I just want to say we very much appreciate everyone’s participation in today’s call and as you can see we had a lot of new information to share with you. We believe that we have set the right priorities for this business and we look forward to keeping all of the stakeholders updated on our progress. And to all of our associates who are listening, on behalf of all of us, we’d like to thank you for your efforts. As we head into the holiday season, I’d like everyone to remember, that these are our stores and these are our customers. Let’s make it happen.

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Source: Circuit City Stores, Inc. F2Q09 (Qtr End 08/31/08) Earnings Call Transcript
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