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3 Best Buy rivals look like better buys
The electronics giant dwarfs its competitors. But its stock sells at a premium, while competitors Tweeter, Ultimate Electronics and particularly Circuit City look like deals in comparison.
By Michael Brush
Best Buy (BBY, news, msgs) is hands-down the nations 800-pound gorilla in home electronics, but better buys abound for investors looking to put money in the group.
Chief among them are three smaller rivals that sell at a good discount to the gorilla. They should bulk up in value over the next two years as they take steps to look a little more like Best Buy and steal business from the leader.
They are: Best Buys chief rival Circuit City (CC, news, msgs); Tweeter Home Entertainment (TWTR, news, msgs), which caters to high-end home electronics lovers; and Ultimate Electronics (ULTE, news, msgs), which operates in the Midwest and Southwest.
Best of the breed
Of these, Circuit City looks like it offers the most upside for two reasons. First, its the largest of the three rivals, with more than 620 stores. Thats a far cry from Best Buys 1,900 stores, but its still a pretty big base. That means it has a lot to gain from a chainwide makeover it's doing over the next few years.
Second, Circuit City's stock is the cheapest. It has been beaten down badly by tough competition from Best Buy, a weak economy and worries about its somewhat scary credit-card division. The stock traded at $20 at the start of 2002. Last September, when I suggested shorting the stock, it was down to $10. By March of this year, shares had fallen another 55% to $4.
Since those March lows, however, the stock has rebounded by 90% to trade at $7.70. The shares still look cheap to value investors who bought recently. Circuit City is trading well below its book value of $11, says John LaForge, who helps run the Phoenix-Hollister Value Equity Fund (PVEAX) and the Phoenix-Hollister Small Cap Value Fund (PDSAX). Meanwhile, Best Buy is at five times book value. I mean, lets get serious here, people.
Circuit City also looks attractive because it has around $3 per share in cash and little debt, says John Buckingham, a value manager with the Al Frank Fund (VALUX). Buckingham, who edits The Prudent Speculator, an investment newsletter often ranked No. 1 by Hulberts Financial Digest, thinks the company could trade up to $14 in two years. He says its worth buying anywhere below $7.21.
For the very same reason -- valuation -- many investors are now dumping shares of Best Buy. The stock has shot up past $40 from $20 last November. Best Buy has moved to a price-earnings ratio of 20, from 10 times earnings, and now it is a little above its historic valuation range, says one fund manager who plans to close out his position over the next few weeks. Unless you can tell me we are going to keep going straight up from here, I am inclined to take my profits.
Heres why value managers and insiders recently buying shares of Circuit City, Tweeter and Ultimate Electronics think they will reap similar profits as these Best Buy rivals change tactics to steal some of the gorillas business.
Circuit City
Circuit City has the most work to do, and the most to gain. Its essentially taking three steps to look -- and sell -- more like Best Buy.
First, as an older retailer, Circuit City has many stores that show a lot of wear and tear. And often theyre in the wrong part of town -- areas that used to be shopping hubs but arent anymore because newer shopping districts have popped up elsewhere.
To correct these shortcomings, Circuit City is in the midst of a fairly aggressive makeover in which stores are remodeled or relocated. If initial results are any indication, the impact could be impressive. Sales at the handful of relocated stores are running 30% above chainwide results, says Ann Collier, who handles investor relations for Circuit City. And remodeled stores are seeing sales increase by around 14%.
So far, only about 15% of stores have been remodeled or relocated. The company hopes to get to around 40% of them in two years, says Collier. Near term, it plans to remodel four stores and relocate up to 22 before the all-important holiday shopping season that starts after Thanksgiving. Circuit City is also carrying out more-limited makeovers in lots of other stores, where its putting in new fixtures that allow for better displays and improving lighting. It should have about 200 of these mini-makeovers done by the end of September.
Next, Circuit City recently eliminated commission-based pay, again a step that moves it closer to Best Buys way of doing things. That helped bring costs down 9% -- excluding the remodeling -- in the most recent quarter. They are acknowledging that Best Buy has a better mousetrap in their sales approach, says one fund manager. That will help them close the gap.
Finally, Circuit City confirmed in its conference call last week that the board gave the OK for management to look for ways to get out of its sometimes-volatile credit-card business. Thats good news for investors.
To be sure, a lot of profit comes from the banking division, known as First North American National Bank, which issues Circuit City, MasterCards and Visa cards. It has accounted for anywhere from 50% to 90% of pretax earnings in recent years. So its a big part of Circuit Citys earnings story.
The problem is, the credit-card division scares investors for several reasons. First, Circuit City does not release all the details of how it works. Second, profit from this division swings wildly as changes in external credit-market conditions change the value of cardholder accounts that Circuit City can book. For example, the credit-card divisions posted a $20 million loss in the most recent quarter, compared to a $20 million gain a year before. Finally, in this economy, defaults and problem accounts are worryingly high.
In short, a sale of this credit-card division could lift a cloud from over Circuit City stock and net the company $3.68 per share, according to analysts at CL King & Associates, one of the few Wall Street brokerages with a positive opinion of Circuit City. Buckingham points out that shares of Sears Roebuck (S, news, msgs) advanced sharply after it announced plans to sell its credit-card division. It would definitely clear the story up, agrees LaForge. The reason you dont get a higher multiple is that people dont fully understand how the credit-card business works because Circuit City is still not divulging everything.
To be sure, this lack of full disclosure on the credit-card division means there could be more serious problems lurking in there. But LaForge doesnt think the company would be talking about selling the division if it knew there were serious flaws hidden inside. Besides, hes more interested in the prospects for the retail business and says Circuit City discloses as much as anyone there.
Tweeter Home Entertainment
Back in February, I wrote in a Market Dispatch item that this high-end home electronics retailer looked like a good buy after Michael Cronin, a director at the company, plunked down $9.25 million to purchase 1.8 million shares at $5. Chief Financial Officer Joseph McGuire and Chairman Samuel Bloomberg were also big buyers around the same time. Since then, these insiders have done well. Tweeter recently traded for $8.25.
But they are still not selling -- presumably because they have high hopes for the advice theyre getting from former Best Buy execs on how to turn around the business after two years of consistent sales declines. In addition to Retail Masters, a consulting group made up of ex-Best Buy managers, Tweeter has also brought in a former merchandising chief at Staples (SPLS, news, msgs), Philo Pappas.
These experts are improving Tweeters inventory management, merchandising and advertising at the chains 177 stores. Theyre also developing a long-term strategy to help Tweeter continue to set itself apart from mass merchants like Best Buy and Circuit City. Tweeter intends to sell more and more high-end home-electronics gear. At around $8.25, the stock trades in line with book value of $8.
Ultimate Electronics
This home electronics retailer based in Thornton, Colo., is taking several steps to improve profits. First, the company is reducing the number of items it carries, eliminating those that move less quickly to increase inventory turnover at its 58 stores. The full benefits will be seen in the third and fourth quarter and 2004, says David Workman, the chief of operations at the company. Its also putting in software systems that can track sales better. Next, the company has decided to stop selling computers; it's using the extra space to stock higher margin video games, cordless phones and digital cameras. It also has plans to roll out smaller stores, which produce higher profit.
At a recent price of $13.25, Ultimate shares trade below book value of $14.40 per share. During the past 10 years, the company traded anywhere from .3 to 4.5 times book value, with a midpoint of 2.4 times book, according to analysts at Dougherty & Co., suggesting room for upside.
Big-picture trends and risks
Two big-picture trends may help spur sales at all these home-electronics retailers. First, cable companies are getting more aggressive in rolling out high definition television (HDTV) in their ongoing battle for subscribers with satellite operators. That should juice sales of new television sets that can handle HDTV technology. With cable getting on board, that means 70 million households will have HDTV content available to them, says Workman. There are about 250 million analog television sets to be replaced over the next several years as HDTV technology catches on.
Next, the consumer is spending more on home electronics again. In the most recent quarter, Best Buys sales at stores open for a year or more were up by 2.3%. And the government reported recently that consumer-electronics sales in May grew by a seasonally adjusted 2.9% over April, when sales were up just .8% compared to March. Workman says Ultimate Electronics is looking for low-single-digit growth in sales at stores open for more than a year in the third quarter and mid-single-digit growth in the fourth quarter.
Theres always the risk that Wal-Mart Stores (WMT, news, msgs), with its power to force suppliers to cut prices, will grab a lot of that new spending as the nations biggest retailer moves deeper into home electronics. But Circuit Citys Collier is not too worried about that. We will be competitive with them on price, and we have a broader assortment from the low end to the high end, she says. The specialty home-electronics retailers also offer better customer assistance and home delivery service of large items. I think that whole Wal-Mart threat is overblown, says LaForge. Eventually price does not matter anymore; it is more about the experience.
Perhaps a bigger risk is that the hoped-for economic recovery turns out to be just a mirage. Weekly initial jobless claims continue to come in well over 400,000 -- the limit above which economists say economic growth is at risk. Meanwhile, with interest rates so low, how much more room is left for additional home mortgage refinancing, which has supported consumer strength for the past few years? If the home-refinancing boom peters out and unemployment stays high, you can expect the weak sales to hold back shares of Circuit City, Tweeter and Ultimate no matter what they do to grab business from Best Buy.
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