Pitched 9/20/05, Updated: 10/9/05

Circuit City. $17.17

Long- No Catalyst- Medium Conviction- 6-mo. Price Target: $21- Risk: $16

Background: Circuit City (CC) is managing a turnaround while the Consumer Electronics (CE) sector enters a product adoption sweet spot. If last holiday season was the season of the iPod, this year is likely going to be the year of the $1,500 42” plasma TV. Additionally CE will benefit from a new launch of video game systems, sub $1,000 digital SLR cameras, HD/bluray DVD players and other new technologies. These items are bullish for retailers as they expand margins and increase revenue with their higher ASPs and warranty attach rates.

Recently, despite oil, storms and rising interest rates, the consumer has not slowed in September (SBUX SSS +10%, WMT +3.8%, ANF +20%, TWTR Q4 +10%) and housing sales (drive home electronics demand) remain extremely strong. In Q206 (9/20/05), CC beat earnings estimates by $.04, reporting a profit of $.01 v. expectations of a loss of ($.03). The company also reported comps of +5.3% for the quarter and raised FY06 sales guidance to +5% to 8% vs. previous 3% to 6% guidance. CC has a new, energized and proven management team, strong cash position, and potential for significant operating margin expansion. The marketplace remains fragmented with industry leaders positioned to take market share (CC and BBY account for about 33% of the market, compared to HD & LOW’s @ 50%, ODP, SPLS, OMX @ 75%.).

Thesis: Trough EPS is behind CC. CC is not fully appreciated as a turnaround story. Back-to-School was solid and is often a solid leading predictor of the holiday season. As money managers prepare for ’06 and the holidays, CC will be discussed and dug into. As the street rolls over to next year’s numbers, I expect CC to appreciate up to 25% over the next 3-6 months.

Timing: Few upcoming catalysts, so we will need to be very cognizant of trends in consumer spending, confidence, jobs, etc…  There is the temptation to try and wait for a market pullback, but I prefer to buy here and not get cute on an entry point. BBY has an analyst day on 10/19 which may provide some color on the promotional environment.

Risks: Within the industry, there is the threat of a return to a more promotional, less rational pricing environment. The big risk is that there is a macro meltdown in consumer spending driven by a rising interest rate environment/bear market for housing, rising energy and commodity costs, upward revaluation of the Chinese Yuan putting pressure on inflation & GM, etc… I would like to look for hedge ideas directly related to what I consider the most likely bear market scenario (a slowdown in housing) by shorting a name like KBH. Furthermore, there is the counter-argument that if you want to play the HDTV cycle this winter, that you should buy the industry leader BBY. However, I think that the valuation argument favors CC over BBY and that BBY has currently taken their eye off the ball. Industry leadership in CE is not self-evident. Remember, CC in the ‘80’s was featured in “Good to Great” as an example of a tremendous industry leader. Load up on industry leader BBY under $40.

Conviction Explanation: No upcoming catalyst, so buying here requires taking on market risk, but I feel pretty strongly about the turnaround taking place and the street coming around to the story—the question is when.

Target/Risk: As street rolls forward to FY07 numbers, I expect that estimates will move up near $1.00 a share (~2.5% Op. margin v. 1.3-2.3% guidance for FY06) and CC will trade at 21x forward earnings, in-line with their current multiple and at a slight premium to competitors due to the potential earnings power of a successful turnaround. I think that there is very limited downside due to buyout offers in the mid teens and current earnings growth.

Additional:

> CC continued their positive financial momentum. In Q106, when inventory growth exceeded revenue growth, analysts became worried about the sustainability of gross margins. However in Q206, revenue growth (7.8% y/y) exceeded inventory growth (2.0%). Additionally, Accounts Payable grew by 9.0%, significantly exceeding inventory growth. Together these statistics could indicate that CC has a relatively very "fresh" inventory (high A/P growth) and is using that to help continue a trend where they are able to sell off current inventory efficiently, rather than have it build up in storage (inventory growth > revenue growth). This will hopefully reduce the need to run aggressive price promotions or inventory liquidations in the future and thus will protect gross margins.

>CC has identified 5% operating margins as their target. BBY current enjoys 5.8% margins. Applied to current sales, a 5% operating margin would produce FY06 EPS of approximately $2.00. (At a 17x multiple on $2.00, you get $34/share. Not something expected to happen for several years, but clearly shows the power of the turnaround thesis.)

>Phil Schoonover joined CC in October ’04 and was named President in February ’05. Schoonover was previously at BBY where he helped to lead their turnaround in the mid ‘90’s and was recently responsible for their Consumer Centricity initiative. (Centricity-converted store sales have significantly outperformed other BBY stores behind initiatives to abandon highly promotional, low margin areas such as DVDs and CDs and focus on the 20% of customers that drive 80% of profits).

>In Q205, CC lapped positive comps with positive comps (+2.9% in Q205 v. +5.1% in Q204)- a key to getting the leverage necessary to move towards 5% operating margins. SSS were boosted by higher close rates and an increase in average ticket prices. However, they were hurt by 89bp due to a decrease in wireless sales and by 38bp due to a decline in digital video service sales due to business model shifts in FY05. CC anniversaries changes in Digital Video Services on 7/1, wireless in Q306. Those hurt comps by 127bp in Q206 and as they are lapped, comps should benefit as a result. Furthermore, if the 2yr trend of 4.0% from Q206 is maintained, SSS could rise into the low double digits in 2H06 which should generate excitement.

>BBY Taking their eye off the ball? BBY has traditionally run the most relevant ad campaign, but recently I have not found that to be the case. CC’s ads are irritating, but run constantly during MNF and other important shows, drive home their position as a retailer of advanced TVs and appear more focused than BBY’s current ads which build their brand but do not specifically sell TVs.

>CC has approved an $800m share repurchase program, funded by $678m in cash on their balance sheet (~$3.50/share) and positive FCF (~$60m est. FY06). $540m has been repurchased so far. This shows management confidence in the turnaround as well as supports a stock valuation in the mid teens.

>Highfields capital made a buyout offer for CC at $17/share in February ’05. This was the second buyout offer in two years to be rejected and gives support to current valuations.

> On the downside, Wal-Mart, Costco, Dell, HP, Amazon.com and EBay are all competing in this market. Costco is getting especially good reviews.