The Revival Of Brick-And-Mortar

Investor's Business Daily

Retailers of consumer electronics have vastly outpaced the general market since the start of February, signaling that the industry's ongoing shakeout may have turned a corner.

Chains like Best Buy (BBY), Circuit City, Fry's Electronics and H.H. Gregg (HGG) suffered or failed in the past decade as customers turned to online shopping, and big-box names led by Wal-Mart (WMT) and Target (TGT) carved out portions of the market.

Now, with Circuit City gone and the economy improving, remaining consumer electronics retailers are looking more svelte, smart and attractive to investors.

"The worst is behind as consumers begin to show signs of recovery and new product cycles hint at emerging upticks in some categories," said B. Riley & Co. analyst Scott Tilghman. "But ultimately companies will have to manage their cost structures and their differentiation to effectively compete in the coming years of these new cycles.

Shares of Best Buy spiked 16% Thursday (and are up 112% year to date) after the company announced smartphone maker Samsung Electronics would this month launch Samsung Experience Shops built within Best Buy and Best Buy Mobile stores across the U.S. The program targets 900 locations by early May, and aims for more than 1,400 sites by early summer.

The shops would leverage the brick-and-mortar advantage over online shopping by giving customers a firsthand look at Samsung's smartphones, tablets, laptops and connected cameras, offering brand-specific expertise.

The move is the kind of thinking that has drawn several analyst upgrades in recent weeks amid turnaround efforts by new management and an improving market. One came from Piper Jaffrey analyst Peter Keith, who on March 11, upgraded the stock to overweight from neutral.

"The essence of the upgrade is a substantial upgrade in management talent and diminished competitive head winds, both of which should contribute to meaningful operating margin expansion over the coming years," Keith told IBD.

Best Buy's new management is headed by turnaround wiz Hubert Joly, who took the chief executive spot in September. He's looking to jump-start growth through a restructuring aimed at upping online sales, escalating the multi-channel customer experience and cutting costs.

But not all funds are buying. At the end of 2012, Cubic Asset Management owned 318,340 shares of Best Buy, then sold them off in the first quarter. Frank Lombardi, portfolio manager at the Boston-based firm, said the stock had reached a fair valuation.

Why did Cubic buy Best Buy to begin with? "I think there's space for one big box consumer electronics retailer out there, and Best Buy has the brand equity to remain viable," Lombardi said. "Also, the valuation was attractive, particularly at $12 a share, given the free cash flow the business produces.

Lombardi was also impressed with the "intelligent thought" Joly has put into his restructuring efforts, including shrinking the store size and lowering the cost structure.

Investors have responded by driving the small, six-stock group to a No. 2 ranking among the 197 industries tracked by IBD, up from No. 150 at the start of the third quarter.

Part of the reason could be the recovering housing market, which could benefit the group by spurring demand for appliances. Keith says that should help players like H.H.Gregg, a specialty retailer that sees a large share of its revenue from appliance sales.

Another beneficiary, Beaumont, Texas-based Conn's (CONN,), specializes in consumer durables like appliances and furniture as well as electronic devices. It has logged four straight quarters of strong growth. In the fourth quarter, earnings jumped 59%. For the full year, earnings spiked 136%.

The performance sent the stock up 22% for the week, and to a 43% gain so far this year.

Powerful TurnaroundBest Buy has, by far, the group's biggest footprint, with 4,379 stores in the U.S., Canada, China, Europe and Mexico. More than 1,500 of those stores are in the U.S. It has 2,876 stores overseas, primarily in Europe.

Keith describes the Richfield, Minn.-based chain as being in the early stages of a "powerful" turnaround. Holiday season sales strengthened vs. the prior couple of quarters. The quarter showed some "stabilization" in U.S. same-store sales growth and gross margins, he said.

For the fourth-quarter, earnings slid 25%, but still easily topped analysts consensus views. Analysts polled by Thomson Reuters don't see profit growing until 2014, and then only by 8%. They forecast a 9% rise in 2015.

But management is launching a growing number of initiatives to battle online rivals. A key challenge is "showrooming," where shoppers use brick-and-mortar stores to test and experience a device, then turn around and purchase through Amazon.com (AMZN)and other online retailers.

On March 3 Best Buy also launched its low-price guarantee. It pledges to match the price of any local rival retailers as well as 19 top online venues. The promise covers all product categories and nearly all in-stock products.

Conn's has been the group's top performer, measured in financial fundamentals, turning in strong gains the past four quarters. In the most recent fourth quarter reported April 3, that 59% earnings climb was built upon a 10.4% sales gain. Same-store sales rose 7% vs. a year earlier.

Unlike many rivals, its 68 retail locations across the Southwest and Texas offer in-house credit options for customers. In the last three years, it's financed roughly 61% of its retail sales through internal credit programs.

Its target audience is low-income customers who are "under-banked" and don't have what Tilghman calls "credit-worthiness," making Conn's alternative credit a big draw.

Tilghman says customers tend to buy a little at a time — and then pay their bills in the store. So they may buy a TV and come back to the store to pay it off and then buy more while they're there. That leads to a nice repeat business, he says.

The company also does a strong business in higher-ticket, deliverable items like home appliances, which shoppers typically don't buy online or at mass market chains, says Tilghman.

H.H. Gregg, which has 228 stores in the Midwest, East and South, gets about 40% of sales from appliances. Its commissioned-based sales force offers a more "service-oriented" experience compared to other big-box retailers, Keith says.

It's seen earnings decline the past few quarters, including what Keith calls a "challenging" holiday season. Analysts polled by Thomson Reuters expect a decline in profits in 2013, followed by a 7% rise in 2014.

The company is slowing its store growth, focusing instead on making existing stores more productive, Keith says.

If there's a "solid multiyear" appliance replacement cycle, the company will benefit. But year-to-date, he hasn't seen evidence appliance replacement has picked up dramatically, he adds.

Wholesale revenue for the consumer electronics industry rose 4.7% in 2012. The Consumer Electronics Association expects this year's growth to slow to about 3% to $209.6 billion.

Consumer spending on consumer electronics is rising, says Koenig, director of industry analysis at the CEA. Spending on consumer electronics in 2012 — among households that spend on these products — measured about $1,300 per household, up 36% from 2011.

Koenig attributes the rise to the huge popularity of mobile connective devices — tablets, laptops and smartphones.

"This trend of mobility and connectivity is increasing in importance, and we're expecting continued growth in a lot of these categories," he said.

The CEA sees tablet shipments climbing 45% this year to 116 million units in the U.S. market. Wholesale sales of tablets are forecast to pop 21% to $37.2 billion this year.

Smartphones continue to be a key revenue driver for the industry. The CEA sees smartphone unit sales up 12% to 129.9 million. Smartphone shipment revenue is expected to climb 12% to $37.3 billion.

The CEA expects laptop/notebook computer sales will continue to rise as 26 million units are projected to be sold in 2013, accounting for $17 billion in wholesale revenue.

A Bite Of The AppleApple (AAPL), which operates its own stores, has taken a lot of consumer electronics share over the last couple of years with introduction of the iPhone and iPad, says Keith. While many retailers in the space sell Apple products, the allocations certain retailers get from Apple are quite small, he adds, because Apple has its own strong self-distribution capability.

But the playing field is leveling out a bit. In recent months more "legitimate" competition has come to the market in smartphones and tablets from companies like Samsung, which uses the Android platform and has had some recent success in both these product categories.

Best Buy stands to gain a nice competitive boost from its deal with Samsung.

Another plus for consumer electronics chains: Amazon's competitive stance has weakened a bit, says Keith. The reason: Amazon will be starting to charge sales tax across various states by the end of 2013, he says, resulting in about 50% of the U.S. population paying sales tax on Amazon purchases.

Following Best Buy's lead, H.H. Gregg has implemented a price match guarantee. The chain pledges to match competitors' lowest advertised prices on in-stock merchandise of the same make and model up to 30 days after a purchase.

A Cautious BullTilghman is "cautiously optimistic" that Best Buy can make the right moves to succeed.

"For the time being, I remain focused on company specific opportunities that offer unique investing opportunities," he adds. "For instance, Conn's has a unique customer focus and H.H. Gregg is going after the appliance and delivery markets.

Keith also takes a company-specific approach.

"We're very bullish on Best Buy," he said. "We think there's a very company-specific multiyear turnaround in the early stages of beginning. We think we can see a very nice improvement in operating margins over a couple of years.

He's less optimistic and still neutral on H.H. Gregg. He says it's more dependent on the industry backdrop with appliances and TVs and less on company-specific drivers.

Koenig says brick-and-mortar retailers can't simply compete on price.

They have to add more to the mix, including building relationships through social media and other ways and taking a more consultative selling approach.

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