Wednesday, February 6, 2013

Experiments Leading To Profits

"On the subject of economies of scale, I find chain stores quite interesting. Just think about it...You get a whole bunch of little laboratories out there in which you can conduct experiments" - Charlie Munger

Certain former market darlings are having a rough go of it these days. Though Mr. Market's mood has turned decidedly positive over the last 3 months, certain retailers remain mired at cyclical lows. The market has all but written off some of the country's largest electronics retailers, as they have seen declining sales and profits as a seemingly non-profit competitor continues to expand its reach.

But Mr. Market's outlook may be grossly wrong, having under-estimated the advantages some of these companies have combined with ROIC mean reversion. Now that the industry faces challenges, you are likely to see some of these advantages come to light once again.

For a few years leading up to the housing bubble and thereafter, Americans couldn't get enough of new flatsceren tv's. As a result, electronics retailers were in cruise control, selling these high margin products for generous profits. When overcapacity finally hit the tv industry, however, the recent glory days for electronics retailing came to an end. Prices, along with margins and profits, fell. New products (smartphones, tablets, e-readers) could not grow fast enough to match the declines in tv's, especially as one supplier (Apple) came to dominate a chunk of the market (commanding market power in the form of lower gross margins) and a major online competitor (Amazon) had a sales tax advantage and saw no real need to generate profits.

This has forced the industry's bricks and mortar retailers (Best Buy, hhgregg, RadioShack among them) to re-think their strategies. And the initial results appear to be positive.

Consider the latest of these companies to report, hhgregg (HGG). While same-store sales are down in the high single digits, there were a number of new initiatives discussed on the company's latest conference call which provide reasons to be optimistic.

The company is using in-store experiments to test a number of new ideas, some of which have gone so well as to be rolled out company-wide. Following these experiments, the company has begun selling furniture and fitness equipment, taking advantage of the company's local presence in delivery and installation. It is growing its non-recourse consumer credit program, having found that customers using hhgregg credit cards become more loyal shoppers, buy more expensive products (thanks to credit), and have higher attachment rates.

At the same time, the company is cutting SKUs in its declining tv business, which is a positive for the industry as a whole. When an industry is plagued by overcapacity, sometimes exits are the only way to push returns back to normal, which bodes well for all participants.

For their part, both RadioShack (RSH) and Best Buy (BBY) are also cutting investments in areas that aren't profitable through a combination of reductions in store-count, store type, and square footage. In addition, Best Buy has also been testing new-concept stores with better-trained employees, which will also provide the company data it can use to determine which initiatives to roll out nationally. Despite the headwinds facing the company, Best Buy actually managed to hold US same-store sales flat in the all-important holiday season that just passed, demonstrating that the company is far from dead.

With strategic exits leading to ROIC normalization in poorly performing categories, along with declines in the importance of the video category, the beaten-down shares of leading electronics retailers (i.e. those with economies of scale and barriers to entry) could see dramatic rebounds. The power of the experiments Munger describes in this article's opening paragraph can help these well-capitalized retailers find categories suited to their localized presence and their more personal contact with the customer.

Happy investing!

Disclosure: Author has a long position in shares of BBY, HGG, and RSH

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