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Circuit City, the Bad Way Home

My Thoughts On: November 12th, 2008

Well, most of you know that I am an employee of Circuit City, part of their firedog staff. Recently, the company has been beat up financially and left for dead by most financial news outlets. I thought I'd record my insight on it, because my thoughts really apply to more than just Circuit City, probably just detailing my general outlook on businesses in this situation in whole. Still though, my opinion in no way represents Circuit City stores and everything I'm going to comment on is news that is already public. I apologize that I could not title this article "Short Circuit City" or "Holiday Closeout Sales Imminent", but that would be tacky and dumb - as it was on hundreds of financial news blogs carrying similar prose. In 2000, Circuit City stock traded for $58. In the last year it was as high as $9.58. Now it's about 13 cents. I think there needs to be some perspective on why this is, what is happening, but the more I read the press on it the less I see things giving a good glimpse of the whole picture, thus necessitating why I wanted to write about it.

Keep in mind two things before we start, first is that I'm attempting to remain neutral about most of these issues given that I'm clearly biased (I like my employer), and secondly is that most of these issues I am bringing up I am talking about the financial side of things, which may or may not float your boat. I know animosity is the prevailing attitude towards corporations, especially retailers, and I'm not going to deliberately try to play to that crowd (if you like that kind of thing, go read Gawker media network blogs). I personally just want to present this to you in the context of being open-minded about the situation.

The Big Picture

Circuit City recently filed for Chapter 11 bankruptcy, which most people don't understand very well. From what I've followed from financial news in the world today, most people think bankruptcy = immediate closure... which it certainly can, but each type (classified by "chapters" of the bankruptcy legal code) of American bankruptcy is a bit different. That's why it annoys me when people who claim to be economic aficionados say "bankruptcy" every time a company does poorly in any way, because bankruptcy is a legal process that can mean different things. K-mart stores in 2005 went Chapter 11, closed about 25% of their 2,000+ stores, but remained in business. Now they've completely recovered from bankruptcy as a stronger organization. Chapter 11 bankruptcy is "reorganization" bankruptcy, where the court protects the "debtor" (Circuit City) from the immediate legal complications by "creditors" (the people Circuit City owe the most money to are those companies whose product they carry, like Samsung and Hewlett-Packard), but this process gives creditors and the court the right to set certain expectations. Sometimes this procedure is the best way to deal with debt, although I won't lie - most companies, the decided majority, who file for Chapter 11 bankruptcy are not as lucky as K-mart in their restructuring efforts. There are reasons, many negative, why Circuit City seems to have gotten to this point. But, if you want to sort of understand how these things work, you have to look at it from multiple points of view... which financial bloggers and news outlets I've run into simply can't find themselves capable of doing (they "keep it pithy" by explaining a few quippy tidbits about the news, the few lame attempts I've read at explaining the situation got me nowhere at understanding anything about it).

Circuit City as a company operates about 700 American stores and roughly 850 Canadian stores ("The Source", a Canadian electronics chain previously operated by RadioShack). Their net worth is something like $3.4 billion dollars, and like most retailers they have a constant circulating net debt that is a significant fraction of that amount, around $2.3 billion dollars. Most companies like Circuit City operate in the margins - they earn credit to acquire stock, and constantly cycle it out, never having at once all the time to pay back every debt, but cumulatively earning a great degree in the act of rotating supply. Just as they operate in the margins on the national operational level, so do they in the stores - they sell most key items at low or sometimes negative profit margins (many laptops, for instance, are sold at a loss) in the attempt to get foot traffic in to capture those interested in high-risk, high-profit sales (such as extended warranties, accessories with high markup, and in-home or in-store service for their products). Recently, a number of financial hardships that had been building for some time along with the general economic downturn slammed the company, making those margins tighter and when those margins fail to cover the company's expenses, it threatens its entire operation. The result was the decision to close 155 stores (nearly 25%) and cut 17% of its domestic workforce (including 40% of the staff at the company headquarters in Richmond, Virginia). This leaves the investor, consumer and employee wondering what is going to happen next. But before I get into that, let me get into more background on the situation.

Poor Decisions

Companies don't get into these kinds of situations because they make all good decisions. Most of Circuit City's decisions are par for the course for a retail outlet, but some were really boneheaded. A good example to start with is the leasing policies. About 30 years ago when Circuit City was younger and we didn't know electronics would be such an annually changing business, well before the internet and the absolute takeover by bargain-marts like Walmart and Costco, Circuit City picked up what they thought were great leases on buildings and development sites. They were low but very, very long term... many locations wound up moving over time due to the changing landscape of the marketplace. Over the years we picked up many, many leases on sites that were remaining empty, either for stores we had there once but moved out, or were planning to move there but never did. Did we buy our ways out of the lease agreements? Not usually, the company just kept it all on the books. This happened until we were losing approximately $50 million annually on empty buildings/lots (I could be wrong with that number, let me know if I am, that was how I understood it).

In 2001, Circuit City, which was doing well for the time, decided to expand operations with a superstore "big box retailer" store concept. Averaging nearly 44,000 square feet, the stores were big, open and the norm for what you see today. It was equivocal to what you see at Best Buy, and made sense (possibly) for the time. Well, these stores required bigger floor space, more area to staff, higher operating expenses, and higher maintenance costs. When you operate in the margins, increasing all the expenses to have a store that is in all reality about double the size it needs to be can be really painful, and operating expense is a large chunk of the expenses which detract from profitability. In 2007 the Circuit City heads acknowledged the flaws of this model when they unveiled a more moderate 20,000 square foot model store, to be the norm for all stores launched after 2008, called "The City". The City differs from Circuit City Superstores in several key areas - they are nicer (the floor structure in general is more sensible), there is better operational equipment (such as handheld sales terminal devices, and newer sales terminal software), there is much less inventory on the floor (a more efficient warehousing scheme allows them to carry equivocal amounts of product without having large areas to maintain, tag and stock on the floor), and there is less footage so it is far easier to staff - a stark difference from a Circuit City Superstore which can feel completely empty due to its size when it is staffed with 4-5 salespeople (normal for weekdays from my experience). Smaller spaces and more controlled stock makes it more difficult for theft - always a significant area of interest for any retailer since theft always makes up a very sizable margin of business operations. This plays on trends set about by companies like Apple, who as much as I dislike them, demonstrated the profitability of going "smaller and nicer" in how they handle their store locations. Unfortunately, only a handful of Circuit City Superstores were relocated to The City locations, and it will be several years with the delays of future store openings before the financial benefits of The City model will fully impact the company.

Some of the bad decisions weren't so much operations-related as they were business-related. For instance, a lot of bets were hedged in the 2006/2007 battle over flat TV sales. The company was relying a lot on sales to go up, but the competitiveness from nearly every other major retail company doing the same made it a difficult and costly game to play. An investment, and loss, in the field of big screen TV's that year contributed greatly to other cutbacks that damaged the company's profitability (such as the 2007 layoffs, which I'll comment on later). Circuit City is not a big fish anymore, not with Costco's and Wal-Mart's handing out these TVs at ridiculous cuts by the baleful, and while it is important to remain competing, the losses from fights like this show that the company needs to play smarter, not harder. Going head to head with Wal-Mart is not going to win the day, a lesson I feel other electronics retailers already found out - like CompUSA. I think even Best Buy will start learning this lesson soon, despite how well the company is managing, it too is experiencing great dips in its stock value (in the last few months Best Buy lost nearly half its going trading value).

Some decisions were good but made too late to matter. I have firsthand experience with one such decision involving the recent change in how Circuit City handles warranty processing and repairs. For a while, Circuit City made a small but notable income from handling repairs for HP/Compaq computers under the manufacturer warranty, but would lose money on these operations because the agreement requires the stores to return defective parts back to HP/Compaq, and people would often forget to ship these parts back in. This would, quite oddly, result in hundreds of thousands of dollars of expenses - especially since warranty service work often comes with inflated costs on replacement parts ($600 for a hard drive, for example). This was eliminated in the last year by centralizing all warranty repairs at a pair of central service centers. While improving greatly on the profitability of that sector of business, as well as the profitability of all extended warranty repair, and offering an expanded ability to deal with customer manufacturer warranty issues beyond merely HP/Compaq, the centralized service depot financial benefits are only now becoming seen on the books. Operational changes like this were too late to be any real help with the situation we see now.

Cutting back on the salespeople has been a decision Circuit City has repeated in its history, indeed a lot of companies make cutbacks with employees before making operational changes. I've always viewed it like this; there are - at times - good reasons to cut back on available hands, to cut back what they're paid, and to replace them in bulk. I'm not going to say that "never" is a good time to make such a choice. However, too often people look at the payroll and think of it as an easy way to make budgets tighter, when in reality payroll is a very important element of how the business works. Division of labor is one of the central principles guiding any economy, and the typical rule of thumb is the more hands you can afford, the better... but this is contrasted by the easy-to-adopt mindset that labor problems are discipline related and that things would be "just fine" with shorter staffing if people simply worked harder, which is a rewarding but dangerous attitude to take, because it encourages people to run businesses woefully understaffed. Unfortunately, the people who make these decisions in this company and others are often rewarded for finding ways to cut back, reinforcing a bad habit in a very sensitive area to operations. In retail, more experienced people tend towards more consistent sales performance, better customer service, better morale, and lower operational costs (less training time, less time losing things due to mistakes, less internal shrink, less time spent performing basic operational duties all equal more time to capture sales). Cutting established employees shakes consumer confidence in a business, as well as demoralizes the remaining staff. That said, I'm still not going to say that there is "never" a good reason to cut staff, but for a company that needs to excel in customer service, it should be considered one of the last places to cut back, and policies of giving blanket executive/upper management bonuses for cutting payroll should be seriously rethought, in Circuit City and other companies.

At least two major events in recent history in employee cutbacks seem to have made long-lasting negative impacts on business at Circuit City. In 2003, Circuit City followed the standards set by other competitors and got rid of commission sales, which I think is mostly a good choice (electronics retail feels a little hostile to consumers when the salespeople are effectively lower-scale used car salesman), but the hourly rate change was not eased into, and to implement it there was a layoff of 3,900 experienced staff. Again in 2007 there was another major layoff (or "wage restructuring") of 3,400 sales associates the company felt were too "highly paid", many of which were the remaining veterans that had survived 2003 cuts. As part of the same initiative, a major restructuring of the management roles in the store converted salaried department management into step up hourly "supervisor" positions, which resulted in losing a lot of experienced store department management. Then department barriers were shed in favor of whole-store/half-store roles, forcing the remaining associates (mostly new) to become multi-hat sellers (often being asked to cover opposite sides of the store in the same shift). So, the company as it stands has few true long-term salespeople, they have less specialization in a given area, with management that has less of a role in their differing departments than they did in the past. I won't say there weren't a few good reasons going into some of these choices, but together they cumulatively hurt the sales potential of the company, and it takes time to correct these problems.

Faulty Consumership

What I see the most though, while digesting all this news about the company, is that anyone who bothers to leave a comment about it generally approves of the company's downfalls. A common comment is "about time", or "their loss is my gain!" I sometimes wonder what exactly these folks are thinking - sure, it's great to get a deal, but do we want all the medium-smaller sized businesses to close their doors just to get some Christmas-time liquidation sales this year? Where will you shop next year? Online or Wal-Mart will be the only options left, if these people had any say over the situation, and I doubt prices online or in mega-shopping centers like Wal-Mart/Costco are going to stay low if their competition goes under. These consumers don't seem to understand or appreciate the way these marketplaces work, and follow contradictory codes of frugality. Such as encouraging people to shop with smaller and local companies but then they try to drum out businesses that don't have Wal-Mart bargain bin prices. Constantly consumer expectations are being judged on bad customer stories, complaints about being "ripped off", and criticisms of greedy bourgeois fat cats that domineer our 9-5 lives.

I personally don't mind places like Wal-Mart, as much as they are criticized for being a lowest-common denominator business and ruinous to the values of the community, Wal-Mart brings jobs (which, because they are so scrutinized, actually are better than many local area jobs), and convenience of having everything under one roof. That said, I don't shop with Wal-Mart often, and I don't think Wal-Mart should replace every other business that competes with something under their roof. However, the marketplaces are moving that way, because increasingly stores with competing product are getting undercut and consumers are fine with it. With every Circuit City that goes out of business, Wal-Mart gains patrons. Part of Best Buy's success is conversely that it captures a larger share of people who do not share business with hypermarkets like Wal-Mart, in fact surveys show that 55% of Best Buy's shoppers also shop at Wal-Mart, versus 77% of Circuit City's shoppers. That of course is not a failure or success of either store, but a failure on the part of the consumers to support alternatives to single-option, single-roof hypermarket domination of the country.

I feel very similarly about online purchases. The business model of online stores is successful for the same reasons that the business model of hypermarkets like Wal-Mart is successful - it takes advantages of basic principles of the marketplace. Wal-Mart takes advantage of the cost-saving benefit of doing everything for everybody everywhere in one place (one market under Wal-Mart can be doing bad but Wal-Mart's profitability stays high enough to keep the store prices low), whereas online shopping takes advantage of the fact that they have next to no overhead or operating expenses because they sustain few to no brick and mortar locations, thus they keep prices low. There are advantages, and disadvantages to this model. But again I emphasize that the marketplace is large and I really think nobody should be one-sided about shopping online versus shopping in stores. Shopping in stores brings a series of advantages you can't get from online retailers; you have to weigh these things when considering the price differences. You get salespeople to talk to and deal with your sales issues, you get greater options for service, easier processing for returns and refunds, physical stock is actually available to you on the floor to see and sometimes use. But you expect that shopping at a store like this, without paying a Sam's Club membership fee or having to drive 30 miles out of town to one of the few/only physical locations (as it is in Oregon with Fry's electronics, which operates like one ginormous warehouse and does most of its business shipping product), that the price is going to be higher.

That consumers seem persistent to be belligerent about these issues, in lew of a shared attitude that big business is "out to get them" and it's "every man for himself", then you will see challenges for retailers trying to meet their needs. Nothing Circuit City can do will change that, although recently they did announce an initiative to make all prices offered consistent through web and store purchases, which is a good first step. Of course, most consumers will go, "so what, that's what they should do anyways!" despite the fact that, in all honesty, nobody on earth should expect a product being shipped from a warehouse should be the same price as a product delivered and stocked into local stores. Simply put, products delivered should always be cheaper as they are at other online retailers and if you expect to get it in a store you should have to pay more for it (so their online store can be competitive with other online retailers), but apparently that is too confusing a proposition for consumers and a cause of unnecessary customer service issues.

Whatever the case, as nearly every media outlet I've seen report news on this subject has never forgotten to reiterate, you can be sure to find closing sales at the 155 stores that are closing. Just remember what that leaves you with in your communities, higher unemployment and less buying options locally.

The Revolving Door

One of the biggest challenges for Circuit City during the next two months will be procuring enough actual inventory to sell things to people, it needs to have the inventory circulating, as stated before the company's liquidity and profitability go hand in hand. It will be embarrassing and defeating if inventory is pulled and vendors stopped supplying Circuit City with staple holiday goods. Let's face it - inventory of key ad items at Circuit City has been a problem for over a year now. Placement of these products for the holidays is under strain with vendors distressed at the bankruptcy news. Where there are real threats too there are rumors to make things worse, such as the recent incident when trucks of Sony product were shipped back due to a sinkhole at a Circuit City distribution center that was interpreted by internet ponzies as Sony blacklisting Circuit City and recalling their product.

Part of the bankruptcy filing addresses this issue; Circuit City recently lost a significant leverage for its standing $1.3 billion credit line, which left the issue of them paying back vendors in serious doubt. However the filing left Circuit City with an ability to receive up to $1.1 billion from the same lenders as debtor in possession of its remaining assets, as security for the interim changes, making this holiday a "go" as far as inventory goes. The people at Bloomberg seem to think that makes the company viable for recovery, while Forbes seems to hold the opposite view. I don't get paid at work for being a pessimist so I'll hold the former view for the time being.

What Happens Next

So all of that said, exiting 12 markets, closing 155 stores, laying off thousands of employees, renegotiating/closing millions in wasted leases, as well as having the liquidity of a guaranteed $1.1 billion loan on top of bankruptcy protection should buy Circuit City some additional time to get its things together. I'm not an accountant with access to the company books, so I can't tell you for sure if that is enough, or if further "restructuring" efforts will need to be put in place to ensure a turnaround, or if this is a phase of a full scale liquidation. What I will say is that Richmond local news reports that after interviewing interested people involved in the bankruptcy court case, that the game plan for the bankruptcy filing has Circuit City to be out of bankruptcy status in as little as four months, possibly even being in the clear and normal operations as soon as June as a "going concern" (a functioning business intent and capable of not doing any further liquidations or downsizing for the foreseeable future). Of course this is still minus a significant chunk of its previous workforce, a damaging permanent blow, but not an unrecoverable one. I doubt recovering from bankruptcy will be that simple, however, so expect more news to effect the situation in the coming weeks.

A total lack of investment presence means that the company is operating off what it has, which aside from the loan it received and the funds received from liquidation of its stores/liberation of its operating expenses, is not much. A way to revitalize that would be to emerge as a separate shareholding organization, as Kmart did in its Chapter 11 bankruptcy recovery, but that would cannibalize the values of the shares owned by Circuit City's major investors, which a debtor-in-possession should naturally wish to prevent. The thing that bothers me about industry analysts speculating things like this, speculating possible viability, or speculating furthered liquidation, is that the thing that happens in economies like ours today is uncertainty. Analysts lately are really doing a bad job, mostly, of predicting the future with the market bouncing up and down like a bobblehead doll. So anyone projecting one way or another for the company with this latest bit of news is likely, in some capacity or another, going to be proven wrong and we would do ourselves good to be a bit open minded about the possibilities.

Until then I retain optimism, as bankruptcy protection of this variety at this juncture is certainly the logical step if Circuit City wishes to retain operations for the near future and foreseeable future. Thereby, James Marcum (our acting CEO, at the behest of Mark Wattles) has progressed in the correct order. In that order, they may keep Circuit City open as a functioning business, because any prospective buyers would've stepped up by now and that is its only future viability. So, for the time being, it will be "business as usual" as the CEO addressed in a recent letter to customers, investors and employees. It's hard to say though beyond that, it will definitely depend on how these bankruptcy procedures progress through the holiday period and beginning of the next year, and how well the current changes actually affect the books. It's just, that after all the company has been through, it'll be hard to penetrate the idea of "business as usual" into the consumer's consciousness... most people simply don't have the time to understand how complicated this type of thing can tend to be.

That said, I'm still working Black Friday whether customers decide to show up or not, so how this affects me in the short term is pretty clear - none. Unfortunately in some parts of the country, Circuit City employees cannot say the same as me.

To me, there are a few fundamental flaws I would like to see fixed before I could say Circuit City is back as a contender again like it was 8 years ago, and they're all achievable if the company is capable of weathering the storm it's facing right now. One, is the deployment of The City on a scale where it has become the standard form for Circuit City's retail presence, this would save a lot of money and make the company much more viable for the long-term, as well as greatly improve the shopping experience of their customers. Two, would be the abandonment of profitless sales and high-risk attachments, making some of those key products a little more profitable while making the profit-earning attachments a little more affordable (thus exposing people to our services a little more), but that would require institutional changes I think that could never take place. Basically the idea being, that consumers are not as afraid of buying at rates where we actually make money on key items, so long as they got a "no bullshit" attitude by the company about the services and accessories available with that purchase. Lastly I think would be the issue of actually capturing the market of those interested in customer service, by not being afraid to spend on a healthy budget for in-store staff at the new, smaller "The City" locations. It would really be great if we could keep the stores chock full of handy helpers to fill their shopping carts (well, Circuit City doesn't really have shopping carts, but still). Survive the maelstrom and complete that set of challenges and I think it would be smooth sailing into the limelight again for the company. In the meantime there is a lot to wreck the trip, Circuit City definitely did not pick the easiest path to go.

- Phoebus Apollo

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