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Watch Out, Best Buy And Circuit City


This holiday season, Wal-Mart Stores Inc. () has made no secret that it's gunning for the nation's two largest consumer-electronics chains, Best Buy Co. () and Circuit City Stores Inc. () Wal-Mart has spiffed up the interiors of many of its electronics departments and added a slew of high-end products, from Sony () liquid-crystal-display televisions and Toshiba () laptops to Apple () iPods. It's backing the changes with an aggressive holiday marketing campaign and a big day-after-Thanksgiving sale. But here's what really has Best Buy and Circuit City worried: Wal-Mart has entered their most profitable line of business, extended warranties, and it aims to turn that business on its head.

Although they don't disclose it in their financial filings, the real earnings engine at Best Buy and Circuit City is not the sale of gadgets themselves but the sale of warranties. Those are the high-priced, multiyear protection plans on TVs, computers, and other items that are hawked by the retailers' salespeople at the close of each purchase. This fiscal year analysts estimate warranty sales will account for more than a third of Best Buy's operating profit and all of Circuit City's. On Oct. 27, Bentonville (Ark.)-based Wal-Mart attacked that profit source by launching extended warranties on TVs and computers at prices that average 50% below Best Buy's and Circuit City's, says Jane J. Thompson, head of Wal-Mart's financial services.

Best Buy is better positioned than Circuit City to take the hit because it has found more high-margin services to bolster its bottom line. But Wal-Mart's entrance ultimately puts both retailers in a bind. They can either not respond and potentially lose sales, or cut warranty prices and hurt profits. The dilemma comes at a difficult time. Prices of electronic goods are steadily falling, crimping margins for both companies. "Profit on extended warranties has always been the Achilles' heel of Best Buy and Circuit," says Todd Kuhrt, a former consumer-electronics retailing analyst who is now president of Ardor Capital, a Cleveland hedge fund. "Wal-Mart is cutting right at the heart of their business model."

Wal-Mart's push in consumer electronics is part of its broader effort to attract more upscale shoppers. It has found that wealthier consumers generally use Wal-Mart just for food and cleaning products. To get them to shop the whole store, Wal-Mart is upgrading its apparel, home furnishing, and electronics departments. But analysts figure that if any one of them will get traction first, it will be electronics, because it offers more respected brands.

Shoppers at the newly remodeled Wal-Mart electronics departments -- 1,300 of its 3,100 U.S. stores -- will feel the difference walking down the aisles. The new Rogers (Ark.) store reflects the change. The entire section can be seen in a glance, thanks to lower shelf heights and wider aisles than are customary at a Wal-Mart. Shoppers will find higher-quality displays packed with digital TVs, cameras and camcorders, portable DVD players, and a special display case for iPods. Wal-Mart is negotiating to add more strong brands, such as Samsung TVs. Borrowing a page from Best Buy and Circuit City, Wal-Mart has added 0% financing. Gary Severson, Wal-Mart's chief electronics merchant, says shoppers often exit Wal-Mart to buy gadgets at Best Buy and Circuit City. "I want to give them a reason not to leave," he says.

Should Wal-Mart successfully divert sales from Best Buy and Circuit, its entry into extended warranties will have a substantial long-term impact on the two retailers' profits. On any warranty contract, Best Buy and Circuit City keep 50% to 60% of the revenue, says Jim Sebastian of SAFE LLC, a warranty consultancy involved in setting up Best Buy's program. The balance is divided between an administrative firm that handles the adjudication of claims and an insurer that underwrites the warranties. With little selling expense, the retailer's portion flows straight to the bottom line. This fiscal year, Ardor's Kuhrt estimates warranty revenues will deliver 36% of Best Buy's operating profits and all of Circuit City's.

EARNINGS HIT?

Because such a small percentage of overall sales accounts for such a large percentage of profits at both Best Buy and Circuit, any fall in warranty sales would have a proportionally bigger hit to earnings. Kuhrt, whose hedge fund has no positions in any of the retailers, estimates that, as a percentage of overall sales, a one percentage-point fall in warranty revenue would cause an 8% drop in Best Buy's operating profit and a 29% fall at Circuit.

Apart from the cut rate, Wal-Mart's warranties will be similar to Best Buy's and Circuit's. Wal-Mart uses the same administrator and insurer for its warranties as Best Buy -- N.E.W. Customer Service Companies Inc. and American International Group Inc. (), respectively. On a $1,000, RCA 52-inch digital projection TV, for example, Wal-Mart is charging $29 a year for an extended warranty, while Best Buy is charging $62 and Circuit $100. Wal-Mart's Severson says it's "safe" to conclude that the retailer will eventually market its pricing advantage on warranties. "It's a good story to tell."

One other big difference for buyers: Wal-Mart's extended warranties commence after the manufacturer's warranty ends. At Best Buy and Circuit, warranties begin upon the product sale, so they overlap with the manufacturer's warranty and don't give buyers much additional benefit for the first year or more. Best Buy claims that its policy would cover things a manufacturer's wouldn't, such as power surge damage. Circuit declined to comment.

Investors wouldn't know how important warranties are to Best Buy and Circuit City just by reading the financials. Circuit only discloses total warranty revenue and its percentage of total sales: $182 million, or 4% of total sales, for the first six months of this fiscal year. Best Buy used to give those figures but stopped providing them after fiscal 2001, burying it in a revenue category called "other." Then it stopped reporting that category in fiscal 2004. Spokespeople for both companies decline to give more detail.

Not all analysts are convinced Wal-Mart's move will cut into Best Buy's and Circuit's earnings. Colin McGranahan, of Sanford C. Bernstein & Co., notes that it's the sale of the gadgets themselves that drives warranty sales. He believes consumers will put Best Buy's and Circuit's greater choice before the price of a warranty. But of course, most buyers still don't realize how much more expensive their warranties are than Wal-Mart's. The test comes when they find out. Eric Arnum, editor of the online trade publication Warranty Week, predicts this outcome: "[Wal-Mart] is killing the goose that lays the golden egg."

By Robert Berner


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