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Circuit City Left At The Altar, Now What?

By Glenn Curtis

Tickers in this Article: CC, BBI, NFLX, BBY

Second thoughts - they're not just for Hummer owners anymore. In April Blockbuster (NYSE:BBI) was the talk of Wall Street when it offered to pay $6-$8 per share for struggling electronics retailer Circuit City (NYSE:CC), but now it appears the company has had a change of heart.

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Blockbuster withdrew its proposal on July 1. Jim Keyes, Blockbuster's CEO, said the decision was "based on market conditions and the completion of our initial due diligence process". In short, this seems to be good news for Blockbuster and bad news for Circuit City. Here's my thinking on the matter:

The Positives For Blockbuster
One could argue that it would have been nice see Blockbuster team up with a big-name electronics chain to cross promote its wares, but at the end of the day, Blockbuster made the right move.

I don't think that the investment community was overly thrilled about the potential for the combination because Circuit City just didn't bring much to the table. Fact is, in its first quarter ended May 31, Circuit City reported a 7.4% drop in sales and lost $1 a share. That's not too swift given that arch rival Best Buy (NYSE:BBY) posted a roughly 13% increase in Q1 revenue and had earnings per share of 43 cents. Now with Circuit City apparently out of the picture, fence-sitting investors may be more willing to jump on the Blockbuster bandwagon, and the sell side may become a bit more upbeat about its future prospects as well.

The second big plus is that this allows Blockbuster to seek out other deals. It needs to retake some of the market share it has given to nemesis Netflix (Nasdaq:NFLX). We don't know which companies it might now look to pair up with, but in this operating environment, the more options you have, the better.

Bad News For Circuit City Shareholders
Not everyone is happy that the deal is off the table, however. Circuit City shareholders no doubt saw the potential merger as an "out". With Blockbuster's interest waning, the company will have to fend for itself again. Unfortunately, Circuit City, isn't quite ready for this. Consumers are very reluctant to spend money on big-ticket items. Meanwhile, deep-pocketed rival Best Buy is pushing really hard to drive traffic at its locations.

Circuit City saw some gross margin pressure in the latest quarter. In Q1, the company posted a gross margin of 20.8%, which is much lower than the 22.5% it reported in the comparable period last year. Meanwhile Best Buy saw its gross margin slip a mere 20-basis point from 23.9% in the comparable period last year to 23.7% in Q1. (For more on investigating margins, check out Analyzing Operating Margins.)

There are very few catalysts left for Circuit City's stock in the near term. Even if another suitor were to come along, which is possible, Circuit City won't be negotiating from a position of strength. At this point I doubt we will see much favorable research coming from the sell side, and some anxious institutional players could bail on the stock.

Bottom Line
Blockbuster made the right choice when it backed away from the Circuit City deal. Wall Street was never thrilled with the idea, and this gives Blockbuster a chance to find a more suitable partner. Blockbuster shareholders should feel relieved, but, unfortunately, Circuit City shareholders won't be able to share in the joy. For them the deal represented a lifeline, now that it has been pulled, the company has been left to fend for itself yet again.

To learn more about investing in merging companies, read The Merger - What To Do When Companies Converge.

By Glenn Curtis

Glenn Curtis started his career in the 1990s as an equity analyst for a regional firm in New Jersey. There, he covered companies in the technology, entertainment, and gaming industries. Curtis has since worked as a financial writer at a series of both web and print publications, including TheStreet.com and Registered Rep Magazine. He has held his series 6,7,24, and 63 securities licenses.

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