Price-War Worries Trip Up Best Buy

Electronics retailer Best Buy (BBY Quote) failed to reassure investors Tuesday that it could avoid a damaging price war.

Shares in Best Buy, the dominant electronics retailer, skidded Tuesday after the company reported a solid first quarter, but said second-quarter numbers would fall short of expectations. Best Buy attribued the shortfall to higher-than-expected costs to open stores in Canada.

Compounding investors' concerns was evidence of continued price-cutting at rival Circuit City(CC Quote), which also reported a decent first quarter on Tuesday. Some investors are clearly worried that price cuts could eat into Best Buy's margins, which were slightly disappointing in the latest quarter.

Meanwhile, Circuit City is in the midst of a turnaround begun when it exited the appliance business in 2000; since then, the company has been busy remodeling its stores. But once the outlets are remodeled, the company has to get the customers back, and beating its big rival on price is the easiest way, observers say.

"Circuit City's strategy is to drive traffic by selectively cutting prices, and of course Best Buy has to match them," says Colin McGranahan, who follows the company for Sanford Bernstein. (He has market outperform ratings on both Circuit City and Best Buy; his firm does not have an investment banking business.)

In its conference call, Best Buy executives admitted promotions have been higher than expected, particularly for lower-end DVD players. The company's gross margin edged up by just 0.3% compared to a year ago -- tiny compared to last quarter's 2.6% rise.

In the quarter, Best Buy said it earned $70 million, or 22 cents a share, up from $55 million, or 17 cents, in the year-ago period. On average, analysts expected the company, which operates over 1,900 stores, to earn 21 cents a share, according to Thomson Financial/First Call. More importantly, the company forecast second quarter earnings of 30 cents to 32 cents a share. The company had not previously given second-quarter guidance, but Wall Street was anticipating earnings of 33 cents a share, on average.

Eden Prairie, Minn.-based Best Buy said costs from launching stores in Canada and sprucing up and remerchandising two of its smaller chains, Future Shop and Sam Goody, will eat up about 4 cents a share of second quarter earnings. Still, the company stuck by its previous forecast of 17% to 20% growth for the year, which would equate to $2.10 to $2.17 a share. The consensus forecast is for $2.13 a share.

Meanwhile, Circuit City, based in Richmond, Va., reported net income of $27.9 million, or 8 cents a share, up from $16.9 million, or 5 cents a share last year. Sales rose 13% to $3.12 billion. The company said it has slashed prices on video games, music and some DVD players.

Best Buy shares closed down $3.14, or 7.4%, at $39.12, while Circuit City lost 29 cents to trade at $21.11. Both stocks have lost ground this year. In Best Buy's case, valuation worries, as well as concerns that slack demand seen at competing chains could eventually hurt Best Buy, have weighed on shares. But Circuit City has had its own problems, and earlier this year investors worried that the costs associated with the remodeling would be higher than expected. And they were: in February, the company forecast that the costs would eat away about 18 cents a share in earnings this year; Circuit City stuck by that guidance Tuesday.