ࡱ> qsp5@ 4bjbj22 M`XXT,hhhh$$$8%%%8%4 &L8I2d&d&z&z&z&,4,4,4 I"I"I"I"I"I"I$JR%MFI$<1>3@<<FIhhz&z&4 [I>>><Thz&$z& I>< I>>?VLG@6$Gz&X& r%>G ,HqI0IGTM>:MG88hhhhM$G@,4 86v>7,8,4,4,4FIFI88>88  November 11, 2004  Ian Madsen, MBA, CFA, Editor imadsen@zacks.com  www.zackspro.com 155 North Wacker Drive ( Chicago, IL 60606 Tweeter Home Entertainment (TWTR NASDAQ) Note to reader: All new comments since last report are highlighted. Overview Tweeter Home Entertainment Group is one of the nation's largest high-end specialty consumer electronic (CE) retailers in the US. The company currently operates approximately 175 stores in 21 states. While its stores are spread out, it has higher store concentrations in the South and South East, California, and the New England states. It operates primarily under the trade name Tweeter in most parts of the country, but it uses the trade name of Sound Advice in Florida and HiFi Buys in Georgia. Its stores average approximately 12,000 square feet. Tweeter reported lackluster third quarter results on July 27, but the analysts had been expecting those results after the companys negative pre-announcement in late June. After the report, the analysts indicated the companys current business trends and a lack of visability make forecasts for the fourth quarter an increasingly difficult task. As a result, most took a more negative view of the quarter. Longer-term, analysts believe Tweeter will continue struggle until higher-end consumers feel more comfortable making big outlays for discretionary purchases. When that happens, analysts expect Tweeter to once again post strong sales gains well ahead of retail in general. Key Positive ArgumentsKey Negative ArgumentsTweeter is making progress in lowering its cost structure. Management believes it can deliver expense leverage even with flat year-over-year sales. Flat panel display TVs are showing strong growth, up 70% year-over-year in the December quarter. Tweeters inventory productivity has benefited from its portfolio management approach and is now more in-sync with consumer demand.Higher-price point merchandise and lack of promotions make it difficult to drive store traffic during weaker economic times. Competition from bigger retailers (Best Buy and Circuit City) and direct sellers (Amazon, Dell, and Gateway) continue to pressure Tweeters sales and margins. Low sales volumes may lead to smaller vendor rebates and smaller margins. All the analysts believe that the stocks current price already discounts the potential for an earnings recovery at Tweeter. Tweeters fiscal year ends September; all calendar references are to the fiscal year.  Sales The analysts (CIBC, CL King, RBC, Thomas Weisel) expect Tweeter to increase sales by 2.1% in 2004 and 3.5% in 2005.  Third quarter summary: Tweeters third quarter sales were $168, which was $1 million below the Digest average. The Digest average for 2004 sales remains basically unchanged at $803 million. But, the Digest average for 2005 sales fell by $8 million to $832 million. According one analyst (CL King), [S]ame-store sales declined 2%, while total sales declined by 1%, to $168.6million. Year-ago comps were negative 10%. By month, comps were down 6% for April and May combined, but up 5% for June. These trends ran counter to the companys marketing efforts, as TWTR spent less on advertising in June than in May. As usual, advanced technology TV was the leading product category. Through the first 25 days of July, comps were up 2%. The analyst (CL King) continued, As has been the case for the past two years, slow customer traffic continues to be a big problem for TWTR; and we do not believe management has found a solution to this issue. We believe TWTR and other high-end CE retailers (including Ultimate Electronics) are losing share to Best Buy and, to a lesser extent, Circuit City. This news really wasnt a surprise to analysts. At the companys recent analyst meeting, management admitted that Tweeter can no longer effectively differentiate itself through its merchandise offerings and intends to achieve differentiation through customer service and offering a comprehensive solutions-based approach. And despite the companys good news regarding comp-store sales so far this quarter, another analyst (CIBC) believes that [g]iven TWTR's history of volatile sales and that it is still early in the quarter, we are not ready to declare a rebound in TWTR's business. New image marketing campaign began on July 21, so we believe that has yet to gain traction. It is uncertainty whether this new marketing strategy can immediately drive traffic TWTRs number one issue. See the TWTR earnings model spreadsheet for more detail on the companys revenues. Margins With Tweeters lower cost structure in place, analysts (CIBC, CL King, RBC, Thomas Weisel) are anticipating higher margins for Tweeter in 2004 and 2005.  Third quarter summary: Tweeters third quarter gross margin was 250 basis points (bps) higher than the Digest average. However, the analysts in the Digest average slightly reduced their gross margin assumptions for the fourth quarter. Third quarter operating margin was 20 bps below the Digest average; this decline flowed through to 2004 Digest average. According one analyst (CIBC), TWTR benefited from increased vendor allowances. As we have mentioned before, we see TWTR's merchandise gross margin stabilizing on a year-over-year basis. As video becomes a larger percentage of TWTRs mix, overall gross margin tends to deteriorate. Another analyst (Parker/Hunter) noted that [a]ttaching the sale of higher-margin goods with lower-margin video products as well as the development of private label products and a leveling off of the high-margin audio business positively impacted gross margin. While another (Thomas Weisel) noted that the operating cost increase was due to higher compensation associated with home-installation services build out. See the TWTR earnings model spreadsheet for more detail on the companys profit margins. Earnings Per Share Analysts expect continued weakness in the companys business, and this is reflected in the analysts dour estimates for 2004 and 2005. The Digest average EPS for 2004 is ($0.34). For 2005, the Digest average is ($0.03). There are two estimates for 2006; the average is $0.08. Due to the volatility of its business, Tweeters management did not provide EPS for the fourth quarter.  See the TWTR earnings model spreadsheet for more detail on the EPS estimates. Target Price / Valuation The price targets range from $4 and $9.50 with average of $5.88. The analysts use various valuation techniques including EV/EBITDA, DCF, a multiple on TWTRs book value, and a multiple on TWTRs EBITDA. Go to the valuation tab of the TWTR earnings model spreadsheet for more detail on the brokers valuation methodologies and individual price targets.  Upcoming Events EVENTDATEFourth quarter earnings release November 23, 2004  Long-Term Growth In 2004, the current product cycle in consumer electronics is focused on wireless connections. For example, more evolved flat panel TVs include wireless capabilities, which negates the need for expensive installation to hide wires. Analysts also expect other product applications that negate running wires to connect the home. An example is the HomePlug in which media content will run through the power source to different parts of the home. This could allow media content to be shared on TVs in different rooms just by inserting the HomePlug into the power source and hooking up the TV to the plug. The other focus of the current product cycle is the convergence of the home PC and home entertainment. For example, consumers will be able to download audio and video content from a home PC using Microsofts Windows Media Center software into the home entertain system. Even so, the analysts believe that most consumer electronics retailers are unable to leverage the strength of the product cycle and improved consumer spending into consistent profitability. Circuit City, Tweeter, and Ultimate Electronics are all posting lower than expected same-store sales and total revenue growth for the Holiday season. They also believe that Best Buy may be the only way for investors to participate in the growth of consumer electronics through the retail channel. As the digital product cycle increasingly shifts into the mass market, Best Buy is in the best position to capture the growth in flat panel TVs and other digital media products. However, investors must recognize that even Best Buy is pursuing market share at the expense of a higher profit margin rate over the near-term. The analysts long-term EPS growth estimate for Tweeter is a solid 15.5%. Individual Analyst Opinions POSITIVE RATINGS IRG Research Buy ($9.50): report date 09/27/04 TWTR continues to trade at a discount to its more consistently performing peer group. Specifically, a 1.5x multiple of F05E book value of $160 million versus the peer group average of 2.0x. NEUTRAL RATINGS Parker/Hunter Market Perform: report date 10/06/04 We do not expect the company to be materially profitable until FY 06 and, therefore, believe that TWTR should trade near or below its tangible book value of $6.80 until there are more concrete signs of top- and bottom-line improvement. As a result of the weather-related store closings in 4Q04, we are lowering our FY 04 EPS estimate by $0.04 to -$0.30. Our FY 05 EPS estimate is unchanged at -$0.01. RBC Capital Sector Performer ($6): report date 10/06/04 Tweeter sounded more upbeat during its presentation than we have heard from them in some time. We believe the company is finally turning the corner operationally and now poised to capitalize on any kind of improvement in sales trends. NEGATIVE RATINGS CIBC Sector Underperformer: report date 10/06/04 The company continues to make progress in strengthening its balance sheet and cashflow generation capability. It appears that LT debt will be lower by 28% y/y. Inventory levels declined 11% y/y. No change to SU rating, sales and earnings uncertainties remain high in the near term. CL King Sell ($4): report date 10/06/04 As has been the case for the past two years, slow customer traffic continues to be a big problem for TWTR; and we believe management has not found a solution to this issue. We also believe TWTR and other high-end CE retailers (including Ultimate Electronics) are losing share to Best Buy and, to a lesser extent, Circuit City. Harris Nesbitt Underperform ($4): report date 09/07/04 Re-initiated coverage. We believe increased competition has been a major reason why Tweeters comps have declined in 12 of its last 13 quarters. Deep in a turnaround effort, we expect sales trends to remain erratic, but generally disappointing. Although cost cutting initiatives should benefit the bottom line, we believe the deleveraging effect of weak comps and pressure on gross margins from increasing competition will keep Tweeter from reaching profitability next year. Thomas Weisel Underperform: report date 09/28/04 TWTR has been trading on recovered earnings for some time and given the recent top-line and profitability trends, we feel a recovery is unlikely near-term. TWTR shares are trading at 4.5x our 2005 EBITDA estimate, a discount to the peer group at 5.2x. We believe a discounted valuation is warranted, given TWTRs operating challenges. Zacks Investment Research Page  PAGE 2 www.zacks.com  Copyright 2004, Zacks Investment Research. All Rights Reserved. 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