Egghead Lays Foundation For Comeback Struggling Company Changes Strategy, Plans Merger

Shareholders of Egghead Inc. will have the chance Thursday to vote on the latest in a procession of strategies for restoring Egghead to profitability.

Shareholders will decide at a special meeting whether to approve Egghead’s merger with Surplus Direct, a company that specializes in catalog and Internet sales of off-price computer hardware.

That merger is the centerpiece of Egghead Chairman and Chief Executive Officer George Orban’s vision for rescuing Egghead from its past mistakes.

“Egghead has historically missed a lot of opportunities in the dozen or so years that reselling of computer hardware and software has existed as an industry,” Orban said.

“We’ve been looking very carefully at how to re-establish a leadership position for Egghead,” Orban said. “And it doesn’t work to just become a ‘me-too’ to somebody else who has already surpassed us.”

As a founder of Ross Stores Inc. in 1982, Orban knows how well the “off-price” retail clothing industry has paid off for him. His vision calls for reshaping Egghead into that image.

At least one industry expert, Roger Lanctot, editorial research director for Computer Retail Week, thinks the timing is right for the computer industry to go after bargain hunters.

“This certainly isn’t any time to be going upscale with commercial merchandise,” Lanctot said.

In any cast, Egghead’s make-over will be drastic.

Say goodbye to staid and slightly snooty Egghead Software.

Say hello to Egghead Computer Manufacturers Clearance Warehouse.

In Orban’s view, Egghead’s biography is a litany of missed opportunities.

When he guided Egghead’s previous management out the door early this year and became CEO, it was because of his conviction that the next big opportunity was about to whiz past and land on some competitor’s doorstep.

“The former management of this company felt that the future lay in 5,000-square-foot stores,” Orban said. “I do not believe that.”

Terry Strom, Egghead’s previous CEO, who engineered the company’s relocation from the Puget Sound area to Spokane, realized, as Orban did, that Egghead’s traditional retail format could not sustain the company.

That format consisted of 2,000-square-foot shops offering a broad range of software at premium prices, a formula upon which the company was based when it was founded in 1984. The formula worked wonderfully in the early years.

But then warehouse retailers like Kmart and Wal-Mart went into the discount-priced software business. Computer “superstores” like CompUSA and Circuit City gobbled up market share. Mail order catalogs became formidable competitors for the software retail market. And now, Internet commerce is emerging as a retail force.

“So, Egghead was left with a chain of predominantly software stores in an industry where 80 percent of the revenues are generated by the sale of items other than software,” Orban summarized, “and the chain was losing market share in this rapidly growing, dynamic industry.”

Throughout the 1990s, Egghead has been a company in search of a strategy. Strom’s idea was to expand the Egghead retail outlet to 5,000 square feet, dress it up to look and feel like a mall book store, and add a line of high-end hardware products to the inventory.

The company has opened eight such stores, including its Spokane store on North Division. But the market’s response was mixed, at best.

It lost $11 million in fiscal 1996, and lost almost $40 million in fiscal 1997.

Strom’s efforts to stem the losses included moving the company, closing unprofitable stores and, finally, selling the company’s direct sales division to a competitor.

Orban’s first move as CEO was to sell off still more stores, shutting down 77 of Egghead’s remaining 156 retail outlets, and reducing its presence from 54 to 24 markets.

Depending upon which lines you want to emphasize in your reading of financial reports, Egghead either got a lot better or a lot worse during the first quarter of fiscal 1998. During the quarter, Egghead had a net loss of $3.7 million compared with a net loss of about $547,000 during the first quarter of last year.

Orban prefers to focus on pre-tax earnings from continuing operations. By that standard, Egghead still lost $3.7 million in the first quarter of the current fiscal year, but that’s an improvement on the first quarter last year when the loss was $12.4 million.

Starting fresh

Orban’s most significant retail achievement has been Ross Stores Inc., a Newark, Calif., clothing chain he co-founded in 1982. Today, Ross has 12,000 employees and $1.7 billion in annual sales.

Ross buys “distressed inventories” of clothing from manufacturers in huge quantities and sells them at bargain prices. This “off-price” formula worked once for Orban, and he wants to apply it to computers.

“When I came to Egghead last fall, I did not for one moment believe that the company could create a future for itself by becoming a ‘me too’ to any of its major competitors,” Orban said. “I did, however, believe - based on my experience in the apparel industry - that there was a serious opportunity to develop what I refer to as the ‘off-price’ retail business in this industry; namely the acquisition and resale of distressed inventories from their manufacturers.”

Although several companies - including Surplus Direct - are selling off-price computer hardware and software through catalogues and direct Internet sales, the model is a new concept for a retail outlet environment.

Being among the first, Orban says, gives Egghead “the opportunity to create an economically viable retail format that was sufficiently differentiated from other retailers.”

Orban envisions 20,000-square-foot warehouse stores where bargain hunters find refurbished or end-of-life computer hardware at a fraction of the price the equipment would cost under other circumstances.

The concept is almost the antithesis of Strom’s high-end software-hardware boutiques. It also runs counter to the historical marketing thrust of a computer industry that practically denigrates anything that’s a few months old.

“These products are changing so fast that not everybody needs the latest and greatest at a high price point,” Orban said. “There are plenty of people sending their kids to college or high school who don’t need to spend $1,999, who can have all their desires satisfied at $599, or $799.”

In looking at the resources he has at Egghead, though, Orban was confronted with the reality that Egghead knows little about the highly competitive field of off-price computer equipment procurement.

That’s where Surplus Direct comes in.

A marriage of convenience

Egghead is a struggling company long on retail experience and cash. Surplus Direct is a fast-growing, cash-starved hotshot in the catalog and Internet sales business that knows everything about buying and reselling off-price computer merchandise.

By merging the two companies, Orban reasons, Surplus Direct gets the cash it needs to feed its explosive growth. And Egghead gets a direct pipeline to the off-price merchandise it needs to fill out its new inventory.

Surplus Direct, based in Hood River, Ore., was founded in 1992 by Gregory J. Boudreau and Stephen M. Wood. Boudreau had been making a living by selling surplus inventories of computer software at trade shows. He wanted a vehicle to sell those inventories to the general public.

Surplus Direct published a four-color catalogue offering off-price merchandise in 1992 and did $980,000 in sales. Sales hit $3 million in 1994, and $12 million in 1995. The company began selling directly through the Internet in 1996, and in 1996, sales approached $21 million. Last year, catalog and Internet sales exploded to $58.7 million.

Surplus Direct has 160 employees. The private, closely-held company has 15 holders of its common stock and four holders of preferred stock.

Surplus Direct does between 150 and 800 Internet transactions a day, according to Boudreau. It’s Web site has a visitor count of 40,000 to 50,000 a day, making it the fifth most active commercial site on the Internet.

Egghead also has a direct sales presence on the Internet, and believes Surplus Direct can be an invaluable ally in expanding that channel of Egghead’s business.

Despite all its growth, Surplus Direct lost $2.3 million in fiscal 1997, its first unprofitable year. The losses occurred, Boudreau said, because the company was plowing its earnings into building a corporate infrastructure necessary to keep up with rapid expansion.

Surplus Direct is constantly scouring its network of contacts for bargains that can be acquired from manufacturers in large lots. The competition for this merchandise is fierce, and company officials must make quick judgments as to whether they are getting a load of turkeys, or something that they can move quickly without tying up precious cash in an inventory that won’t sell.

“We’ve been undercapitalized for some time,” Boudreau said. “We are buying products we hope to move in 30 to 120 days, and that takes a lot of cash.”

“Buying in large lot sizes up front gets you a great break on price,” said Jonathan W. Brodeur, Surplus Direct’s president. “But the challenge is in coming up with all of that money up front.”

Orban, who has been a director of Egghead since 1985, was elevated to board chairman in May 1996. Boudreau and Brodeur approached Orban with a proposal for a joint venture between the two companies a month later, and invited Orban onto Surplus Direct’s board.

The two companies agreed to jointly open an off-price warehouse store in Portland as a prototype of Orban’s retailing model. The store opened last November, and, Orban says, results have been encouraging.

It was a short path from the joint venture to ironing out a merger agreement. The final step in that process will come Thursday when Egghead’s shareholders vote.

Under terms of the merger, Surplus Direct shareholders will get 5.6 million shares of Egghead stock, and Surplus Direct will become an operating subsidiary of Egghead. But the two companies will retain distinct identities and separate operations.

“We see these two companies coming together like ships in the night, and exchanging passengers and crew and information, and then moving apart again,” Orban says.

The relationship will be closely allied operations in which each offers consultation to the other on its own area of expertise.

“The driver here is not to get expense reductions,” said Brian W. Bender, Egghead’s chief financial officer. “Surplus Direct’s organization, given their growth, should not be downsized. If those operations were merged with Egghead, it would only complicate their growth process.”

The two companies will enjoy some economic advantages from the combination, though. They will have a lot of buying clout in ordering surplus bargains in large quantities and get greater volume discounts in areas like Internet advertising.

Egghead brings big dowry

One of the big questions in the merger is how long Egghead’s cash can hold out. It goes into the deal with $74 million in cash. But Orban says the combined company will not be profitable in 1998, and he can’t assure profitability in 1999.

Egghead must ride out the leases on many of its existing tiny stores, then fund the expansion of those stores into the 20,000-square-foot warehouse models.

“If we could wave a magic wand and have as many large stores as possible open in as short a space of time as possible, we would do that, but we can’t,” Orban said. “We will open at least two of these new stores quickly in existing markets.”

One market is Spokane. In the next few weeks, Orban said, Egghead will expand its 5,000-square-foot space on North Division to 8,000 square feet. Site limitations won’t allow the store to get to the 15,000 to 20,000 square feet that Orban thinks is necessary. And the company has a three-year lease there.

But the Spokane store represents an opportunity to continue to refine the new retail format, Orban said.

“I would like to see the company be profitable as early as it can,” Orban said, “but profitability is very hard to predict because of the fluidity of the present situation. We don’t view the interests of the shareholder in the short and medium term. We see this as an opportunity to grow a business over the next 10 years.”

But does Egghead have enough cash to ride out another 18 months of losses while funding its own restructuring, and being Surplus Direct’s cash cow?

That’s the question the few financial analysts who still follow the company are trying to sort out. Those analysts, still sorting out the Surplus Direct merger and Orban’s new retail format concept, say they haven’t had enough time to make a recommendation for investors.

Lanctot, the editorial research director for Computer Retail Week, sees the off-price concept as a growing retail trend in the computer industry. One of Egghead’s principal software competitors, Electronics Boutique, has unveiled a strategy of opening 1,000 off-price software mini-superstores.

“Electronics Boutique is a few yards ahead of Egghead in this area right now, I think,” Lanctot said, “but the Egghead edge is a more active Web presence, and the integration of hardware into what they are doing.”

And Lanctot likes what Surplus Direct brings to the game.

“Surplus Direct certainly has the expertise in obtaining pre-owned product in quantity,” Lanctot said. “When you combine that with Egghead’s cash position, well, one of the critical things is being able to take possession of the merchandise as opposed to taking it on consignment.”

, DataTimes