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Operator
Welcome to the Best Buy 3rd quarter earnings conference call for Fiscal 2003.
At this time, all participants are in a listen-only mode.
Later we will conduct a question and answer session.
At that time, if you have a question, you will need to press 1 followed by 4.
As a reminder, this call is being recorded for play back and will be available by 12:00 p.m. eastern time today.
If you need assistance on the call, press star 0 and an operator will assist you.
I'll turn the call over to Jennifer Driscoll, Vice President of Investor Relations.
- Vice President, Investor Relations
Good morning.
Thank you for joining us today.
With me are Brad Anderson, Vice Chairman and CEO, who will provide an overview of our 3rd quarter performance as an enterprise;
Al Lenzmeier, President and Chief Operating Officer, who will give a report on our domestic and international businesses; and Darren Jackson, Executive Vice President and CFO, who will provide outlook for the 4th quarter.
Dick Schulze, Chairman and participating via conference call, as is Kevin Laydon, President of our Canadian Operations, from Vancouver.
Also with me in the room and available for our Q&A session later are Mike Keskey, President of Best Buy Retail Stores;
Kevin Freeland, President of Musicland Stores;
Mike London, Executive Vice President and General Merchandise Manager;
Susan Hoff, Senior Vice President and Chief Communications Officer;
Bruce Lasagel (ph), Vice President of Planning and Performance Management; and Shannon Burn, Senior Investor Relations Manager. .
As always, comments made by me or others representing Best Buy may contain forward-looking statements which are subject to risks and uncertainties.
Our SEC filings contain additional information about factors that could cause actual results to differ from management's expectations.
I would like to remind our participants that the media is listening to this call in an listen-only mode.
Also, in case you miss a portion of this call, let me give you the replay instructions.
Dial 973-341-3080, and enter the personal identification number of 3629074.
With that, I'll turn the call over to Mr. Anderson for our prepared remarks.
- Chief Executive Officer
Good morning.
Thank you, Jennifer.
We are pleased to report the total sales increased 16% to 5.5 billion, driven by new stores and the addition of Future Shops.
Our comparable store sales were essentially even, achieving the expectations we communicated to you earlier.
Our growth profit remained high at 21.6% of sales despite comparisons with last year's benign promotional environment.
We continue to benefit from the digital product cycle which drove double-digit increases in digital TVs, digital cameras, and DVD software.
One reason for our success is we effectively address the needs of more value conscious shoppers while winning in key categories, such as home theater, digital products and video games; and we'll look for the momentum to continue into the 4th quarter.
Finally, we proved we can curb the growth of SG&A.
While our SG&A rose a modest 10 basis points, it was even with last year's on a pro-forma basis.
Keeping expenses flat when comparable stores sales gains are under 3% is very difficult, and I'm pleased with our progress.
As a result of these trends, our earnings of 26 cents per diluted share surpassed last year's solid results and hit the top half of the earnings guidance we provided in August.
The biggest winner of the quarter was our Best Buy stores.
In fact, earnings generated by the domestic Best Buy stores rose nearly 30% in the quarter on top of a 70% increase last year.
Those stores truly are a core growth engine.
Now I'd like to comment on our product mix and provide color on our core product categories.
I'll then address the business highlights of the 3rd quarter before turning the call over to Al.
Al will cover performance of our domestic and international segments as well as further details on the three brands that comprise our domestic segment, and finally, Darren Jackson will provide our outlook for the 4th quarter, including the expectations for the remainder of the holiday season.
Consumer electronics continued to update the growth of our other product lines at Best Buy and at Future Shop Stores.
Consumer electronics had a comparable store sales gain in the mid single-digits, paced by strong gains in digital television sales.
Digital TVs have increased to roughly 45% of our television revenues at Best Buy, up from approximately 25% just a year ago, with consumer demand rising as prices have become more attractive.
We broadened our assortment at Best Buy and Future Shop stores in the quarter, including five new plasma models and a dozen LCD choices at Best Buy, and we also remerchandised the area.
Digital cameras continue to sell double-digit growth as well.
DVD players also enjoy the strong unit growth, but that gain was lost in part by falling prices, resulting in high single-digit comparable stores sales gain.
While audio products declined, home theater in a box and satellite systems experienced comparable stores sales gains as consumers enhance their home entertainment experience.
In the home office category, sales of desktop computers continue to be soft, resulting in mid-single digit decline for the category.
The prior year's period included the launch of Microsoft's new operating system, XP.
This year, notebook computers, computer monitors, networking, and cellular phones had comparable stores sales gains, but they were not strong enough to offset the drop we experienced in desktop.
Monitor sales benefited from our increased success in attaching monitors for the purchase of notebook computers as well as consumer preference for LCD displays.
Sales of cellular phones were up, in part, due to the increased consumer acceptance of prepaid cellular alternatives.
Sales in the appliance category had a double-digit comparable stores sales decrease with major appliances themselves down in the high single-digits at Best Buy but up slightly at the Future Shop stores.
We saw low single-digit decline for the entertainment software category.
Although DVD sales - software - posted strong comparable stores sales gains, supported by more DVD players in consumers' homes, the category saw a solid performance from the sales of video gaming, which faced comparisons of the launch of X box and the GameCube and higher prices last year.
Like sales of DVD movies, exciting new titles were introduced along with higher opinion trace of the hardware.
More than offsetting the gains from the movies and gaming was a weakness in the sales of computor software based on comparisons with the XP launch that we had last year as well as continued weakness in the sales of prerecorded music.
Sales of CDs have declined 10% in the U.S. this year, similar to the trend at Best Buy stores, while music comparable sales have declined more than 20% at our Musicland stores.
The mall based business has been disproportionally affected due to the fact that mall traffic has declined in the high single-digits since the events of 9/11.
We're also going to be very forthright about the challenges we faced in our Musicland business, and in his portion of the call, Al will elaborate about our current situation and our plan to address this issue.
Last quarter I outlined our plan for improving our profitability and market share, and we've made progress in three of those key areas: managing expenses in areas that do not face our customer and pushing forward with new stores and gaining market share.
I'll talk about the successes in the context of our highlights of the 3rd quarter which were as follows: one, on schedule, we successfully launched Best Buy stores in Toronto, our first international location for this brand.
At the same time, our Toronto Future Shop Stores comparable stores sales exceeded that of most of the other markets in Canada.
We are also pleased with the first month results of both brands, and will - we are very pleased with the first month's results of both brands and will discuss our dual branding strategy in more detail next month.
Two, we continue to expand our services offerings at Best Buy stores. [ audio difficulties ] Portion of transcript missing.
Please review transcript shortly after end of call for complete transcript.
- President and Chief Operating Officer
...from mall based stores and Media Play locations have been disproportionately impacted by increased competition from discounters and big box stores, including Best Buy.
In addition, these stores were disproportionately effected by promotional pricing in the quarter.
Our focus during the holiday season is on maximizing sales and profits at these stores.
Concurrently, we are reassessing all of the Sam Goody mall locations based on the revised trends.
Inevitably, significant number of underperforming locations will need to be scrutinized.
A more comprehensive review of the business alternatives is underway to determine the overall profit potential of the business.
We will update you as work progresses on this.
In total, we currently expect our Musicland business to produce an operating loss, in Fiscal 2003, of approximately 80 to 85 million compared with our prior guidance of a $10 million loss for Fiscal 2003.
The significant increase in operating loss is primarily the result of lower sales expectations in movies, games, and prerecorded music products based on double-digit comp store decline experienced during the 3rd quarter.
December typically generates at least 90% of Musicland's operating profits for the year.
With sales softer than expected, the gross profit shortfall drops directly to the bottom line.
We simply cannot cut expenses fast enough to adjust to the lower sales expectations given our high fixed cost.
This updated guidance includes an operating loss of approximately $40 million in the 3rd quarter and an operating profit of approximately 5 to 10 million in the 4th quarter, which would represent a 55 to $60 million decline versus the prior year's 4th quarter.
Next I would like to discuss Future Shop's performance.
As you know, we achieved comparable store sales gains for our international segment in the 3rd quarter, but those gains were at the low end of our expectations.
We attribute the difference to heightened competition in Canada ahead of the launch of the Best Buy stores in the market as well as the weaker economy and lower consumer confidence in Canada that started in the 3rd quarter.
We believe, however, that we gain market share in the 3rd quarter, specifically, sales in Toronto grew on an overall market basis by 40% due to the Best Buy entry.
The gross profit margin increased in our international segment, but the gain was moderated by higher costs associated with providing consumers with free financing.
In addition we saw a significant increase in our expense rate due to the launch of the Best Buy stores in Canada, which had been planned, as well as initiatives to boost Future Shops profitability.
We remain confident that we'll be able to lift our international segment's operating margins to Best Buy store levels, although we expect the speed of change to be modestly slower.
Primarily driven by higher expenses, operating margins in our international segment declined by 150 basis point on a pro forma basis.
Meanwhile, we expect an EPS impact of the international segment to add approximately 0 to 2 cents per diluted share for the fiscal year, rather than the original guidance of 4 cents of accretion per diluted share.
This figure includes a loss in the quarter of approximately 1 cent per diluted share and a gain in the 4th quarter of 3 to 5 cents per share.
As we mentioned in our sales release, our Magnolia Hi-Fi stores also posted a comparable store sales gain in the 3rd quarter in low single-digits.
Our Best Buy stores had an outstanding quarter with a modest increase in comparable store sales and an operating margin increase of 50 basis points.
A more profitable sales mix was partially offset by increased commoditization and a more promotional environment.
The SG&A percentage improved considerably thanks to efforts to control costs in a more cautious consumer environment.
As a result, we increased operating income over 25% in the quarter.
We continue to gain market share in the very important New York City market with comp store sales growing in the high single-digits in the quarter.
Additionally, our West Coast markets continued their strong growth in the quarter.
Our customer loyalty and preference scores remain at an all-time high despite the uneasiness the consumer is feeling.
It's easy to focus on the parts of our business that are currently challenged, but we would be remiss not to highlight the Best Buy brand which continues to roll on.
Next, Darren Jackson will provide our outlook for the company's 4th quarter.
- Executive Vice President, Finance and Chief Financial Officer
Thanks.
Good morning, everyone.
I'd like to provide some additional insights into the quarter and then give our outlook for the balance of the year, including the all important month of December.
Inventory levels on average store basis increased approximately 5.5% at Best Buy stores.
The company elected to take a more aggressive position in certain categories that have driven our sales growth, such as digital TV and cameras, and other hot categories that Brad mentioned.
Were also were cautious about inventory levels ahead of the potential West Coast port closure earlier this fall.
We expect our inventory levels to be more in line by the end of January.
We were able to reduce our net inventory to 40 million at the end of the quarter which compares to 275 million at the end of the 2nd quarter.
We have been managing capital expenditures down as well in the second half.
We have cut our full year forecast to 875 million, down from our original guidance of $1 billion.
Overall, these actions have helped to increase our cash position to a solid 1.2 billion at the end of the quarter.
Now turning to our guidance, we expect total sales to increase 10% in the 4th quarter, reflecting the addition of new stores and flat comparable store sales.
Backed by strong sales of digital products, we estimate Best Buy store's comparable store sales for the 4th quarter to be up low single-digits.
That would offset a decline in the high teens at Musicland stores related to the weakness in sales of prerecorded music, heightened competition from discounters, and declines in mall traffic.
Our international stores, which will be added to the company's comparable stores sales calculation in the 4th quarter are expected to post a comparable store sales figure of flat to up low single-digits on top of last year's 16-1/2% increase.
We believe that the softening of the Canadian economy and the heightened competitive activities will continue into the final quarter of the year.
As you know we report monthly sales for December because it is our largest month of the year.
Our outlook for December is much the same as our outlook for the full 4th quarter.
After reviewing the current trend of business, we expect total 4th quarter sales of approximately $7.7 billion, reflecting the addition of new stores as well as flat comparable store sales.
Next I'll provide our guidance on operating performance for the 4th quarter starting with gross profits.
At a company level, our guidance has a decline in growth profit percentage of 110 basis points compared to the 4th quarter of Fiscal 2002.
We estimate that the gross profit rate for our domestic segment will decline similarly at 110 basis points despite favorable product mix changes, and it's due to a more promotional environment than we saw last year, increased commoditization, and lower contributions from our higher margin mall-based businesses.
We expect international segment's gross profit rate to decline due to a higher cost of providing consumers with free financing.
The good news is our SG&A rate is expected to decline as well in the 4th quarter compared to the prior year's quarter as our recent expense reductions build through the quarter..
The amount of the improvement will depend on sales.
We expect our core Best Buy business to perform in line with our prior guidance, but it will not make up for the lower contribution for Musicland and our international segment.
Adding to the computation net interest expense of $1 million for the 4th quarter and applying a tax rate of 38.7%, we arrive at an earnings per diluted share of approximately $1 to $1.10 for the 4th quarter.
The 5 cent reduction in our guidance is primarily related to the unexpected weaknesses in comparable store sales at Musicland.
The new guidance would bring us to a full year EPS for Fiscal 2003 of $1.67 to $1.77 excluding the cumulative change in accounting principle compared with $1.77 in Fiscal 2002.
With that, I'll return the call to Brad.
- Chief Executive Officer
Thanks Darren.
The 3rd quarter results we reported today were at the high end of the guidance we provided earlier this quarter, and we're pleased to report a 16% increase in sales and a 5% increase in earnings during such a difficult quarter.
We also had positive comparable store sales at all three of our consumer electronics brands.
In addition, we launched Best Buy stores in Canada, expanded services offerings, cut our expense structure, and grew our market share.
Yes, the picture going forward is challenging.
We're very focused on the problems with our Musicland business and working on a plan to address them.
This is far from the whole story.
We expect to make continued progress in our efforts to manage our expenses.
In addition, we expect to continue to report significant top line growth due to modest comparable store sales gains and the expanding digital product cycle coupled with new store openings.
With much of the holiday spending ahead of us and given our leaderships in sales within many of our key product categories, I have a great deal of optimism, and I'd like to thank you for your support in the past year.
Now I'd like the operator to open up the floor for questions from the investor audience.
Operator
Thank you.
The floor is open for questions.
If you have a question, please press the numbers 1 followed by 4 on your touch-tone phone.
To remove yourself from queue, please dial the pound sign.
Please limit yourself to one question to allow the maximum amount of callers to ask questions.
Our first question is coming from Matt Fasler of Goldman Sachs.
Thanks and good morning.
- Chief Executive Officer
Good morning.
I'd like to dig a little deeper into the Musicland situation.
You discussed far more explicitly in the past the potential to exit some of these stores.
Can you talk about the means by which you might do so: whether that would mean getting out of stores ahead of lease expiration, and how you would consider accounting for that?
- President and Chief Operating Officer
Matt, this is Al.
In response to that, I think it's too premature to speculate what alternative or alternatives we may eventually end up, I guess, other than to say that we'll take the path or paths that provide us the best financial returns over the long-term.
Obviously with the acceleration in declines in the mall business, leases - in the past we've looked at each year and ended up closing stores in the malls as the leases expire.
With the declines accelerating a little bit more, we're probably going to end up looking more aggressively at that.
On the same topic, hopefully this still counts as one question, Darren, is there any -- any features of our debt covenants related to your convert or financial boundaries that you have to adhere to that would make the taking of a substantial charge to close some of these stores prohibitive for you?
- Executive Vice President, Finance and Chief Financial Officer
Matt, the way I'd answer that question is I wouldn't foresee issues with our debt covenants, but I think that presumes we would have a significant charge, and I'd echo what Al had said that it's premature.
This time of year we traditionally, as many mall based stores do, review our store leases because this is when we make our money in terms of those individual stores.
So let us go through that process first.
I don't anticipate issues to the extent that we would come to some other conclusion in the future, our debt getting in the way of that.
Thank you.
- Executive Vice President, Finance and Chief Financial Officer
Thanks.
- Vice President, Investor Relations
Next question
Operator
Thank you.
Our next question is from Colin Madranahan of Sanford Bernstein.
Good morning.
Darren, I want to focus on the gross profit or gross margin guidance for the 4th quarter a little bit.
It's a promotional environment, but it was in the 3rd quarter commoditization.
It's clearly difficult, but I don't see the delta versus the 3rd quarter.
Can you help me understand in how you can be flat on gross margin year-over-year in the 3rd and down 110 basis points in the 4th?
Clearly the gross margin in the 4th quarter last year was high.
Maybe help us understand or remind us what contribute to such a high gross margin rate in the 4th quarter last year, but really just trying to understand the guidance a little more.
- Executive Vice President, Finance and Chief Financial Officer
Just to remind the group, 60 plus days ago, we had about the same guidance in terms of flat, and we achieved flat in the 3rd quarter.
If you look back, 100 basis points is what we've been guiding to.
And to remind the group what we said, it's three things: one, you will note that we are anniversarying some of the very large free financing benefits in terms of getting the costs down for our credit programs.
In the 4th quarter, that will be anniversaried, so that's part of the issue.
Two, more we're moving more promotional days with the shorter calendar out of the 3rd quarter into the 4th quarter holiday season this year, and that is putting more pressure in terms of the margin rate in the 4th quarter.
Three, as you look at our mix of business in the categories that are going to be more promotional in the 4th quarter as we go through the holiday season and mix impact, that too will put more pressure in terms of 4th quarter margins.
To your point, we hope we're wrong, and we hope that it's not that difficult, but we think we're planning it prudently and realisticly in light of what we see in the environment and what we can see from our own plans as we go into the 4th quarter.
- Vice President, Investor Relations
Thanks, Colin.
Hopefully this is the same question.
Same issue, in terms of the mix, is there any impact on mix from some of the subscriber models, whether that be wireless or satellite that the circuit had talked about weakness then it seems that you may not be seeing that weakness?
- Vice President, Investor Relations
Mike London will take that one.
- Executive Vice President, General Merchandise Management
We have seen strong sales in both wireless, cell phones, and advance TV or DVS.
We've had comp store increases in those categories, and we feel confident that they will continue to be strong in this quarter, as well.
- Vice President, Investor Relations
Next question, please.
Operator
Thank you.
Our next question is from Bill Julian of Salomon Smith Barney.
Thank you.
Good morning.
- Chief Executive Officer
Good morning.
It seems pretty clear that the Musicland business is suffering from industrywide trends, and a big part of your decision about what to do with that business revolves around just that.
Can you tell us what assumptions you're making about music sales trends for prerecorded music over the next few years?
- Chief Executive Officer
Our general assumption is the trends we are seeing will continue.
Kevin did you have any other...?
- President, Musicland Stores, Corp.
The declines nationally this year are slightly ahead of the declines nationally last year, and our assumptions are assuming that that deterioration continues at a slow and steady increase.
- Vice President, Investor Relations
That was from Kevin Freeland.
Next question?
Operator
Thank you.
Our next question is coming from Allen Rifkin of Lehman Brothers.
I was disconnected so I apologize if this has been addressed.
With the significantly reduced guidance on the Musicland side and your new corporate guidance, it looks like you've raised your expectations a little for the Best Buy position.
Can you articulate what you've seen over the last 30 to 60 days to raise your expectations on that side of the business?
- Chief Executive Officer
If you look at last quarter, where we were at the high end of expectation, part of the significantly worse trend at Musicland began in -- became much more pronounced in that last quarter.
We were able to make up for it with Best Buy's performance.
Do you have any other comments about that in terms of..?
- Executive Vice President, Finance and Chief Financial Officer
Yes, the short answer is: you're correct.
We outperformed in the core Best Buy business, and I would say it was a little bit on each line.
Comps were a little better than we expected, our expense savings came in better than expected, and we were able to achieve the margin outcomes we're looking for; and we're simply extending some of that trend information into the 4th quarter in terms of coming up with our guidance.
Could you articulate in dollars or even as a percent with respect to SG&A dollars, how much opportunity have you earmarked for reductions in the 4th quarter?
- Executive Vice President, Finance and Chief Financial Officer
The way I'd answer that, when we're adding stores and divisions, we want to think about it in terms of the SG&A rate because you're adding new businesses all the time.
And the way that we have focused the enterprise is ultimately how do we get more leverage across our SG&A structure.
So if you go back a year ago, I think what you would see is we had a tremendous year in SG&A expense.
I think SG&A was essentially flat in dollars.
We improved 110 basis points last year in the 4th quarter.
To have a repeat performance on that in terms of getting our SG&A rate down this year, we have really focused all of our efforts in the enterprise to take out discretionary spending.
Not only are we holding corporate headcounts flat, in some areas we have taken those resources out of the business, and we are planning conservatively and starting to turn our attention in terms of - to FY '04 - in terms of planning efficiencies across the balance of the expense areas in the business.
- Vice President, Investor Relations
Thank you, Darren.
Thank you.
- Vice President, Investor Relations
Next question, please.
Operator
Thank you.
Our next question is coming from Dana Telsey of Bear Sterns.
Good morning.
Can you give us an update on '04 guidance and what you're thinking '04 even in terms of cap ex and new store openings, and can you comment -- give us an appliance update and initiatives to improve Future Shop profitability.
Thank you.
- Chief Executive Officer
We can't give any guidance for 2004 yet.
We're working on the plan.
We would typically give that guidance in April.
Go ahead.
- Executive Vice President, Finance and Chief Financial Officer
That takes care of the first question.
I think the other question is do we we have any updates regarding appliances and two, Future Shop.
- Vice President, Investor Relations
Mike London will address the appliance question.
- Executive Vice President, General Merchandise Management
We continue our work on the appliance category.
I think you've seen that shipments have dropped pretty significantly in the industry.
Trends have remained consistent, and we have put together a number of issues and tactics both at retail level and logistics area.
As we said before, this is a category that does not necessarily have a lot of innovation and will take hard work, and we believe we're making progress on that front.
- President and Chief Operating Officer
With respect to Future Shop, I think the profitability in terms of maybe increasing at a more modest rate is -- Canada generally likes the United States from a consumer standpoint in terms of the economic situation and we started to see some pull back there in the 3rd quarter and that's pretty much public.
The other thing is, it's just that there's a lot of regional consumer electronics retailers that are starting to respond more aggressively from a promotion standpoint, not just in Toronto where we've opened Best Buy stores, but in all of the major markets in terms of anticipating the Best Buy entry to the marketplace.
That's something that's natural, a cycle we're going to go through, but it's not something that can be sustained long-term.
Eventually the market will rationalize itself.
- Vice President, Investor Relations
Thank you, Al.
- Chief Executive Officer
Just one more, the profits-to-profits initiative that we've been working with in Canada, we've seen some changes between working with the commission environment and some changes with the culture there, so we're expecting the gains we get will take us a little longer than they took in Best Buy experience.
To just add to that, the kind of competitive margin pressure in Canada, if you look at what we did in Toronto with a 40% increase in the market as Best Buy stores rolled in, that is part of the reason there's some competitive pressures.
They're looking at the potential strength of our move in Canada.
- Vice President, Investor Relations
Thank you, Brad.
Next question, please.
Operator
Thank you.
Our next question is from Mark Rowan of Prudential Securities.
Thanks, and good morning.
I have a detail question for Darren and a broader one for Brad if I could.
Darren, some of the competitors have said that there's been a mixed shift towards lower price point products, and my detail question is whether the percent of revenue that you're getting from warranties has gone down from a year ago, and if that's true, if that's related to that mixed shift that competitors are seeing, or are you not seeing that?
- Executive Vice President, Finance and Chief Financial Officer
I'll tell you what we're seeing broadly at the Best Buy stores is that our average ticket year-over-year is holding the same, so we feel good about that the in terms of warranties and accessories and other attachments.
I will tell you that similarly we're not seeing a degradation in that business either, and you would assume that when you see our big ticket categories, particularly digital TVs, with the healthy growth rates that those businesses have been experiencing.
So no change in percentage of revenue from warranties from a year ago?
- Executive Vice President, Finance and Chief Financial Officer
No.
My broader question is when you look at your 45,000 square foot print, there is a few categories that cover a pretty large portion of that footprint that have been struggling the last 18 months: the computer business, appliances, music.
Do you have to wait out a turn around in those product categories, or have you given much thought to replacing those with other newer product categories that you can get into?
- Chief Executive Officer
Great question.
We've given a tremendous amount of thought about how either replacing or looking at other product categories that we can deliver either because it fits the particular community the store is in or a particular customer segment that's profitable for us, and one of the themes that we'll be working on developmentally in the next fiscal year is to provide a -- to test other product categories that sit in particular communities or other products that we can sell to specific customer segments that will help us, we think, strengthen some of those weaker product categories and improve our comp store results and financial performance in the store; so we'll be working pretty diligently in the next fiscal year on this.
Thank you.
- Vice President, Investor Relations
Thank you, Brad.
Next question?
Operator
Thank you.
Our next question is from Danielle Fox of J.P. Morgan.
Thank you.
Darren, you mentioned Best Buy is cycling a good SG&A performance in last year's 4th quarter.
I'm wondering if you're reconsidering spending on store labor to generate leverage, or is it coming from lower spending on consultants, and when you look out beyond this year, do you expect Best Buy to be able to generate expense leverage on an ongoing basis and if so, what would be the key drivers?
- Executive Vice President, Finance and Chief Financial Officer
Let me try to break that down.
In terms of expenses that touch the customer, those are the expenses we want to touch last.
So it's not about a pullback in terms of store labor.
As a matter of fact, we're making investments in the service side of the equation as Brad and Al had highlighted earlier in order to improve our turn times in terms of repairs, particularly around the PC part of our business.
What we have done is we will look at the back of the house expenses, and the back of the house expenses include back of the house in store, back of the house in field, and back of the house in corporate in terms of taking those expenses out that don't touch the customer, and as Brad talked last time in our 2nd quarter conference call, he's taken a number of activities off the table in terms of acquisitions and other types of growth which we are putting money and funds against that we're not spending money on these days.
We're also taking a hard look at discretionary advertising where we didn't see that we were getting a payback, and we're putting more energy around taking those expenses out.
We're making good inroads in terms of as we look to the future.
We're having great success in terms of using E-sourcing and auctioning to both take expenses out of our cost of sales in terms of procuring product as well as the commodity parts of our business, as well.
Organizationally, we're looking across the organization and trying to find ways that you would expect us to reduce expenses in headcount because that's better than 50% of our costs when we look across our entire enterprise, to leverage management and improve our spans of control.
All of those efforts have sustaining benefits as we look to the future in terms of the Best Buy enterprise.
I think we're being practical and realistic in terms of balancing growth and our ability to get operating profit, rate increases, and more that as we look to the future will have to come out of the SG&A part of our formula versus gross margin.
- Vice President, Investor Relations
Thank you, Darren.
Next question?
Operator
Thank you.
Our next question is from Dan Wewer of CIBC World Markets.
I was surprised that the sales trends during the holiday season aren't stronger than what you're indicating today.
When we were visiting stores they were absolutely packed.
On many occasions you can't find a parking spot.
With the heightened seasonality of your business, if like Wal-Mart, Best Buy begins to bump into a physical capacity constraint during the month of December and as a result, the same store sales growth in the holiday season may actually be the lowest of anytime of the year because of that capacity constraint?
- Chief Executive Officer
If you look at what we did over the Thanksgiving holiday weekend, if there's any point that stress our capacity, particularly Friday after Thanksgiving, the kind of growth we saw this year on that day, I think we're confident that there's a substantial amount of room and with what the enterprise is able to do out of our stores.
We've done things to increase our through put.
At things like the front lane, you'll find a queueing system that we started using last year that has markedly increased the speed at which we can process customers on very busy days.
We've done a number of other things with the stores to increase their capacity for through put.
So we wouldn't expect that to be a limiter.
I think, Dan, you also have to remember, we're going againstsome very strong numbers last year.
We had a 6-plus% comp increase in December, so the stores may be -- may look filled up this year, but they were pretty filled up last year as well, and again, we certainly have the capacity to process more people, but -- and at the same time, we feel that we are going to get more than our fair share of the business, but we also want to plan and be cautious in terms of what to expect there.
And just to follow up also on the comment about Canada and the dual branding strategy, could one make the case that with the terrific results, the new Best Buy stores are doing in Toronto, while Future Shop same store sales are weakening, that maybe a single brand strategy focusing on the Best Buy brand might actually be the optimal strategy
- President and Chief Operating Officer
We've done a pretty elaborate analysis on that from an EVA standpoint, and even taking into consideration certain levels of canabalization that are going to occur as a result of Best Buy opening up stores near a Future Shop, overall, the EVA number is -- of all the alternatives versus just opening -- or having Future Shop or just having Best Buy or having a combination of Best Buy and Future Shop stores, that third alternative provides us with the greatest EVA for the market.
- Chief Executive Officer
And it's not an insignificant difference.
It's pretty significant.
Good luck.
- Vice President, Investor Relations
Thank you, Brad and Al.
Next question.
Operator
Thank you.
Our next question is from David Ritchie of William Blair and Company.
Good morning.
I have a question on the core businesses, not Musicland.
As you look in the increases in promotional activity this fall, any thoughts in how much of this might simply be related to cyclical issues with the economy versus what might be structural change going forward related to competitive conditions and the nature of the industry?
Thanks.
- Chief Executive Officer
There is a cyclical part that's always part of our business, which is the rate of commoditization.
When you saw things happening overall like the slow down in the rate of how was the -- how fast the wide bandwidth home was going to be delivered to the American consumer, that increases the rate of commoditization for a period of time.
We're seeing some of the impact of that rate of commoditization.
What you're seeing with the strength of Best Buy is we've been able to withstand that and offset it with - from 3rd quarter - you're looking at upholding a slightly growing margin in spite of that commoditization and in spite of some of the competitive pressures.
So the strength of the format and the balance of the products sold in the format we think has met the test very well.
Mike, any further comment?
- Executive Vice President, General Merchandise Management
I would just add, Brad, that we do have a commoditization cycle.
We've always had it.
It may be happening a little faster, but I think as we talked before, Best Buy continues to focus on products that are targeted to our customers, and we have an ability to sell products with higher product pricing than the average retailer.
- Vice President, Investor Relations
Okay.
Thank you, Brad and Mike London.
Next question, please?
Operator
Thank you.
Our next question is from Stacy Woodliss of SG Cowen.
Thanks.
Could you update us on the New York market and expense control in that market, and also give a quick comment on the most recent commercial environment and what you're seeing?
- Chief Executive Officer
Mike Keskey, you want to talk about New York?
- President, Best Buy Retail
Well, New York is clearly a pleasant surprise for us.
We've expanded to 31 stores this year in a 75-mile radius of downtown New York.
We've put a store in downtown Manhattan, in Chelsea, that's perform really well for us.
And as we've put more stores in there, we're able to leverage the expense out of the business that we have invested in it.
Clearly we are seeing advances in our revenues because of competitors' troubles in the New York market.
So we're extremely happy with what we've seen, the growths we've seen in New York, and it continues to move forward.
And can you give us an update on the promotional environment and what you're seeing?
- Chief Executive Officer
Mike - Mike London?
- Executive Vice President, General Merchandise Management
I think we talked about promotional environment.
You certainly have seen with less shopping days as Brad alluded to, and some pricing activity on traffic, low ticket items, but at the same time, we believe that the environment is still very positive for higher priced products like digital TVs, plasma TVs, high end digital cameras.
So I think it's a mix out there.
There are people taking some rifle shots on some low priced products to drive people in because we have less shopping days.
- Vice President, Investor Relations
Next question, please.
Operator
Thank you.
Our next question is from David Campbell of Davenport Company.
Can you elaborate on the digital product mix, what you expect for that in the 4th quarter, and where you think that could go in the next couple of years?
- Chief Executive Officer
Well, that's been one of the real plus stories as I alluded to with the growth in digital TVs from 25% last quarter to 45 - a year ago in the last quarter - to 45%.
We have seen really strong trends.
Mike, did you want to add anything else in terms of..?
- Executive Vice President, General Merchandise Management
In the last two years, the share of digital products has continued to increase at Best Buy.
We don't see any slow down of that.
We're trying very hard to position ourselves to continue to be the leader in that product category from our assortments, from our advertising, from our store training, and our merchandising in store.
We only see continued growth in that area as products in the low end, or the commoditized products, eventually have very low value or actually disappear.
- Executive Vice President, Finance and Chief Financial Officer
Just to remind you in the 3rd quarter, we saw our digital product mix grow to 23% of our overall sales versus roughly 17% last year, and as we finish out the 4th quarter, we would look for that number to approach 25% of our business for the 4th quarter as we head into FY '04.
- Vice President, Investor Relations
Thank you, Darren.
Next question.
Operator
Thank you.
Our next question is from Richard Zimmerman of Commerce Capitol.
A question regarding the Musicland.
Outside of closing stores and taking a look at the merchandising concept, anything that would preclude you from actually going into other areas, like the video game areas, which has been one of the fastest growing categories in retail, to replace some of the prerecorded music with the video game category?
- Vice President, Investor Relations
Kevin Freeland will handle that question.
- President, Musicland Stores, Corp.
We have gone more extensively into the video game category.
It had historically not been carried other than a few tests in the Sam Goody chain.
Today, in all 800 stores, we have a full complement of video games, which is partially offsetting the decline we're seeing in music sales.
We made a change last fall and this fall in our Media Play stores expanding the footprint of video games.
What you did not mention, we have expanded the footprint of DVDs in both the Sam Goody and Media Play chain as well as trading out DVD floor space for VHS floor space in the Suncoast chain.
You see further opportunity to leverage the demand for those kind of products in replacing and increasing the productivity of those stores?
- President, Musicland Stores, Corp.
We have not yet caught the consumer demand in those two businesses.
Just a comment.
If you look at what Sam Goody's known for, if you decide you want to take advantage of what some of the other specialty retailers are doing, clearly if you had a better penetration, breadth, and depth of product you might be able to see that opportunity.
- President, Musicland Stores, Corp.
We're still working diligently to see if we can find the clue or strategy that will make Sam Goody work for us, and we haven't, frankly, found that.
We've tried a variety of experimentations with assortments and pricing, and we're still working on that.
It's part of the alternatives mix we're looking at for Sam Goody.
- President and Chief Operating Officer
And right now, Sam Goody, from a branding standpoint, still has very much in the image of the consumer a place to go buy music versus a place to go buy movies.
Like Kevin says, we have assorted all of those stores with games and we've seen some increases there.
But again, the mall business in general like we talked about is down high single-digits and we're also seeing a softening in those areas that we expanding into, including both movies and games in the Sam Goody business.
Thank you.
- Vice President, Investor Relations
We have time for one more call.
Operator
Thank you.
Our next question is from Scott Cicerelli of Gerard Clouer Madison and Company.
Hi.
I guess this is a broader question, but as you see Wal-Mart and others trying to move upstream with digital televisions and even flat screens, maybe earlier in the cycle than you might have seen than in the past, what do you see is their impact, and how do you defend your turf in those areas over time?
- Chief Executive Officer
The impact of Wal-Mart will continue.
You see us move to say 45% of our TV sales in digital TV.
Wal-Mart is going to get -- jump into that category more aggressively because it's maturing as a product category.
We're looking at the kinds of things that we think are terrificly important to differentiate our experience.
That's part of the reason I've alluded to the increase in improvement of service offering that we have in the stores.
We're really trying to get to the complete solution.
So we're -- while we'll be very competitive with Wal-Mart from a pricing standpoint, the more we can offer the customer in terms of a solution and the better the overall experience with the product, we think that's our best way to stand off the competition from Wal-Mart.
Just related to that, how much of an impact do you think Wal-Mart and friends may have had on your business this year?
Thanks.
- Chief Executive Officer
Wal-Mart has more years been our most formidable or second most formidable competitor.
They certainly are in that space this year.
Go ahead, Al.
- President and Chief Operating Officer
If any area that has had more of an impact on than in the past is probably the whole software entertainment business in terms of movies and music.
Which obviously is impacting I'd say the mall business disproportionately.
Thanks a lot.
- Chief Executive Officer
Thank you very much.
I'd like to thank everybody for participating in the call and wish everybody a happy holiday season.
Thank you.
- Vice President, Investor Relations
Thank you.
This is Jennifer.
The call will be available for replay by dialing 973-341-3080 and entering the pin number of 3629074.
Or you can hear the replay on the web at www.bestbuy.com and clicking on investor relations and then audio archive.
If you have additional questions, please call me, Jennifer Driscoll, at 952-947-2350 or Shannon Burns at 952-996-4489.
Thank you.