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Operator
Welcome to the Best Buy third quarter conference call for fiscal year 2004.
At this time, all participants are in a listen-only mode.
After the presentation, we will conduct a question-and-answer session.
At that time, if you have a question, you will need to press one on your touch-tone phone followed by four.
As a reminder, this call is being recorded for play back, and will be available by noon eastern time today.
If you need assistance on the call, please press star zero and an operator will assist you.
I would now like to turn the conference all over to Jennifer Driscoll, Vice President of Investor Relations.
Ma'am, you may begin.
- VP-Investor Relations
Thank you.
Good morning, everyone.
Thank you all for joining us today.
With me are Brad Anderson, our CEO, who will provide an overview of our third quarter performance; and an update on our progress of the four strategic initiatives.
Allen Lenzmeier, President and Chief Operating Officer, who will give a report on our domestic and international segments; and Darren Jackson, Executive Vice President and CFO, who will comment on our earnings drivers for the third quarter, and he will also elaborate on our outlook for the fourth quarter and fiscal year.
Kevin Layden president of Best Buy Canada is participating in our call from Vancouver.
Also with me and available for Q&A session are Ron Boire, Executive Vice President, General Merchandise Manager.
Brian Dunn, Executive Vice President, Retail Sales;
Bruce Paseco, VP of Finance and Shannon Burns, Investor Relations Manager.
I would like to remind you that 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.
As usual, the media are participating in this call in a listen-only mode.
Also in case you miss a portion of the call the call is available for replay.
Let me give you the replay instructions.
Simply dial 973-341-3080 and enter the personal identification number of 4371504.
With that, I will turn the all over to Brad Anderson who will begin our prepared remarks.
- CEO
Thank you, Jennifer and good morning, everyone.
It is a pleasure to be speaking with you today about our results for the fiscal third quarter.
We grew our top line by 18% including a comparable store sales gain higher than most other retailers.
Our bottom line grew even faster increasing by 42%; primarily due to the success with improving our gross profit rate.
The results we attained illustrate how we, as an industry leader, are innovating in order to increase our share in our core businesses.
They also illustrate the strength of our brands and our ability to connect customers with technology and entertainment through fun experiences.
As reported, we achieved a comparable store sales gain of 8.6%.
We believe that the main driver behind our significant gain was an increase in market share.
As other companies in our industry experienced a much more challenging quarter.
Our gain in market share came from multiple product categories from computer to advanced TVs to digital cameras and even from CDs.
Our own internal measures support that conclusion.
Customer traffic, customer loyalty, and brand awareness are at an all time high.
With, that I will turn it over, the call over to Al Lenzmeier, the President and COO to discuss the business results of the third quarter.
Later I will conclude with formal remarks and an update on the progress of our four strategic initiatives.
Al?
- President and COO
Thank you, Brad and good morning, everyone.
Like Brad, I was very pleased with our results for the third quarter.
And am optimistic about the conclusion to the holiday season.
As I look to the third quarter performance, I would like to focus on five areas.
The continued strength in the home office category, the favorable impact of falling prices in key categories, our success in entertainment software, the improvement in our appliance business, and the growth of our Canadian operations.
First, revenue from the home office category continued to be strong in the third quarter.
We continued to educate customers about the potential of computers as the hub of a digital lifestyle, and they are choosing to upgrade to more powerful machines.
We saw a strong double digit comparable store sales gain in notebook computers, and a high single digit gain in desk tops, and monitors.
The increase in sales of desk top computers compares to flat industry sales.
That gap demonstrates that our sales associates are doing a superior job of explaining to our customers the merits of desk top computers as media servers.
Consumers growing preference for portability, and a high single digit market share gain drove the increase in revenue from notebook computers.
This trend also is reflected in the strong double digit growth of networking products we experienced in the quarter.
As broadband Internet service achieves greater household penetration, more families are taking advantage of the technology available to create home networks.
These solutions allow family members to share broadband connections and printers throughout the house, and not be tied to outlets.
Second, deflation has helped many of our products become affordable to a greater number of consumers.
Price points in certain categories such as digital TVs have placed these products in Best Buy's sweet spot.
In addition, deflation has helped consumers afford enhanced functionality.
We actually will have seen rising average selling prices in select categories such as digital cameras, as consumers climb the functionality ladder.
Third, we had a very strong quarter in entertainment software.
Both CDs and DVDs boasted strong double digit comparable store sales gains for the quarter, driven in part by the very attractive new release schedule.
While this is a continuation of the trend for DVD sales, it is a complete turn-around for our CD business, and we are extremely proud of our market share gains in this space.
We have increased our catalog of CDs, improved our instock position, and added labor to that area of the store.
Lower prices on CDs also contributed to the gain.
We are reinforcing our position with the consumer as a market leader.
In the third quarter, our exclusive arrangement with the Rolling Stones was a prime example of how we intend to cement our position in this important segment of the business.
We produced and sold a four DVD set of the Stones concert tour, Four Flicks has already gone platinum five times selling more than 125,000 sets, and it is ours exclusively until the end of February.
While entertainment software may account for only a fifth of our revenue, it is an important category for driving customer traffic.
For example, half of our customer transactions today include the purchase of entertainment software.
Fourth, the appliance category had a low single digit comparable store sales gain for the quarter.
The last time we had a quarterly comparable store sales gain in appliances was four years ago.
Major appliances showed a modest gain in comparable store sales as consumers were attracted by our broader assortment including new front loading laundry appliances, an even broader assortment is available through our special order capability, which we launched this summer.
I am pleased to add that our Canadian operations reported a 4% gain in comparable store sales, and a 42% revenue gain as both store traffic and the average ticket increased for the quarter.
A stronger Canadian dollar contributed roughly half of the revenue growth.
The revenue gain was also driven by the addition of four new future shop stores and 11 Canadian Best Buy stores, in the past 12 months.
We achieved this growth in a basically flat retail environment.
The retail -- the recovery in the Canadian economy has not yet reached the retail sector.
The Canadian consumer electronics market remains very competitive, and we believe we are gaining market share with our dual branding strategy.
We are very encouraged by our experience in the Toronto market, the first market we entered with Best Buy stores over a year ago.
Magnolia Audio Video reported a solid 5.8% comparable store sales gain for the third quarter, outperforming several other higher end retailers.
Total sales grew 30% to approximately $40 million for Magnolia.
We are pleased that we are experiencing comparable store sales gains across all our brands.
Such consistency is the result of the contributions of all of our employees.
Next Darren Jackson, our CFO, will provide a few more details on the financial results we achieved in the third quarter; and elaborate on our outlook for the fourth quarter and fiscal year.
- CFO
Thank you, Al.
And good morning, everyone.
Al gave you the background on our segment and product category performance.
I would like to focus on our operating rates.
But before I do, I would like to talk about the progression of sales in the third quarter and our current trend of business.
Monthly comparable store sales for the third quarter were remarkably consistent.
In addition, the Thanksgiving weekend comparable store sales gain met our expectations.
However, the first two weekends of the fourth quarter brought difficult weather in the northeast.
As a result, comparable store sales gains quarter to date are running below our guidance for the quarter.
However, we have one extra shopping day for this holiday season.
And we expect to make up the business over the balance of the holiday season and quarter.
We expect the comp to be driven by strong results from digital TVs, digital imaging and home office products.
Similar to our experience from the third quarter.
With that, I will turn my focus to operating rates, beginning with the quarter just ended.
First, I would like to address the factors that enabled the gross profit rate to increase 40 basis points in the third quarter.
The gains were largely due to margin improvement -- margin rate improvements, specifically we benefited from store level initiatives, to manage all of our gross profit drivers, including reduced mark downs, and better handling of clearance items.
We saw the largest improvements in consumer electronics, and we had gains in the home office and appliance categories as well.
However, part of that gain was offset by the impact of Reward Zone, which reduced the gross profit rate by approximately 30 basis points in the quarter, which was consistent with the guidance we provided on the last conference call.
Our SG&A rate improved slightly for the quarter; falling 10 basis points.
This improvement was better than we expected, considering the technology write-off which cost us approximately 20 basis points in the quarter.
The primary factors were leverage associated with high comparable store sales gain, and to a lesser extent, the sale of stock acquired in connection with a vendor co-marketing agreement; which reduced SG&A rate in the quarter by approximately 10 basis points.
We also achieved savings related to our efficient enterprise initiative and I want to thank our employees for their relentless focus on cost control.
These improvements were offset in part by planned customer centricity investments and increased incentive compensation.
Overall, we are pleased that our operating income rate was up 50 basis points for the quarter, and on a year-to-date basis.
Our balance sheet at the end of the period indicates a strong financial condition with $1.8 billion in cash; an increase of nearly $700 million.
This increase included the impact of $60 million in stock repurchases at an average price of $58.39 per share.
Our increase in merchandise inventories reflected not only revenue gains in new store growth, but also investments in product categories that had been driving our growth.
Lastly, we now expect our capital investments to come in at $650 million for the fiscal year, down from our original guidance of $700 million.
The cash balance does not reflect our first dividend payment which totaled approximately $100 million.
The dividend distribution was made last week as a way to share our success with investors while demonstrating our commitment to top quartile performance.
Next I would like to speak to our outlook for the fourth quarter.
We look for revenue of nearly $8.3 billion.
An increase of 18% based on new store growth, and a comparable store sales gain of 6-8%; as I mentioned earlier.
We are looking for an improvement in our year over year -- on a year over year basis in our gross profit rate of 10-15 basis points in the fourth quarter.
The improvement would be driven by the same factors as in the third quarter, and would largely be related to margin rate, not product mix.
Our forecast includes the impact of Reward Zone, which we estimate will lower gross profit rate on a year over year basis by approximately 50 basis points in the fourth quarter.
That brings me to the expectations for our expense rate.
We projected our SG&A rate will be essentially flat in the fourth quarter.
Compared with the prior year's fourth quarter.
We expect to gain expense leverage associated with the comp store sales gain.
We also continue to pursue ways to reduce expenses and boost efficiency.
These benefits however are expected to be offset by an increase in incentive compensation, as well as continued investment in customer centricity, one of our areas of R&D.
These factors drove us to the estimate in our news release of diluted earnings per share from continuing operations of $1.34 to $1.39 for the fourth quarter.
A gain on average of 18%.
For the fiscal year, we look for earnings per diluted share to be $2.35 to $2.40, an increase of approximately 24% for the year.
I will now return the call to Brad Anderson our CEO.
- CEO
Thanks, Darren.
I would now like to update you on the progress of our four strategic initiatives which we believe will drive our financial performance for the long term.
The four are: customer centricity, the efficient Enterprise, winning the home with service, and winning in entertainment.
Together they are designed to leverage our strongest competitive advantage, our stores.
First, is customer centricity.
We already have noncommissioned sales associates, who daily achieve things which were previously unprecedented in our industry.
Such as attaching services and warranties, at a high rate of sale, to devices; in order to make this business more profitable.
We expect that one of the outcomes of our customer centricity initiative will be to take these associates to the next level of performance, increasing the ability -- their ability to complete complex sales, will be an important competitive advantage for us to use in the future.
As product categories converge, as technologies grow even more complex and as customers seek services to go with their hardware and software, this is a core differentiator.
Our customer centricity strategy gives our associates tools for using their talents more fully in engaging the customer.
For our 32 customer centricity lab stores our employees are formulating, testing, and validating new value propositions each day.
They are learning a lot.
And I visited some of these stores and the only way you can describe the employee base is energized.
Of course customer centricity is a long journey and will take us several years to perfect it, and roll it out throughout the system.
Another aspect of customer centricity is our loyalty program.
Reward Zone.
Which has been very successful.
We are on track to attain approximately 2 million members in the program's first year.
Reward Zone will give us helpful insights on customer buying patterns on top of what we are learning through their dot-com visits and credit card purchases.
The second initiative is the Efficient Enterprise.
This initiative was designed to narrow the gap between Best Buy and the best retailers in terms of operating profit rate.
And we're proud of the improvements we made in the third quarter, as we grew earnings faster than revenue while investing in customer centricity and landing Reward Zone which initially requires an investment.
That improvement included the benefits of our work to decrease bureaucracy and become more efficient.
For example, during the quarter, we simplified many of the store processes.
We have identified significant potential to increase supply chain efficiency and make it more responsive to customer -- to changing customer needs and we believe that the potential for structural sustained improvement, most of that potential is still untapped.
Third, we have made additional strides in our win the home with service initiative, which differentiates us from retailers that focus only on hardware or on software or that compete exclusively in the direct channel.
We continue to improve our instore service capability at Best Buy stores.
We launched an -- excuse me, we launched an instore computer data backup solution and we're now installing almost a quarter of all the memory chips sold in our domestic stores.
To compliment our instore technicians we've added geek squad service in Columbus, our seventh market for the geek squad, and this premiere computer support service.
And finally, we continue to expand our new inhome wiring business.
Having recently signed three additional builders, bringing us to a total of 10 builders.
At the Consumer Electronics Show next month we will be showcasing a networked family home for all of our vendors.
And these efforts together are teaching us about the -- about the services that matter to our customers; and those lessons will provide an avenue for our final initiative, which is the fourth quarter, winning in entertainment.
An initiative we have now defined more clearly.
If you start with packaged media including movies, music, games, and computer software; we believe that we will provide ultimately an integrated solution through this initiative.
But that's not the whole picture.
Entertainment is and has been the soul of the company.
It is a big part of the reason that we are a fun place to shop; and it is also dear to the hearts of our consumers.
The good news is that we're already winning in the current space.
We're gaining share in entertainment.
Furthermore, our customers define entertainment as not only content but also the devices that play the content.
And we're winning in that space as well.
Our goal is to build on that success.
And to offer customers more choices including multiple ways to access their entertainment.
That's why we've been a leader in offering new entertainment services such as Rhapsody, Music Now, and the Napster service.
Services such as these are the starting point of bigger changes that will arrive in the future.
So one of the keys to this initiative is to increase our capacity to listen and to touch the entertainment customer.
We are the only company that is engaged with this customer at so many different touch points.
We offer hardware and software services, having both physical stores, and an online store presence.
And even coming to their homes.
We envision a future where entertainment flows from many sources, and where consumers have multiple methods for accessing it and we are singularly positioned to satisfy those multiple needs.
I'm pleased with the energy and enthusiasm of our people.
As we work together on our four strategic initiatives.
And I will provide you another update on our progress with each of them at the close of our fiscal year.
And with, that Maria, we're now open for taking questions from our investor audience.
Operator
Thank you, the floor is now open for questions.
If you have a question, you may press the number one, followed by four on your touch-tone phone at this time.
If at any point your question has been answered, you may remove yourself from the queue by pressing the pound key.
We do ask that while you pose your question, that you please pick up your hand set to provide optimum sound quality.
Your first question is coming from Aram Rubinson of Bank of America securities.
Please go ahead with your question.
- Analyst
Thanks.
- CEO
Good morning.
- Analyst
You caught me with -- unprepared here.
All right.
A couple of things.
- CEO
That's a first.
- Analyst
Right.
Can you tell me a little bit about your use of consultants where are you in some of these initiatives?
And how it compares to some of the prior use of consultants, question number one.
Number two, on inventory can you give us a sense as to the balance of and categories that are maybe heavy or light; and then the final question is free cash flow targets for this year and perhaps next.
- CEO
I mean the primary use of consultants we have in relationship to the initiatives is on the customer centricity initiative, where we have used a firm to help us get it launched and also to help us with the architecture.
I think our overall -- Darren you want to comment on the overall use of consultants during the course of the year?
- CFO
Yeah, what I would say is in terms of consultants, our practice is that, you know, you can look back five years, is that we have brought in consultants to help us with content and help us with execution.
We wouldn't say that this year is extraordinary.
We are setting budgets for next year, and we're crafting our plans for next year.
And those aren't final as to just what type of support in terms of content or execution that we will need.
But it is fair to say as we move forward, consultants, when we look back to SOP, were a big help in driving those benefits; and we're seeing real value in terms of what they're helping us drive in terms of the benefits today.
- VP-Investor Relations
Thank you, Darren.
Would you like to comment?
- President and COO
Really, the two primary areas are consumer centricity and supply chain is where we're using consultants.
- CEO
And I think the second question Aram had was in terms of our inventory position, where do we see -- how are we positioned going into the balance of the holiday season and if there are any specific categories that we're heavy or light on.
- President and COO
Ron Boire you want to answer that?
- Executive VP, General Merchandise Manager
Sure.
We had a strategy throughout this fiscal year investing in the categories that we want to win, those categories primarily have been the digital categories; and I think that Brad and Al commented earlier on the market share gains we've had in some of those categories, so we have invested in PC and particularly notebook and desk top.
As Al talked about previously, we took very high single digit share gains in notebook and beat the industry handily in desk top.
Digital imaging is also an area we invested in, digital camera, digital camcorder, and photo printer; as well as, digital music players.
The other thing we've done is versus prior year, we've improved instock in some key categories, PC in particular, we've dramatically improved instock where we had shortages in the December period last year, we now are at what we think are very good instock levels in notebook and desk top in particular.
Music where you've heard that we are handily beating the industry and in fact have comparable store gains, we improved our instock purchase.
MP 3 players where we had dramatic shortages last year we have improved our instock position significantly over prior year, we are still not where we would like to be; but we have significant improvements there.
And you also heard about our gains in peripherals, where in networking devices, peripherals and software we improved our instock position; so we're comfortable that we are in stock in the products in the digital categories that customers are going to be buying and are buying this season.
- CEO
And I think the final question Aram had was around cash flow and cash flow targets.
Aram, the way I would answer that question is historically we've not given out cash flow targets.
Another way of answering the question would be how are we year to date in terms of our overall management of cash flow and what I would say is that if you look at our cash flow from operations, year to date, it is up about $400 million.
If you look at our investing activities, principally related to cap ex, we've actually saved $100 million.
And probably another one you wouldn't want to lose sight of is that, in terms of discontinued operations year to date, we have saved over $100 million in terms of our decision to exit Musicland.
So across the front -- across the waterfront in terms of where we're picking up $700 million in improved cash flow, the good news is it is coming out of operating activities, being more efficient in managing our capital expenditures; and being rewarded for the decision we made earlier in the year in terms to exit the Musicland business.
- Analyst
Great job on that front.
Thanks.
- CEO
Thank you.
- VP-Investor Relations
This is Jennifer.
Just a reminder, please restrict your question to one question, out of fairness to the other callers in the queue.
Now we will take our next question.
Operator
Your next question is coming from Colin McGranahan with Sanford Bernstein.
Please go ahead with your question.
- Analyst
Thanks, guys.
One question.
Well, why don't I focus on Reward Zone then.
- CEO
Okay.
- Analyst
Maybe you could give us a little bit more color where are you in terms of the accrual rate versus where you expect it, any sense of what percent of sales you're doing on Reward Zone here in the third quarter and what you expect for the fourth quarter?
And I would assume that that ramp-up of the gross margin impact is because a greater portion of sales will be in the fourth quarter, but if you could explain that a little bit.
And this is all one question, Jennifer.
And then any experience you have so far with the redemption of the coupons in terms of what kind of a sales lift above the face value you're getting.
- President and COO
Didn't ask for customer names.
- CEO
You want to start with -- I can start with the best job I've ever heard of cramming a lot into one question.
- VP-Investor Relations
Very creative.
- CEO
Go ahead.
Allen's going to be a politician.
No. 12-part question.
Colin, let's do -- so in the third quarter, Reward Zone, year over year reduced our gross margin by 30 basis points.
In the fourth quarter, as we said in our comments, 50 basis points.
You might ask, what is the difference between the two?
It is two things.
One, our run rate in terms of redemption, our best information to date is running in that 60% type of run rate in terms of redemption.
In terms of customers, using Reward Zone and percent of sales, we haven't given that information out at this point in terms of viewing it as propriety versus competition.
The difference you will see between the third quarter and the fourth quarter are two things, one you're absolutely right, just the sheer volume in the fourth quarter and the -- the building adaption -- customers adapting to Reward Zone is getting stronger as we're going through the quarters; and we did benefit probably to the tune of at least 10 basis points in the third quarter by making the true-up adjustment in terms of the redemption rate, because as you will recall in the second quarter we were accruing at 100%.
We have real experience that allowed us to make the adjustment in the third quarter, down to roughly 60%.
So the third quarter did benefit a little bit by the second quarter adjustment to get to the redemption rate.
- President and COO
Did we miss anything with that answer, Colin?
- Analyst
Just any color experienced in terms of what kind of a lift you're getting when are you seeing a redemption above the face value of the coupon.
- CEO
Yeah, Colin, that would be another one, as we talked about last time, we view as proprietary, in terms of how we run the Reward Zone program versus our competition.
But suffice it to say we wouldn't have launched a program without testing a program to know that the ultimate lift would pay for the margin costs that we're seeing today.
And to be quite honest one of the things that has us optimistic for the fourth quarter is that we view post holiday, the Reward Zone certificates feeding into that post holiday business in order to drive the comparable store sales gains.
- Analyst
And it looks like maybe you've been a little slow in getting those coupons out.
And I'm making a mistake of using personal experience, but my Reward Zone coupons have been coming later than I expected with an expiration date at the end of the first quarter really, end of March.
Have you had any issues in terms of just keeping up with the demand?
- President and COO
Go ahead.
- CEO
Well, first, we apologize for it getting to you late.
In terms of we want to give you as a happy customer.
I would say initially, we were a little overwhelmed in terms of customer acceptance of the program.
We did get some feedback in terms of the coupons getting out late, and certain circumstances we did extend that for the customer because we thought it was the right thing to do.
The teams are now better calibrated to the overall acceptance and volumes and so we don't expect difficulties going forward.
But you can appreciate one, we're thrilled with the acceptance, two, just the learning curve of making sure we're keeping up, and three, we are going to do the right thing for the customer if we made a mistake in terms of getting it out late.
- Analyst
Great.
Thanks guys.
- CEO
Thanks very much.
- VP-Investor Relations
Next question, please.
Operator
Our next question is coming from Matthew Fassler with Goldman Sachs.
Please go ahead with your question.
- Analyst
Thanks a lot.
Good morning.
- CEO
Good morning, Matt.
- Analyst
I don't know if I should ask to be grandfathered into Aram's three questions or be as creative as Colin. [ Laughter ] I will try to keep it simple.
You are -- you got it essentially to a flat expense ratio.
And you've made the rationale pretty straightforward, you're investing in the business to improve your competitive standing and to continue your market share gains which have obviously been quite notable.
As you think about the way you're planning the business going forward, how far into this investment cycle are you?
And would you envision, you know, if you think about customer centricity, and the fact that it is only a 32 stores and is fairly early in it's life cycle, would you expect to continue to invest essentially to the, you know, to the potential that your strong business trends are allowing, and how do you feel about expense leverage on a go forward basis in that context?
- CEO
Well, that's part of what I was trying to allude to as we went through the four initiatives, particularly the Efficient Enterprise that we see much more opportunity in front of us, than the gains that we've had in the past.
So there is a lot of head room in terms of what we can see from this point in further getting at our supply chain, getting at our operating expense structure, that helps produce substantial -- substantial cash we believe in the future.
The extent to which we use or will be required to use that in the roll-out of the customer centricity, at this stage, is unclear.
One of the things about when you're doing like a 32-store test is you really -- it is suboptimized for the efficiency of it's particular operation because it is a test; and second, it is still -- we still haven't delineated what our roll-out plan would be.
So we think we've got a lot of head room in terms of making the company more efficient.
What exactly we'll do with customer centricity is still not -- is still not clear.
- Analyst
And truly a follow-up to that, to that first part, you know, obviously, your fourth quarter shows a lot more volume seasonally than your first three quarters.
Does the customer centricity investment tend to flex with that seasonal trend?
In other words does that investment go up in the fourth quarter?
Is that something you can leverage in the fourth quarter versus where it was in the first three quarters?
- CEO
It won't get leveraged at this stage because we're -- we're in the process -- it is kind of like a learning lab.
And so you're -- as you're doing that, you, you know, you literally have tests going on in any given day.
So we won't get to the making it more efficient stage until sometime in the upcoming year.
That means that the holiday season, don't give it any additional leverage, than it gets to the rest of the system.
- Analyst
Gotcha.
Thank you so much.
- VP-Investor Relations
Next question please.
Operator
Thank you.
Your next question is coming from Bill Sims with Smith Barney.
Please pose your question.
- Analyst
Good morning, thank you.
Can you give us some color in sales in areas where weather was not impacting your business, directly were sales trending above guidance or in line with guidance in these areas?
And then the follow-up to Matt's question, and in line with the sales question, you said in the past that there are a number of levers you could pull should sales weaken in the quarter.
In line with customer centricity, would you consider pulling back your investment in the fourth quarter or are there other areas that you could, you know, offset a potential sales weakness as a result of poor weather?
- CEO
I'm going to turn it over to Brian, but the biggest pattern we've seen so far is we've seen strong midweeks with dips in the weekend directly related to the weather.
Brian did you have any other comment on that?
- Executive VP, Retail Sales
I would just simply comment that in areas unaffected by weather we are on track.
- CEO
So we're pretty confident that our position as we go into -- barring some other unforeseen developments, our position will be good going through the holidays.
So at this point, we're not putting any sort of plan in place to adjust from our initial expectation.
- President and COO
And I think if your question on consumer centricity, that we would not roll back the investments or -- that we're making in R&D with respect to that, if business conditions change, I mean obviously we always -- you know, looking at where the business is going, and if we -- get to the point where we feel it is not going in the right direction, we will react in terms of adjusting our variable labor costs, and things like that, and, you know, look again at expenses in terms of other areas that we might squeeze a little bit tighter.
- CFO
As we get into next year, we will share more information about what is happening with those customer centricity labs, but at this stage what we're seeing would cause us not to to do anything but pull back from that investment.
- Analyst
Thank you.
- CEO
Thanks a lot.
- VP-Investor Relations
Next question.
Operator
Thank you.
Our next question is coming from Gary Balter of UBS.
Please pose your question.
- CEO
Good morning, Gary.
- Analyst
Hi.
I have a question and then Brian actually gave me a question.
So it is one from each of us.
First one is just the impact of gift cards.
That's obviously had -- has become a bigger part of your business.
And what are you seeing in that?
And I don't know if you discussed what percent of sales it is, or what the impact is but obviously it delays some of the sales and I assume better margins.
Brian's question was, on the days that you have seen the snow day, have you seen a pickup in the dot-com sales on those days from the areas where you have seen it snowed in?
Could you find any correlation in that?
And then when the questions are over, could you put me back on hold so I could listen to the rest of the Rolling Stones CD.
- CEO
We debated whether we should run the Stones cd, we thought it would be more fun than this.
- President and COO
This is Al.
Dot-com we kind of stayed away from commenting on that, but I don't think we've seen a significant increase in that as result of the weather in those areas.
Regarding gift certificates, I think, you know, for at least the last several years where we put a real increased focus on selling gift certificates, and you know to a certain degree you could probably say this about Reward Zone as well.
Each year, the amount of business that takes place, the first week or two after Christmas continues to increase year over year.
And a lot of that we believe is being driven by the gift card sales that we have in the months of November and December.
- Analyst
Do you discuss what percent of sales are gift cards?
- President and COO
No, we haven't.
- CEO
No, we haven't but it is fair to say, Gary when we get through December we will have a better view on that and we will have a better picture for you in projecting what do we think the gift card volume will do for the balance of the quarter but it is fair to say that it is clearly running ahead of last year.
- Analyst
Okay.
- CEO
In terms of consumers making that choice.
- President and COO
And I again, I think that positions that we occupy in terms of having the assortments that we have; particularly in the software area in terms of CDs, movie, games, those are prime areas that people use those gift certificates, so we're well positioned in those areas.
- Analyst
And I guess it is a better margin sale because by the time they come, in some of of the specials we're seeing now are not on.
Is that a fair statement?
- President and COO
That's true.
But it also has the benefit the same kind of thing you would see with the Reward Zone which is they buy more.
They add on sales and we're now in a position that based on -- we look at history in terms of what in the past what customers have bought so we are actually buying inventory knowing what customers traditionally have bought with those gift certificates.
- CEO
And positioning labor in the stores, based on that.
- Analyst
Great.
Thank you.
- CEO
Thanks so much, Gary.
- VP-Investor Relations
Next question, please.
Operator
Thank you.
Our next question is coming from Mark Rowen of Prudential.
Please pose your question.
- Analyst
Thanks, good morning.
- CEO
Good morning, Mark.
- Analyst
Two quick questions if I could.
First one is for Al.
The music business, you talked about the turn-around.
Is that sustainable?
Or were there things going on like the DVD Stones from the Stones, that caused that big turn-around?
Is that going to be sustainable going forward, do you think the music industry is turning now?
Or was it a one quarter aberration?
And then the second one is for Darren.
It seems like you're not getting quite as much leverage from the strong comps as I might have expected, and you talked about some of it going to incentive compensation.
Could you be a little bit more specific about that?
Because I know you don't pay your sales people commissions or spiffs for selling those warranties, and things like that that are high margin, so could you be more specific about what -- why we're not seeing a little bit more leverage on those strong comps?
- CEO
I will let Darren do that but I just wanted to mention one of the things, one of the perverse benefits -- I said our scores are the highest they have ever been on customer loyalty, on -- if you look at all of those high scores, we also have bonus structures associated with every one of those score sets, so they are -- they are pegging where they've ever been historically and along with that, goes the incentive compensation with that.
- CFO
It is a trifecta.
So what we have going on this year specifically, Mark, is two things.
If you recall, you know, better than 60% of our profits are made in the fourth quarter.
And you know, our original plan for the year, if you rewind the tape, was earnings and EVA improvement, call it 14-16%.
As we talked about earlier, with our fourth quarter guidance, we're pegging 24% type of improvement, so we're well ahead of what our plan expectations would have been for the year.
And if you -- if you look at last year, last year, compared to others, we had a very strong fourth quarter, but well below our expectations.
So last year's incentive comp is low, this year we're well ahead of our original plan expectations, so that's one.
Two, what we're finding to Brad's point is that it is more than just profit that will drive payouts in our incentive comp system.
It will be customer scores.
It will be brand scores.
- President and COO
Employee scores.
- CFO
Yeah and our employee scores, and across the board, they're up.
Those are all good leading indicators.
And then three, as you recall from last quarter, we did adopt a new long-term incentive plan.
Part of that has restricted stock that goes with it.
And so year over year, in the fourth quarter, we are experiencing long-term incentive plan expense related to introducing restricted stock as a part of the overall L-tip plan.
Now within the context of the option L-tip plan, the overall plan from an economics point of view is much more shareholder friendly than the other plan; but because of the accounting, we're having to recognize more L-tip expense this year versus last year.
So those are the three things.
Last year was a low base.
This year, we're well ahead of our plan.
We're well ahead of our plan on all consumer metrics and employee metrics and we have L-tip expense.
Those things are driving the incentive come.
- Analyst
So Darren, does that suggest that a lot of the comps that there's really not that much leverage in higher comps in general?
Because some of it, because of the way the incentive plan is structured, is really variable?
Or is that not correct?
- CFO
No, I don't think that is correct.
Because you would have to look at it in the context of all of payroll.
So within the context of all of our payroll, you're still going to be given -- given the majority of our payrolls on the store floor.
It is going to be 80% in terms of base pay.
It is just that we have this good thing occurring, is that we're far exceeding our original expectations.
- CEO
Well, there's actually one other thing you have to add to that picture, which is what we're using to gain market share with, because we're -- you know, if you looked at those -- if we're seeing very high results in terms of employee performance, what we're actually doing is we're leveraging that investment on the floor, with our employee base, so we're actually -- we're spending more resources, we put actually more labor into the stores, to win, and you see, I think if you look compared to our competitors we're actually will having margin increases at the same time we're gaining shares where other folks are not.
And so we believe this is part of the component that is getting us share so it is kind of all of those factors together, that caused us to make a specific decision.
That does not say we don't get leverage.
It just says we're using it in a different way.
- President and COO
And a lot of the sales are taking place, really more higher skilled sales in terms of digital cameras, notebooks and so forth; where we are gains some pretty good market share gains.
With respect to the music, I guess first thing, the music business is the industry is doing better, and I don't know, you read a lot of articles on it, and you know, there is more new releases on it, and litigation in terms of piracy seems to have slowed that down a little bit; but even in spite of that, Best Buy, like we said, we have some pretty healthy double digit comp increases that we are doing better than the industry and we are gaining market share and that is a result of a lot of good efforts on the part of I think the people here, in terms of the merchants, improving the assortment and getting better deep catalog, better advertising and promotion as to the product.
We talked about that we are adding additional labor, into the music area, you've got the pricing decisions that universal took in terms of taking some of those prices down so it is a combination I think of all of those ingredients in terms of just doing a lot better job executing internally both on the part of the merchants, the marketing group, as well as the retail people in the field from execution standpoint.
The Rolling Stone thing, DVD, is really in the DVD category.
It is not in the music category.
Although I expect there is some overflow from that.
But I would expect that that is pretty minimal.
That is really in the DVD area that that is helping.
- Analyst
So it sounds like do you expect it to be sustainable, that those kind of increases?
- President and COO
Well, I wish I was -- you know, I was clairvoyant and I could predict those things.
You know, how far is it sustainable, you know, I don't know.
Assume we continue to execute, we can, hopefully it will continue, but how long?
We don't know and we're not going to be complacent with that, either.
We talked about the initiative that we have with in terms of entertainment and we think we do -- we are the only retailer that has all the tools in the tool kit in terms of the online experience, the store experience, the fact that we sell the hardware that the entertainments played on, we sell the software, the content, we sell the services, and we talked about getting into the home; in terms of integrating all of these things and eventually the network home will be there and it is a matter of having the tool kit in terms of the stores, the dot-com, the service that integrates all of those things together that is going to make us a winner.
- CEO
And if you looked at each of those components, we had a pretty energetic plan to make each of those components strongly better, going into the future, than they are today.
So that is kind of what we're counting on working as a whole for the Enterprise.
- Analyst
Great.
Thank you very much.
- CEO
Thanks a lot.
- VP-Investor Relations
You're welcome, Mark.
Next question, please.
Operator
Our next question is coming from Alan Rifkin with Lehman Brothers.
Please pose your question.
- Analyst
Yes, a lot of my questions have been answered.
Given the multiple parts, but I just had a couple of quick ones.
Al, I find your comments with respect to the upgrade cycle on PCs pretty interesting.
Could you maybe provide a little bit more color as to, you know, why you think we could possibly be on the upgrade, on the cusp of an upgrade cycle?
It certainly appears that the strength that you had in back to school has extended even beyond that.
And my second question I guess is for Darren, it relates to your cap ex which continues to come down.
Can you maybe provide some color as to why that is coming down?
Are you seeing your preopening expenses actually come in lower than what you originally anticipated?
- President and COO
Why don't I let Ron address the question on computers.
- Executive VP, General Merchandise Manager
I'm not sure how deep we are into an upgrade cycle.
I'm not sure that I would necessarily say that that's the key driver for us.
I think certainly notebooks have become a much better value proposition for the consumer.
We have increased our assortment, and really focused on notebook computing as a -- as a key value driver for the enterprise.
So I think we're -- not only are people moving to more mobile computing and portable computing, but I think our execution, both from an assortment, advertising standpoint, as well as the tremendous retail execution is creating a winning formula for us.
Additionally, I think things going digital, whether it is photo, music-- photo, music, and broadband is driving PC and networking, and we're certainly winning in that space.
If we look at network devices, for example, as a leading indicator, we're selling almost one in three network devices in America today, so people are coming to us for that integrated digital solution and the soul of that right now is the PC.
And the changing value prop of notebooks are more affordable and higher performance and more media centric falls into our sweet spot.
- Analyst
And Darren I think --
- CFO
Alan, as to cap ex, you know, as I look across the categories, I think the good news is cap ex is coming down by modest amounts across all of our categories of business.
So what is happening is that we've talked about being more efficient, trying to find ways to streamline and get our costs per square foot down it takes to build our stores, and as I look at what is driving the 50 -- part of it is just getting the cost per square foot down and what we're seeing too, is we're still able to maintain the IRRs in terms of those small stores.
Now they're not as-- in terms of profit rate they're lower but in terms of getting the cost per square foot we're able to offset lower profit rates with lower cost per square foot, getting the returns.
The other thing I would say is that the other big driver is that we had made some assumptions in terms of investments, we would be making in terms of a hypothesis in our customer centricity stores; and what we're seeing is that we have expense dollars that we're talking about, but the teams are also being thoughtful in terms of not spending as many capital dollars.
And so part of our learning journey in terms of the dollars on customer centricity is spending a few more expense dollars, in line with what we thought, but the capital dollars are not as high in terms of our original hypothesis.
And I would say those are the two big drivers that have moved the $50 million dollars saved that we're seeing right now.
- President and COO
On your comment on preopening expenses, those we -- we expense those so that doesn't have any relevance to capital.
- VP-Investor Relations
Next question please.
Operator
Thank you.
The next question is coming from Danielle Fox of J.P. Morgan.
Please pose your.
- Analyst
Hi, thank you.
- CEO
Good morning, Danielle.
- Analyst
Good morning.
I'm area wondering outside of Reward Zone, are higher staffing levels the main element of the customer centricity initiative?
And maybe, you know, without divulging too much, if you could just give us a general sense of some of the types of things that you're testing, particularly those that have a cost associated with them?
- CEO
The -- basically what we're testing is we're looking for ways to make more -- to really provide whole solutions for customers, and engaging with the customer, taking a combination of the data that we have gotten centrally.
So things like Reward Zone is very helpful for getting us a database and then combining that with what can be learned in engaging with the customers at the store levels.
And then adjusting, constantly adjusting and fine tuning our offers for particular customer subsets that we've chosen to go after.
And so that process started with four stores in May, it is now up to 32 stores, and it is very -- and as Darren alluded to, it is -- we found that the most effective part of it is really adjusting the labor in the store; and the experience between the staff, and the customer rather than major expenditures in capital.
And so we're in a very vibrant place on that journey.
We're going to get a lot more information in the next 45 days about it that will help determine about the rate.
But the biggest variable seems to be what we're learning in the engaged experience between the employee and that customer.
- VP-Investor Relations
Just a reminder to our callers, please use your hand set rather than your speaker phone.
We're getting some feedback.
- CEO
Thank you.
- Analyst
Thanks.
Operator
Thank you.
Our next question is coming from Shawn Malign of Soundview.
Please pose your question.
- Analyst
Thanks a lot.
It's actually Shawn Miln at Soundview.
Really quick you talked about strong growth in your entertainment software business with CDs and DVDs.
Can you talk at all about the video game sector?
We're in a bit of a difficult environment in terms of no hardware price cut this holiday, but can you talk about sales versus expectations in that area?
And if you had any other color on that, that would be great.
Thanks.
- CEO
Ron?
You want to take that?
- President and COO
Ron Boire will take that.
- Executive VP, General Merchandise Manager
Give me the fun categories.
Sales versus expectations certainly are not the issue.
We are, you know, deep into a game cycle right now, and we see the beginning of next year, some new platforms starting to tiptoe into the market, and certainly '05, probably being the beginning of the next growth cycle.
You know, we certainly would like a more robust game environment, but you know, we see that from a platform standpoint, you know, we're well into the cycle.
There really has not been a lot of energy around new titles this year, so the software side of the business has also not been robust.
Versus our expectations, I think we're very happy with where we are.
I think it is an area where we continue to win.
But it is not the growth area that it was as the two platforms were introduced just a couple of years ago.
- Analyst
Sure, but just to clarify, was it above, below or in line with expectations?
- Executive VP, General Merchandise Manager
I would say we are in line with expectations.
- Analyst
Okay.
Thanks a lot.
- Executive VP, General Merchandise Manager
Thank you.
- VP-Investor Relations
The next question.
Operator
Thank you.
Your next question is coming from Budd Bugatch of Raymond James.
Please pose your question.
- Analyst
Good morning.
My question, most of them have been asked and answered.
You had talked about inventory and I just want to make sure I'm clear on this.
Inventory per store looks like it has gone up by about 10% or more.
Can you tell us if that's going to be a permanent investment in inventory?
Or how does that look relative to where you have been?
- Executive VP, General Merchandise Manager
Our plans I think are to be down to normal levels, you know, the intention is by the end of the fourth quarter.
Or sooner.
- Analyst
And inventories are in good shape, I know you've talked about being in good -- in certain categories, are there any categories where you're too heavy in inventory?
- Executive VP, General Merchandise Manager
No, we don't think so.
I think, you know, the best place we're in the categories, we want to win, in the digital categories are the categories we're gaining market share and also some of the categories where we weren't in as good a shape as we should have been last year from an instock that we're in much better shape this year for those particular categories that we're going to win in.
- Analyst
Okay.
Thanks.
- VP-Investor Relations
Operator, I think our call has been almost an hour.
We will take one more call.
Operator
Our final caller is coming from Mark Curland of Bear Stearns.
Please pose your question.
- CEO
Good morning, Mark.
Looks like Mark is not there anymore.
- VP-Investor Relations
We will take another question.
Operator
Our next caller is Dan Wewer with CIBC World Markets.
Please pose your question.
- Analyst
Thanks for taking my question.
Quickly, what kind of same store sales growth is needed during the fourth quarter if you are to reduce the inventory growth per square foot or per store, you know, back to this normal level?
- CEO
Actually, -- Dan, this is -- to frame Al's comment, we have been deliberate in specific categories, in terms of raising our instocks this year.
So it doesn't come as a big surprise to us entering the fourth quarter with a six to eight comp sales plan, and our inventory position is deliberate in terms of getting the business.
So getting back down to normal levels, we should define normal is normal in terms of our instock levels, which we've made a deliberate decision to boost up.
And so when we exit the year this year, in categories that we see that we're playing to win in, we're -- we've permanently made a decision to improve some of those instocks year over year.
So I wouldn't be trying to do the math of 6-8, you pick the number.
If you call it 10% increase in inventory per square foot, we could exit the year on that and we would feel good about it.
Because what we're learning, and part of this came out of the customer centricity testing; is that when we're increasing the instocks we are seeing the return on that, we're seeing the return in the CD business that we talked about earlier.
So I would say it is a combination of we see stronger business in terms of our comp store sales plan, and the deliberate strategy in key categories to be better represented as a part of our strategy.
- Analyst
Let me ask the question this way.
Let's say if were you to make the $8.3 billion sales plan in 4 Q what do you estimate the inventory dollars will be at year end?
- CEO
I don't have that number in front of me, Dan.
- Analyst
Okay.
Thanks a lot.
- CEO
Thank you very much.
Well, I would like to thank everybody for the participation in the call, we are -- we're very excited about the performance in the third quarter.
I'm confident about the position we're going into the marketplace with the fourth quarter and extremely proud of the performance of the employees of this enterprise.
I think we're seeing this in so many ways in terms of the growth and improvement of the position of the company.
That also leaves us very optimistic about where the company is going in the future and how we can continue to leverage and continue to gain share.
By becoming more and more important to the lifestyle of our critical customers.
So thanks, everybody for the participation.
And we have enjoyed the morning.
Thank you.
- VP-Investor Relations
Thank you for participating in our call.
As Brad said before, and I want to remind that you the call will be available for replay.
By dialing 973-341-3080, pin 4371504 -- the approximately 12:00 central, 1:00 p.m. eastern until midnight next Monday December 22nd.
To hear the replay on the web, visit us at www.Best Buy.com.
Click on For Our Investors and then click audio archives.
If you have additional questions, call me Jennifer Driscoll at 612-291-6110 or Shannon Burns at 612-291-6126.
I would like reporters to contact Sue Bush at 612-291-6114.
Happy holidays.
Operator
Thank you, this does conclude today's teleconference.
You may disconnect your lines at this time and have a wonderful day.