百思買 (BBY) 2005 Q2 法說會逐字稿

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  • Operator

  • Ladies and gentlemen, thank you for standing by.

  • Welcome to the Best Buy second quarter conference call for fiscal year 2005.

  • 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 star on your touch-tone phone followed by 1.

  • As a reminder this call is being recorded for playback and will be available by 1:00 p.m.

  • Eastern time today.

  • If you need assistance on the call, please press star 0, and an operator will assist you.

  • I would now like to turn the conference call over to Jennifer Driscoll, Vice President of Investor Relations.

  • - VP of IR

  • Thank you and good morning, everyone.

  • Thank you all for joining us today.

  • With me here in Minneapolis are Brad Anderson, our CEO who will give you the highlights of today's news;

  • Al Lenzmeier, President and Chief Operating Officer, who will give us a report on our operations;

  • Mike Keskey, President of U.S.

  • Best Buy Retail Stores, who will update you on our Customer Centricity transformation; and Darren Jackson, Executive Vice President and CFO, who will comment on our earnings drivers for the second quarter and back half; also, Kevin Layden, President of Best Buy Canada, is participating in our call today from Vancouver.

  • With me here in the boardroom and available for our Q&A session later in the call are Ron Boire, Executive Vice President and General Merchandise Manager;

  • Brian Dunn, Executive Vice President and Retail Sales;

  • Mike Linton, Executive Vice President and Chief Marketing Officer;

  • Susan Hoff, Senior Vice President and Chief Communications Officer;

  • Bruce Besanko, VP of Finance; and Mark Gordon, VP of Finance.

  • I'd like to remind you that comments made by me or by 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 missed a portion of the call, it's available for replay.

  • Let me give you the replay instructions.

  • Simply dial 973-341-3080, and then enter the personal identification number 5163547.

  • That's 5163547.

  • I'd like to remind those of you with questions that, out of fairness to the other callers in the queue, we would like you to limit yourself to one one-part question.

  • And with that, I'll turn the call over the Brad Anderson, CEO, who will begin our prepared remarks.

  • - CEO

  • I don't think that's ever happened, Jennifer.

  • - VP of IR

  • We can always hope.

  • - CEO

  • Yes.

  • Thank you and good morning.

  • Thanks, Jennifer, and good morning, everyone.

  • It's my pleasure to talk to you this morning about our second quarter results and second-half outlook.

  • I'd like to point out 4 highlights today.

  • 1.

  • We achieved higher than expected operating leverage in the second quarter before the charges.

  • We proved that even best in class retailers can always find room for improvement, and we did it in both the gross profit rate and in the expense rate.

  • 2.

  • We continued to gain market share as evidenced by our comparable store sales of 4.3%, which was larger than that of our competitors.

  • And we did particularly well with digital products such as digital TVs, digital imaging and MP3 players, as well as notebook computers.

  • 3.

  • The underlying strength of our business, as well as the opportunities we see ahead, gave rise to our expectation of a comparable store sales gain of 3 to 5% for the second half.

  • That increase is on top of last year's comparable store sales gains of 8.6 and 9.7% for the third and fourth quarters respectively.

  • 4.

  • Despite falling short of our comp target for the second quarter and despite absorbing the charges we described in our news release, we are pleased to reiterate our earnings guidance for fiscal 2005 of $2.80 to $2.93, and -- per diluted share.

  • An increase of approximately 17% even after the charge.

  • As we look ahead to the holiday season we see much reason for optimism.

  • For example, unemployment rates currently are lower than they were a year ago.

  • Consumer confidence levels are substantially improved and our typical consumer appears to be somewhat less sensitive to gas prices than the consumer who frequents the mass merchants.

  • Looking at consumer electronics more -- spectrum more broadly, I would like to add we offer a broad portfolio of products, which reduces our exposure to any single category that may be declining.

  • In addition, we are well positioned to take advantage of one of the strongest product trends in years: Namely, digital television becoming more affordable.

  • As average selling prices for certain digital TV SKUs declined by 20 to 30% compared with last year's prices, we see the impetus for a long-awaited trend toward the mass adoption of advanced television.

  • As one analyst put it, "The resulting contribution to sales and earnings will be a ban for CE retailing."

  • Most important, we believe that we have the best -- one of the best retail machines in the industry and couldn't be more proud of our employees.

  • With that, I'll turn it over to Al Lenzmeier, our President and Chief Operating Officer.

  • - President, COO

  • Thanks, Brad, and good morning, everyone.

  • I would like to discuss several milestones of the second quarter that we believe will drive our growth in the back half and beyond.

  • First, our expanded assortments in home theater, digital imaging and computing at Best Buy stores.

  • Second, our efficient enterprise activities, including our Accenture alliance, sourcing changes and supply chain work.

  • Third, the expansion of our service offerings, including the rollout of Geek Squad to all North American Best Buy stores and an alliance with Napster.

  • Fourth, the exciting progress we have made in Canada where we are pursuing a successful dual branding strategy.

  • And fifth, the preparations for the launch of approximately 70 consumer centricity stores in California.

  • Now I would like to elaborate on each of these 5 topics.

  • First, in August we completed a major reflow in 3 departments of our U.S.

  • Best Buy stores.

  • We called it our Big Three Reset.

  • As part of the Big Three Reset we expanded our assortments of advanced TVs at our larger stores to 60 stock keeping units, or SKUs.

  • We expanded our assortments of notebook computers to 25 SKUs, a 50% increase, and added the Gateway brand in the home office category.

  • In addition, we added a third more SKUs in digital imaging to increase that to 44 SKUs.

  • And that's not all.

  • At the end of the second quarter we also launched new Serpentine displays and signage to draw customers to these new areas and help them learn more about products and services we offer.

  • We supported the new assortments and displays with employee training.

  • We believe that the changes in these 3 areas position us well for the holiday selling season.

  • I would point out that revenue from our home theater business at Best Buy for the first 6 months rose 17%, nearly double the growth rate of the industry.

  • And computing, digital cameras and digital camcorders combined, rose 17% for Best Buy, more than 3 times the industry.

  • So our decision to invest more in the space ahead of the holidays was made for strategic reasons as these are critical growth drivers for Best Buy.

  • On our balance sheet you will see that our inventory levels grew at the same rate as our revenue.

  • We are very comfortable with our inventory balances, which were essentially flat on a per square footage basis.

  • Second, in July we evolved our relationship with Accenture to provide outsourcing of our IT function, as well as to provide consulting services in the areas of supply chain, Customer Centricity, and call center management.

  • This new arrangement was in addition to the contract we signed in January related to our human resources support areas.

  • The purpose of outsourcing these functions were as follows: To accelerate the pace of the development of tools underpinning and enabling consumer centricity; to reduce our risk by utilizing experts in areas where we do not have a core competency; to enable to us lease rather than own specific IT skills on an as-needed basis; and to increase the rate of innovation and to reduce our costs.

  • Following the signing of the IT contract, essentially all of our remaining IT professionals were offered and accepted positions with Accenture.

  • Thanks to a smooth transition, we can now focus on implementing the plan.

  • Over time, the agreement provides incentives for both parties to reduce our total cost of ownership in terms of IT.

  • In fact, that is one of the reasons for our confidence in our 7-by-7 goal.

  • This year we are electing to reinvest the savings to enable strategic initiatives, such as consumer centricity.

  • But we believe that we will achieve greater savings in the next several years of the agreement.

  • As mentioned, we are also working with Accenture to reengineer our supply chain systems.

  • We have developed our strategy and we are now proceeding with the plan.

  • For example, we already have identified efficiencies if we ship inventory to the stores floor-ready.

  • We also have piloted inventory optimization, and tested changes in delivery frequency, which together have potential to improve inventory turns, product availability, average daily inventory and in-stock levels for promotional items.

  • More savings will come over time as we change the behaviors, processes, technology, and the culture to support these new processes which, frankly, are much simpler.

  • Finally, on a related note, we recently launched additional private label products including Insignia computers and Insignia LCD TVs.

  • Next quarter you will start seeing Geek Squad branded accessories in the computer area.

  • Thanks to our progress in this area we are on track to achieve this year's profitability goals for our sourcing initiatives.

  • While those goals are somewhat modest, we would expect more significant savings in this area during the next fiscal year and following.

  • My third topic is the completion in August of our North American rollout of Geek Squad services.

  • Having agents in all of our Best Buy stores adds to the baskets of goods that the average customer purchases, boosts margins in home office category and supports our comparable store sales gains.

  • We believe that offering Geek Squad helped drive the impressive results we saw in notebook computers in the second quarter, more important, it boosts customer loyalty.

  • In fact, customer satisfaction scores with our Geek Squad service are 4 times the scores we earned when we used third-party services -- or providers.

  • Another service area where we expanded in the second quarter was digital entertainment.

  • We formed an alliance with Napster as a way to expand our assortment in digital entertainment, which also includes Rhapsody and Netflix among others.

  • In addition, we are going to anniversary last year's exclusive of the Rolling Stones Four Flicks DVD with a new offering starting in November.

  • For a period of time, Best Buy and Future Shop stores across North America will have an exclusive in Elton John's Dream Ticket.

  • Dream Ticket is a box set of 4 DVD's shot in 4 destinations with more than 70 songs, an exclusive never before seen footage.

  • We are positioned to meet the content needs of our customers, wherever, whenever, and however they would like to access it.

  • Fourth, in Canada, we turned a second quarter profit for the first time since launching Best Buy in Canada.

  • Our international business has made significant progress in the last year or so with reducing its SG&A rate and optimizing its gross profit rate.

  • While being less aggressive may have restrained comparable store sales gains for second quarter, we believe our market share continues to grow.

  • I am very pleased to see progress toward our goal of achieving a 5% operating income rate in Canada in 3 years.

  • Before I leave the subject of our Canadian business, I would like to add that our stores across the border have more in common with our U.S. counterparts than just Celine Dion fans and Rolling Stones exclusives.

  • We now have Geek Squad service, Best Buy for Business and Best Buy for Home in select markets.

  • Geek Squad patrols all Canadian Best Buy markets and 9 Toronto stores have the latter 2 concepts.

  • Best Buy for Business in Canada focuses on connectivity and mobility products for small businesses with fewer than 10 employees.

  • Best Buy for Home focuses on 5 digital entertainment technologies and offers specifically-trained employees.

  • Its rewarding to see the teamwork and collaboration that enable the launch of these new services, which will help Canadians embrace technology at work and at play.

  • Before I move on to my final point I would like to recognize Magnolia Audio Video, our 22-store chain of high-end home theater products stores for strong performance in the quarter.

  • We view Magnolia as the Neiman Marcus of consumer electronics.

  • Our comparable store sales gain at Magnolia for the second quarter was 6.8%, significantly outpacing the comps of our competitors in that particular high-end space, thanks to the strength of digital televisions and of the California market generally.

  • This past quarter we tested a Magnolia home theater concept inside two California Best Buy consumer centric stores.

  • The test was highly successful, and consequently we plan to open 16 more of these Magnolia-type concepts within the Best Buy stores in terms of the 70 stores that we are rolling out in California.

  • Mike Keskey will elaborate on this rollout during his portion of the conference call.

  • That brings me to my fifth point.

  • Our teams have been hard at work since our last conference call preparing for the conversion of approximately 70 Best Buy stores to the consumer centric operating model.

  • As we have said before, we have a 3-month process for converting the stores.

  • This work obviously was a priority during the second quarter.

  • It has been particularly challenging as the changes coincided with our Big Three Reset in preparations for our fall calendar of new-store grand openings.

  • I am very pleased with how the work is progressing.

  • Our stores are responding with their unusual enthusiasm and positive attitudes.

  • Thanks to them we are on track with the conversion process.

  • For more details on this important initiative I will now turn the call over to Mike Keskey, President of the U.S.

  • Best Buy retail stores who is leading our consumer centricity work.

  • - President, U.S. Retail Stores

  • Good morning everyone.

  • I would like to talk to you this morning about Customer Centricity, our lab stores, and the segment at stores we're preparing to launch.

  • Then Darren Jackson will wrap it up with our outlook for the back half, including the impact of our Customer Centricity initiative.

  • We've spent the past 2 months preparing and training our California region, district, and store employees for their conversion to our customer-centric operating model.

  • As Al stated, we remain on track to convert these stores during our fiscal third quarter.

  • We will be sharing more specifics of the new stores after they convert.

  • One quarter from now you can expect us to focus our reporting on our 70 California segmented stores, as they represent the successful, scalable, operating model enhancements we have developed in our innovative customer-centric labs.

  • Clearly, we expect a continuation of comparable store gains, double the Company average, a meaningful gross profit lift, steady improvement in the SG&A expense rate, as well as market share gains in our targeted customer segments.

  • Looking at the 70 segmented stores, the mix of segments will be somewhat similar to what we have discussed previously.

  • Each store was given 1 or 2 segments on which to focus, looking at the demographics near the store, as well as existing penetration of those customer segments.

  • Based on that work, we will be launching 24 Best Buy for Business stores.

  • We plan to aim 16 stores at the family man looking for technology.

  • An equal number, 16 stores will serve our high-end customers using our Magnolia store within a store concept.

  • Another 12 stores will be focused on suburban moms.

  • Finally 11 of the new Customer Centricity stores will serve the young, active, early adopter segment.

  • I would add that we are extremely pleased with the level of talent in these stores.

  • And the enthusiasm that these leaders exhibit in learning how to put the customer at the center of the operating model.

  • As I stated last quarter, we are working with the remainder of our stores to share best practices from our labs.

  • Like LTS, which focuses our people on leadership, talent, and standard operating practices.

  • Further, this best practice has been embraced by our teams, and we're seeing steady improvement across the nation.

  • Clearly, each of our stores want to be next in line to receive our exciting customer-centric operating model.

  • Before I continue, I'd like to point out that these percentages for the customer segments do not necessarily reflect our expectations in terms of profit opportunities for each segment, nor the readiness for national scaling.

  • We have not yet determined whether next year's rollout plans for Customer Centricity will be done by geographic market, like our California segmented stores, or by customer segment.

  • For example, we could decide to roll out all 5 segments in up to a third of our stores based on their geography and readiness scores.

  • Or we could decide to roll out one or more of our most successful segments in all markets across the nation where that customer's needs are not being met.

  • Either way, our goal continues to be putting the customer at the center of our operating model of all stores over the course of the next 3 years.

  • As we noted in our news release, the lab stores collectively continued to achieve a comparable store sales gain, more than double that of our domestic Best Buy stores for the second quarter which, in turn, outperformed all of our competitors.

  • So we're talking about outperforming the best performing stores in consumer electronics.

  • The gross margin benefits in the second quarter for our lab stores was approximately 50 basis points.

  • It is important to note that these are the collective results of all of our Customer Centricity innovation labs.

  • Different segments clearly are performing at different levels as each of them continue to sharpen their value proposition in each of its elements.

  • We are encouraged by these results because they are a scorecard that indicate we are meeting unmet needs and expanding market share for Best Buy.

  • That's job one.

  • The next part is translating that success to the bottom line.

  • This involves building capability to enable these gains, as well as driving these gains to the bottom line.

  • In our segmented stores we are scaling only the successful elements from our labs.

  • So as our corporate and store capabilities grow we are honing profits by getting more efficient at delivering our value propositions to our customers.

  • It remains our object to drive our G&A down while ensuring our customer facing activities are focused on customer-centric objectives.

  • Overall, as an organization, we are committed to drive our total SG&A down, as Darren will elaborate later.

  • Yes, the expense rate for our lab stores continues to be approximately 107 basis points higher than the Company average.

  • We have reached many questions on that count, probably because research and development costs have traditionally been the exclusive responsibility of the manufacturers, not the retailers.

  • In addition, it is tempting in the innovation cycle to apply too early the financial models and expectations of existing established businesses.

  • So in summary, moving forward we will have 70 segmented stores, as discussed, and we will keep you updated on how they are performing, plus we will have approximately 18 customer-centric lab stores that will continue our customer research and development by experimenting with innovative ways to put the customer in the middle of the operating model.

  • In the lab stores we expect the expense rate to improve, but to remain higher than that of our segmented and base stores as they truly are a research and development arm for our Company.

  • Now I will turn the call to Darren Jackson, our CFO, who will comment on second quarter results and the outlook for our second half.

  • - CFO, EVP - Finance & Treasury

  • Thank you, Mike.

  • Good morning, everyone.

  • Today we reported 46 cents a share in terms of diluted earnings.

  • That was a 10% increase versus last year's 42 cents per diluted share.

  • When you back out the charges, it was a 26% increase in overall earnings.

  • And I would remind you in the second quarter of last year we saw our earnings increase nearly 75%.

  • So that is great improvement on top of extraordinary improvement last year.

  • A key driver was comparable store sales which increased 4.3% in the quarter, and overall revenue which increased 13% in the quarter.

  • In terms of gross profit rate, our gross profit rate was 25.5% in the quarter.

  • That was up 10 basis points versus prior-year quarter, reflecting a more profitable revenue mix.

  • The gross profit rate benefited from improved product assortment, excellent performance in our international business segment, and more effective execution.

  • The benefits were offset by the costs associated with Reward Zone, our customer loyalty program, which cost us 80 basis points in the quarter.

  • Now, that's an increase of 40 basis points versus the prior year, and it was principally driven by attachment rate.

  • So consumers being attracted to the Reward Zone offer.

  • When we look at it, we still think it's a very effective promotional tool in terms of funneling our best promotional dollars to our most loyal customers.

  • We now total 4 million Reward Zone members in the program.

  • Next, I'd like to talk about SG&A.

  • Our SG&A rate improved 30 basis points in the quarter when you exclude the legal and impairment charges, and again, I would remind you last year we improved SG&A 100 basis points.

  • So, again, excellent performance by our employees on top of extraordinary performance last year.

  • The investments we made in Customer Centricity are another good news part of the story this year -- this quarter.

  • They came down to 12 basis points in the quarter, and that compares to 40 basis points in the first quarter.

  • So, again, more improvement in our SG&A rate in the quarter this year.

  • As Mike previously stated, we would expect the SG&A rate in our pilot stores to be narrower based on what we've learned from freight, the labor model, and other aspects of Customer Centricity, and over time we would expect to see Customer Centricity be a key driver in our operating income rate expansion in our 7-by-7 goal.

  • I would highlight for you, as Mike alluded to, our SG&A rate and our Customer Centricity labs did increase 107 basis points in the quarter, but that is down from 240 basis points in the first quarter, a significant improvement.

  • Now I'd like to talk about our earnings guidance.

  • Our strong performance in the second quarter and the initiatives that Al and Mike discussed earlier, provide momentum as we look towards the second half of the year.

  • So our earnings guidance in our news release reflects strong gains despite some difficult comparisons in the second half.

  • Our projection for the third quarter earnings is 41 to 47 cents per diluted share, which is an average increase of 19% over the third quarter of fiscal 2004.

  • This guidance is based on anticipated comparable store sales gains of 3 to 5% for the third quarter and it's being driven by our Big 6.

  • And our Big 6 to remained you are, digital TVs, digital imaging, notebooks, home theater, entertainment, and MP3 players.

  • So when you look at the year as a whole, we continue to look for earnings to grow 280 to 293 per diluted share, and I would tell you that includes the legal and impairment charges.

  • Now that is based on a comparable store sales gain of 4 to 6%.

  • We believe that the market share gains that we have gotten so far in this year we'll continue to get in the second half on account of our superior execution at the store level and the strategies that we discussed earlier.

  • Now I'd like to focus on a few other very positive items in the quarter.

  • Our overall inventories in the quarter were flat on a per square foot basis, which we view as very good news as we head into the second half of the year.

  • Two, our capital expenditures are coming down.

  • Our original guidance was 700 million.

  • As we look at the rest of the year we see spending $550 to $600 million in terms of CapEx.

  • We had other good news items in the quarter as well. 1.

  • We were able to increase our quarterly dividend 10% to 11 cents a share which will be effective with the next dividend.

  • 2.

  • We were able to buy back stock, 1.4 million shares of common stock in the second quarter or $68 million, taking advantage of a very advantageous stock price.

  • 3.

  • We were also able to repurchase our convertible debentures and spend $355 million to improve our balance sheet as well.

  • So our goal continues to be to win with our customers and to maximize shareholder return while ensuring adequate liquidity for ongoing demands of the business.

  • Now I'd like to spend a few minutes and get away from the quarter and talk about the long term for Best Buy.

  • Specifically, how we're going to achieve our 7-by-7 operating goal.

  • And there's 4 key drivers I want to focus on in today's call.

  • I'd like to start out with Canada, which had superior performance in the second quarter.

  • And as we look to the long term, we see bringing the Canadian business closer to the U.S. profitability level as a significant opportunity.

  • We're in a growth mode in the Canadian stores and the market is consolidating.

  • But as we achieve scale in the market we see a path to bring the international segment to a 5% operating income rate in the next 3 or so years, which would add 50 basis points to our enterprise operating income rate.

  • 2.

  • Al talked about it earlier, is that we see supply chain improvements and sourcing opportunities also as vehicles to achieve this goal.

  • Examples include more accurate demand forecasting, direct importing, private labeling activities, we mentioned some of these areas of progress earlier in the call, and that will add approximately 50 basis points to our operating income rate.

  • 3.

  • Our opportunity lies with our strategic alliance we recently performed with Accenture.

  • Some of the benefits are contractual and some are based on incentives, and we believe getting our overall total cost of ownership down in our IT infrastructure and related areas is another 50 basis points of opportunity.

  • Finally, and Mike spent a good amount of time talking about this, we see Customer Centricity as a very big opportunity in generating outside comp-store sales gains, increasing our margins and helping us achieve leverage on the entire cost structure of our business as it gets rolled out to the chain.

  • And let's call that modestly another 50 basis points.

  • Now, you're good with math.

  • That's 200 basis points of opportunities and our current operating income rate is about 5.3%.

  • So we think we're focused on the right things in terms of driving towards the 7-by-7 goal and we are committed to making year in and year out progress towards that goal.

  • It won't be perfectly linear, yet we are confident as a management team that we are focused on the right things in terms of driving value for the shareholders.

  • So to conclude, I want to thank our Best Buy employees for their dedication and energy which drove this performance in the quarter, and gives us the confidence to drive the performance throughout the rest of the year and towards our 7-by-7 operating income goal.

  • So with that, I'd like to turn it over to Maria and take some questions from our investor audience.

  • Operator

  • Thank you.

  • The floor is now open for questions.

  • If you do have a question or comment, please press star 1 on your touch-tone phone.

  • 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 handset to provide optimum sound quality.

  • Please limit yourself to 1 question in order to allow the maximum amount of participants to ask their questions.

  • Once again that is star then 1 to ask your question.

  • Our first question is coming from Aram Rubinson with Bank of America.

  • Please pose your question.

  • - Analyst

  • Thanks.

  • Yeah, just 1 question.

  • - CEO

  • Yep.

  • - Analyst

  • Can you talk about the first 30 lab stores, what if any kind of merchandising changes and process changes you've made to those.

  • And also internally, you know, we know that you're rolling out 70 stores, but where is Centricity internally, i.e. in corporate right now in terms of penetration that.

  • Thanks.

  • That was 2, but I tricked you.

  • - CEO

  • I knew this wasn't going to work.

  • Thanks, Aram.

  • I'll let Mike answer it, but one of the things we want to make sure doesn't get missed, we moved it from the 32 lab stores to 18.

  • What we're doing is we're focusing those lab stores on sort of early generation innovation, and we also wanted to take a look at from our experience specifically what we found in getting the talent assessments right and getting the stores in the right position to be effective at lab stores, so we made some major adjustments in the past quarter and the beginning of this quarter to get our lab stores more effectively able to generate the kind of information we were looking for.

  • Mike, did you want to --?

  • - President, U.S. Retail Stores

  • Yeah, first of all, we've talked about, as far as process changes, the difference between AOP and SOP.

  • SOP is standard operating practices.

  • Clearly that is how we run our business in the past 8 years.

  • With putting the customer in the center of our operating model we feel there are some decisions that need to be made at store level.

  • Those we call AOP, or adaptive operating model.

  • Decisions like that could be working with some end caps, they could be working with particular customers in particular segments and applying different processes to those customers.

  • So certainly AOP and SOP are a change that we've made.

  • I would add that SOP we feel is about 80 to 85%, then the AOP, the adaptive part for our stores we think is about 15%.

  • Now, as far as fixture changes in the stores, certainly each of the 5 segments have different value propositions, like, for our high-end customer, our home theater area.

  • We have certainly changed that home theater area in incorporating Magnolia Hi-Fi into the store.

  • Certainly, each --.

  • - CEO

  • Just to be clear, that's a store within a store, so that's a fairly radical shift.

  • There's no way you would miss that if you ran into a store.

  • - President, U.S. Retail Stores

  • Right.

  • When you walk into one of these 2 labs and the 16 other segmented stores, certainly this is a Magnolia store within a Best Buy store, integrated into 1 store, and clearly there's massive fixture changes there.

  • In our Best Buy for Business, a much deeper integration of our Geek Squad area and much more customer-friendly fixtures that you'll see in there with our Jill segment, certainly we have put our PSA's, our personal shopping assistants center stage so that our suburban moms feel more comfortable in the stores, not only with them, but with the signage and how the store looks and feels.

  • And then I would also say with our buzz, our young active customer, we have more rides.

  • We call them rides.

  • These customers are really interested in really experimenting with the products that they're interested in, so we have put many more interactives in those stores.

  • - CEO

  • The only other thing I'd add, too, to that, Mike, it's a living process.

  • So that's why we have lab stores.

  • If we don't think we've got it right, we're continuing to experiment with the process in terms of trying to get it right and much of the early generation focus work is going to be done in those lab stores.

  • - CFO, EVP - Finance & Treasury

  • It's probably fair to say, Mike, that the -- Aram, to your question of, were we overindexing in terms of the merchandise mix, it's probably fair to say we're overindexing in the home theater part of the labs, we're overindexing today in computing, in terms of the lab's store environment.

  • And that being said, as we roll it out we're going to focus on which mix works for which customer segments in the pilot stores and they'll evolve more specifically to the needs of the stores and the community.

  • - CEO

  • Yeah.

  • And, Aram, with respect to, you asked about corporate consumer Centricity, I would describe that as kind of work in progress in terms of what we're doing from a transformation standpoint in terms of the corporate support areas.

  • Let me just maybe ask Mike Linton to kind of give you some examples of as a result of consumer centricity how we're approaching this differently from a corporate support standpoint.

  • - EVP of Consumer and Brand Marketing, CMO

  • Good morning, everybody.

  • I'm Mike Linton and I'm the Chief Marketing Officer.

  • And I want to set a context for how we're thinking about marketing in a consumer-centric framework.

  • And that would be reaching customers on 3 levels.

  • Nationally at the brand level, as we want to maintain our strong national footprint then across the segments that Mike Keskey talked about earlier, and then at the local store level.

  • And we believe if we can reach those customers at those 3 levels, we will maintain our national footprint, while we build local loyalties.

  • I think you can see a lot of -- or I hope you can see a lot of the national work that we do, but as we transform marketing to reach all those 3 levels, some of the things you may not see is the power of a versioned insert by local store level.

  • So in the Sunday circular level we are working to continue to deliver specific page differences to customers around Zip Code difference.

  • Second thing you may not see is the power of the Reward Zone program to connect with these specific segments and our ability to give them offers tailored for them, and also learn about what they are looking for as we progress with our customer-centric initiatives.

  • And the last thing would be the development of local marketing around specific stores where we are experimenting with putting marketers in the field to work with our retail partners to deliver local loyalty building efforts.

  • - CEO

  • Thanks, Mike.

  • - Analyst

  • Thank you.

  • Operator

  • Thank you.

  • Our next question is coming from Budd Bugatch with Raymond James.

  • Please pose your question.

  • - Analyst

  • Good morning.

  • Good morning, Budd.

  • I'll give you 1 question.

  • Just talk a little bit, Darren, more -- or Brad, about Reward Zone.

  • And now that we've anniversaried it, you've got 4 million people in the program, what should we expect financially going forward?

  • We've got a 40-basis-point differential to gross margin this quarter.

  • What about its impact on comps, and how do you look at it going forward now that it's anniversaried?

  • I know it may be a little bit more challenging now that you've anniversaried the program.

  • - CFO, EVP - Finance & Treasury

  • Yeah, Budd.

  • Let me frame in the way is that the Reward Zone program is one of multiple arrows in our quiver when we think about promotional tools.

  • So we have rebates, we have 0% financing, we have Reward Zone, and we have markdowns that we can use.

  • And as we look at the program overall, what it's suffering from is a lot of success, both in terms of membership and attachment rate within the store, and what we're finding is that if we could take rebate dollars and funnel mass rebate dollars to our very best customers, we're finding that we get the incremental trips that we expect, we find that we're getting the incremental basket sizes that we're looking for, and the other thing we've finding out is we're learning.

  • Recently, and members would have received this, is that we're tweaking the offer in terms of Reward Zone points, and as we look forward I think we will continue to moderate and adjust that based upon feedback from our consumers.

  • So the most recent one we've reduced the overall points from, call it a 4% discount to 3.3, so roughly a little over 20% reduction.

  • So you can take that math, all other things being equal, and say that the erosion in margin rate, probably not for the third quarter, but as we look to fourth quarter and beyond should begin to moderate based upon modifying the Reward Zone rates.

  • And then 2, as we get more data and feedback from our customers we'll continue to evolve that program to strike the right mix between driving the traffic, more importantly, getting the customer insights and information from the Reward Zone card and an acceptable level of cost within our gross margin rate.

  • - Analyst

  • Just 1 more follow-up.

  • Can you give us any -- maybe disclose any difference in average ticket between a Reward Zone ticket and a non-Reward Zone ticket on average corporatewide, and maybe penetration of warranties or other metrics that might be of use that could you characterize?

  • - EVP of Consumer and Brand Marketing, CMO

  • Sure.

  • This is Mike Linton, the Chief Marking Officer again.

  • A couple of things.

  • I'd like to give you some consumer research we have, and then some math on the control versus the Reward Zone group.

  • We're seeing 78% of the Reward Zone members say the card makes them want to shop more at Best Buy. 69% of the members are saying it's their favorite loyalty card.

  • So of all the available cards, this is their favorite card.

  • And 59% of the members are saying they purchase more electronics at Best Buy because of the card. 21% are purchasing everything at Best Buy because of the card.

  • Some math behind that would be in test versus control, and we took 6 months of prepurchasing before we launched the card to get test versus control.

  • Members are coming 8 times a year.

  • The people that don't have the card in the control group are coming 5.2 times.

  • Annualized spending of members is running 844 bucks, nonmembers, close to 400.

  • We realize this program is still early, but from both a business results standpoint or a consumer standpoint, as well as a strategic building block for Customer Centricity, we still remain encouraged by what we've got going so far.

  • - President, COO

  • The other thing to keep in mind, too, the 8/10 that we talked about versus the 4/10 last year, the 4/10's was only for part of a quarter.

  • - Analyst

  • Right.

  • - President, COO

  • So it's not that the cost is increasing, it's due to the timing of the introduction last year.

  • - CEO

  • Just 1 last point on this, as you can well imagine the kind of details as Mike just -- we wouldn't have the same level of understanding in the other alternatives we've got, such as rebates, such as increased advertising, such as increased discounting, so this gives us a level of refinement that we don't have with any other tool.

  • - Analyst

  • I think that's great.

  • Thank you very much.

  • - CEO

  • Thanks a lot.

  • - VP of IR

  • Thank you.

  • Those responses were from Mike, Al, and then Brad.

  • Next question, please.

  • Operator

  • Thank you.

  • Our next question is from Bill Mathew with Adage Capital Management.

  • - CEO

  • Hi, Bill.

  • - Analyst

  • Hi, guys, how are you?

  • - CEO

  • Fine.

  • - Analyst

  • I have about 10 I want to ask, but I'll only ask 1.

  • And I'm actually going to follow up on Bud's question regarding Reward Zone.

  • You guys just gave the data 844 annualized run rate and you indicated 4r million customers?

  • - CEO

  • Yes.

  • - Analyst

  • And I'm just trying to back into the 49 million that you took, or thereabouts, in Reward Zone expense in the second quarter, just trying to back into the conversion rate or sort of the uptake rate, and by my math it's getting higher, not lower.

  • So can you give us a bit of color on that?

  • And if you want to say anything about CapEx, feel free, but I'm not asking a question about it. [Laughter]

  • - CEO

  • Darren, did you want to --?

  • - CFO, EVP - Finance & Treasury

  • Bill, here's what I'd -- obviously, from Mike's comments and the team's comments, we are thrilled in terms of the Reward Zone start that we have.

  • And what I would caution you is that -- and we're a transparent company, and that's why we're giving you insights as to how the program is working, but it's still young.

  • The program is still young.

  • It's a year old.

  • We're going to watch the behaviors of these customers and we would be thrilled if they maintained these levels of 800-plus dollars versus 400 for the noncontrol group going forward, but I think in these programs what we've learned is you've got to watch over a 2-year period to make sure we're not fast-forwarding purchases of consumers and we have sustained levels of change.

  • And the good news, as Mike rattled through a lot of the consumer feedback from top to bottom, when 59% of your customers are feeding you back that that is their favorite card, that is a good leading indicator.

  • And so we're going to continue to balance the program, tailor the program to different customer segments and make sure the trade-off for incremental gross margin dollars is more than paying for the rate changes that we're seeing.

  • - Analyst

  • Okay.

  • - CFO, EVP - Finance & Treasury

  • Thank you.

  • - Analyst

  • Thanks, guys.

  • - VP of IR

  • Next question, please.

  • Operator

  • Thank you.

  • Our next question is coming from Gary Balter with UBS.

  • - CEO

  • Hi, Gary.

  • - Analyst

  • Hi, Jennifer.

  • - CEO

  • That's okay.

  • It was Brad, but that's all right.

  • - Analyst

  • Oh, okay.

  • - CEO

  • Just didn't want you to think we changed genders. [Laughter]

  • - Analyst

  • Oh whatever, okay.

  • Just 1 simple question, but first of all make a little comment, that maybe if you limit yourself to 1 answer, Jennifer, we'd get a few more things done.

  • - CEO

  • That's an appropriate point.

  • Thanks, Gary.

  • - Analyst

  • Could you talk about back to school?

  • People are a little worried, and I know it's early so I'm in the asking for the comps, but are you seeing -- if you look at the computer side in particular what are you seeing from notebooks versus PCs?

  • Is there demand right now for those products?

  • - CEO

  • Ron?

  • - EVP, General Merchandise Manager

  • Good news.

  • Yes, still demand there.

  • So, you know, we've seen, we were up against huge comps in Q2 last year and we grew home office this year again in high single comps, really still driven by notebooks.

  • We think that the addition of the Geek Squad this year has had a material impact on the quality of that sale, so there hasn't been much talk about Geek Squad on this call at least.

  • What we're seeing is Geek Squad having a material impact on the basket, having a material impact on the margin, and a material impact on the margin rate for the total department.

  • So we think that not only are we still seeing demand for notebooks, we're up against very significant comps last year and the change in the business model with Geek Squad is adding to -- adding to the quality of the sale.

  • Also, we just finished one of our largest resets of the year, one of the big three was around notebook, and added -- or took the assortment up to 25 notebooks and added solution selling in those departments.

  • - Analyst

  • As you look as part of that question, if you look at the Dell pricing, they seem to have gotten aggressive.

  • That hasn't had much impact on your pricing?

  • - EVP, General Merchandise Manager

  • We think the model with the addition of Geek Squad gives us flexibility that they don't have.

  • Obviously, it's a competitive marketplace and we'll continue to compete aggressively, but the combination of the authority we have with assortment and the power of Geek Squad I think gives us competitive advantage in the space.

  • We also launched last week the Insignia brand, the first launch of the Insignia brand in print was in desktops, and that was highly successful.

  • - Analyst

  • Thank you very much.

  • - CEO

  • Thanks, Gary.

  • - VP of IR

  • Next question, please.

  • Operator

  • Thank you.

  • Our next question is coming from Mark Rowen with Prudential.

  • - Analyst

  • Thanks.

  • Good morning.

  • - CEO

  • Good morning, Mark.

  • - Analyst

  • I wanted to -- my question is going back to the Customer Centricity.

  • Are you still seeing the big divergence by region?

  • In other words, are you getting the best results still in California, and are those significantly better than the double, the store comps?

  • And then, Darren, on Customer Centricity you've been talking about getting the SG&A incremental expense on those stores down into the 50-basis-point range, including depreciation.

  • So if I divide that by your gross margin, do you need about a 2% lift to get a return on investment in that?

  • Is that how you think about it?

  • Thanks.

  • - CEO

  • Just a real brief one on the first question.

  • Yes, we still are seeing the significant difference between regions at this stage.

  • Darren?

  • - CFO, EVP - Finance & Treasury

  • Briefly, on the second one, Mark, you're on the right track.

  • What we've said is that looking for progress in SG&A reduction, saw it in the second quarter, looking for 50 to 60 basis points in the pilot stores on a 4-wall basis.

  • And we're going to need that type of lift, or slightly better, to achieve the longer rate return -- the longer term returns we're looking for.

  • - Analyst

  • Okay, great.

  • - VP of IR

  • Next question.

  • Operator

  • Thank you.

  • Our next question is coming from Danielle Fox with Merrill Lynch.

  • - Analyst

  • Thanks.

  • Good morning.

  • - CEO

  • Good morning.

  • - Analyst

  • I just have a follow-up question on Customer Centricity spending.

  • I think, Darren, you said it was about a 12 basis point drag on overall SG&A in the second quarter.

  • I'm just trying to get a sense if we should expect -- and that was a favorable year-over-year swing.

  • Should we expect a similar pattern over the next 2 quarters?

  • I know in particular in the fourth quarter of last year you had a high concentration of your spending, and it seems like a lot of the stores were opening this year in October, so I'm trying to get a sense of how the rest of the spend will flow over the remainder of the year.

  • - President, U.S. Retail Stores

  • This is Mike Keskey.

  • I'm sitting here almost coming out of my skin, I'm so excited about what we're doing with the SG&A in our lab stores and where we're going with it in our segmented stores.

  • But clearly, we expect in our lab stores the SG&A rate to continue to narrow, and we expect the SG&A rate in our segmented stores to even narrow further.

  • And we are forecasting that narrowing.

  • But I will tell you, as we said early on, we will continue to reengineer our processes, both here in corporate and in our stores, and it is our overall intention to drive our SG&A down over the quarters to come.

  • - Analyst

  • And actually just one point of clarification.

  • When you talk about -- I think you mentioned that there were these 18 lab stores, but there were 32 Customer Centricity stores.

  • When you talk about the double -- the 2 times comp performance relative to the Company average, is that at the 18 or the 32 stores?

  • - VP of IR

  • That's for the entire 32.

  • - Analyst

  • Okay.

  • Thanks very much.

  • - CEO

  • Thank you.

  • Operator

  • Thank you.

  • Our next question is coming from Bill Sims with Smith Barney.

  • - Analyst

  • Good morning.

  • Thank you.

  • My question's on inventory.

  • I see that despite put in significant increases in SKUs of digital televisions, notebooks, imaging, et cetera, inventory on a square foot basis has been flat.

  • Can you comment on -- are you ratcheting down other categories in terms of inventory or is this all supply chain driven?

  • - EVP, General Merchandise Manager

  • So we've been talking I guess pretty consistently since the December call last year about inventory, and it really is all about where we're placing our bets, and we continue to place our bets on the Big 6 categories, so digital television, notebooks, digital imaging, home theater, entertainment and MP3.

  • We have always had a strategy of harvesting slower growth categories and investing both inventory, advertising, and labor dollars on growth categories and we'll continue that this year.

  • - Analyst

  • Thank you.

  • - VP of IR

  • Thank you, Ron.

  • I think we have time for 1 question, maybe 2.

  • Operator

  • Our next question is coming from Scott Ciccarelli with RBC Capital Markets.

  • - CEO

  • Good morning, Scott.

  • - Analyst

  • Hi, guys, how you doing?

  • - President, COO

  • Good.

  • - CEO

  • Just fine.

  • - Analyst

  • Good.

  • I know you guys briefly mentioned a couple private label products that are going to be coming out, what's the best way to think about what your goals are on the private label side?

  • - EVP of Consumer and Brand Marketing, CMO

  • So I think there's 2 ways to think about it.

  • There's both a defensive play in commodity goods which looks like disintermediating rent takers, so you can go to China and make beautiful products and have the Geek brand on it, increase margin and have a brand play.

  • There's also an offensive play as we think about what we learn from Centricity and customer experiences with building a Best Buy brand that, like an Insignia brand, that can be -- provide unique value at a price and fill needs based on customer insights.

  • So short term we are building out the competency around direct sourcing for our brands and driving a lot of value.

  • Frankly, from disintermediating the middle man.

  • Long term we believe that we can drive value based on customer insight uniquely with some of our brands.

  • - Analyst

  • Is there a target goal at some point that you want a product being private label?

  • - CFO, EVP - Finance & Treasury

  • Scott, I talked about it, in terms of our longer term 7-by-7 goal, when you put our supply chain and sourcing initiatives together we're expecting a net 50-basis-point increase in our margins from those initiatives, and so we're not going to set an artificial goal of 20% of our mix because it will be, one, customer-driven where, do we have to fill tin assortment.

  • Two, marketplace driven, how do we have to compete in open price points.

  • And three, balancing that being profit-driven.

  • You net that out, and between supply chain and sourcing, we would expect to see a 50-basis-point improvement in our operating income rate over the next few years.

  • - Analyst

  • Great.

  • Thanks, guys.

  • - CEO

  • Thank you.

  • - VP of IR

  • Final question, please.

  • Operator

  • Thank you.

  • Our last question is coming from David Schick with Legg Mason.

  • - CEO

  • Good morning, David.

  • - Analyst

  • Hey, good morning.

  • Thanks for doing one more.

  • Darren, you talked about changing your CapEx fees a little bit for now.

  • Could you talk about bigger picture '05 to '07, over that calendar time frame, how you guys are thinking?

  • Thanks.

  • - CFO, EVP - Finance & Treasury

  • Well, 2 things, David, we haven't given longer-term guidance, but it's fair to say when we think about deploying capital we think about 3 things.

  • One, we want to find things that we can deploy our capital against long term that are going to generate returns in excess of our nearly 20% return on invested capital today.

  • Best place to deploy that as we see today is growing through our Customer Centricity initiative.

  • Two, returning to shareholders, vis-a-vis dividends or stock repurchases, cash that we can't find a good home for or return 20% on.

  • And as you can see, we announced an increase in our share repurchase program over the course of the quarter from 200 to 500 million and we increased our dividend.

  • Not because we don't think we can grow the business.

  • We absolutely think we can.

  • And we just have the right balance between strong cash flow today and have the luxury of both funding, growth initiatives and returning money to shareholders.

  • Then three, balancing that against our credit rating and making sure that we have liquidity and stability into the business, you know, for any unforeseen downturns or changes in the marketplace.

  • - Analyst

  • That's helpful.

  • Thanks.

  • - VP of IR

  • Okay.

  • Thank you for participating in our second quarter earnings call.

  • Before we end, may I remind you that this call will be available for replay if you missed any portions of it.

  • Simply dial 973-341-3080, and enter the personal identification number of 5163547.

  • The replay will be available around 1:00 today Eastern until midnight on Monday, September 20th.

  • To hear the replay on the web, visit us at www.bestbuy.com, and click on "For Our Investors."

  • If you have additional questions about our second quarter or our fiscal 2005 outlook, please call me, Jennifer Driscoll at 612-291-6110.

  • Reporters, contact Sue Bush, Director of Corporate Public Relations at 612-291-6114.

  • That concludes our call.

  • Operator

  • Thank you.

  • This does conclude today's teleconference.

  • You may disconnect your lines at this time, and have a wonderful day.