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Operator
Ladies and gentlemen, thank you for standing by.
Welcome to Best Buy's third 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, 1 on your touchtone phone.
As a reminder this call is being recorded for playback and will be available by 1 PM 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 call over to Jennifer Driscoll, Vice President of Investor Relations.
- VP Investor Relations
Thank you, Holly, and good morning everyone.
Thank you all for joining us today.
With me here in Minneapolis are Brad Anderson, CEO, who will give you highlights of today's news, Al Lenzmeier, Vice Chairman, who will give a report on our Canadian operations in Magnolia, Brian Dunn, President of Retail North America, who will update you on our U.S. stores, John Walden, head of our Customer Business Group, who will update you on our Customer Centricity Transformation, and Darren Jackson, Executive Vice President and CFO, who will comment on our earning drivers for the third and fourth quarters.
Also, Kevin Laden, President of the Best Buy Canada, and Ron Boire, Executive Vice President and General Merchandise Manager, are participating in the call by phone.
As usual a few others are here in the boardroom and available for our Q&A session later in the call.
I would 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 participating in this call in a listen-only mode.
Also in case you've missed a portion of the call it is available for replay.
Let me give you the replay instructions.
Simply dial (973)341-3080 then enter the personal identification number 5496304.
The replay will be available from 1 PM today until midnight on Monday, December 20th, eastern time.
I would like to remind our callers that we will invite questions after we conclude our formal remarks.
With respect, I request that callers limit themselves to 1 question so that we can respond to a larger percentage of the listening audience.
We already have a few hundred people on the call.
So with that I will turn the call over to Brad Anderson, CEO, who will begin our prepared remarks.
- CEO
Thank you, Jennifer, and good morning, everyone.
It's my pleasure to talk to you this morning about our third quarter results and the fiscal year outlook.
I would like to point out 4 highlights today.
One, we achieved earnings in the top half of our range for the third quarter and we did so despite revenue results at the low end of the range.
The driver of these results was the improvement in our expense rate.
As we've been talking about we've been focused on driving efficiency for a couple of years and it's gratifying to see more evidence that our work is yielding results.
Second, we continue to gain market share which is evidenced by the comparable store sales gains of 3.2% which was larger than that of our competitors.
As you might expect given how much our customers love new technology we performed particularly well with digital products such as digital TVs, MP3 players and digital imaging and we also gained share in notebook computers and especially in major appliances.
These share gains give us positive momentum as we head towards the holiday's highest volume days. 3, we continue to strengthen our reputation for instore execution.
Retailers across the country reported disappointing customer traffic particularly in November yet at Best Buy we seceded in growing the business this quarter thanks to the outstanding ability of our employees to increase the average ticket and conversion rate.
We saw similar trends late in the second quarter and that gives us confidence in our fourth quarter projections. 4, after months of planning we aligned our leadership resources to support 3 growth areas, both to fulfill the mission and execute our succession plans.
The 3 areas, just to reiterate last weeks announcement, include our retail channels, our Customer Business Group and our new growth avenues.
And I'm pleased that we were able to draw on our bench strength to fill all of these leadership positions.
Our Best Buy Future Shop, Magnolia, Geek Squad and on line stores are now led by Brian Dunn, a formidable force, this is Brian quote , in U.S. retailing.
Any way, Brian has been driving Best Buy's store performance -- actually Brian is fairly formidable -- performance for years.
He was integral in our success as we looked to optimize all of our stores and all of our customer touch points and as we continue to move forward with our transformation.
Our new Customer Business Group is supported by John Walden.
John is the executive who has been leading our efforts to recruit, select and develop the right employees for us and to instill the owner operator culture in our customers centricity stores.
He has been a leader in given our employees the tools and the training to make a deeper connection with our customer.
These efforts are key enablers of centricity and I'm pleased that John has accepted this new key role.
Last, but clearly not least, heading up our network -- excuse me -- heading up our work exploring new growth avenues is 20 year veteran Al Lenzmeier.
Nobody is more prepared than Al to consider how the beset -- how best to grow the company for the long-term given his experience with the company, his wisdom and his business acumen.
The same leader who built the operational engine we now have is engineering plans for our future growth drivers and I would like to publicly thank Al for his outstanding service to Best Buy, most recently as COO and now in his new role as Vice Chairman.
As you know, Al and I have worked together for a long time and I am immensely appreciative of being able to have someone with the kind of deep trust and significant working relationship that the 2 of us have had as partners for years.
I also appreciate the chance to be thoughtful about determining the right structure for securing Best Buy's future and Al is going to play a central role in that.
Then I -- to sum it up I believe that this new organizational structure will accelerate our growth.
It supports our work to put the customer at the center of our operating model.
It improves our ability to groom our management team.
It supports our strategy of decentralizing more decision making and in addition it should improve our abilities to insure that Best Buy has the talent at the top to prepare the enterprise and support its growth well into the future.
And with that I am going to turn it over to you, Al.
- Vice Chairman
Thank, Brian.
Good morning, everyone.
Our employees did an excellent job taking care of customers this quarter as Brad indicated.
I am very proud of the job they did at all of our brands, Best Buy, Future Shop and Magnolia.
Our stores continue to set the pace for consumer electronics retailing in North America.
But today I plan to focus my remarks on our brands other than Best Buy as that topic is best covered by Brian Dunn, new President of Retail for North America, who is responsible for U.S.
Best Buy stores last quarter.
Therefore, my 3 topics are as follows: First, our international segments results including both top line and bottom line growth;
Second, our Magnolia Audio Video stores performance, which led the chain in terms of comparable store sales gain;
And third, our exploration of new growth avenues such as the expansion of our service offerings.
Now I would like to elaborate on the 3 topics.
First, again, I want to highlight our international segments results including both top line and bottom line growth.
We continue to be very pleased with our dual branding strategy in Canada where we operate both Future Shop and Best Buy stores.
The addition of Best Buy stores in Canada has brought us additional customers and market share and we are pleased to see the differentiation in the customer base of the 2 brands.
Our revenue growth in Canada was driven by market share gains due to the opening of new stores and our 5% comparable store sales gain.
We also significantly boosted the operating profit rate of our international segment.
The 70 basis point improvement was primarily due to an improvement in the gross profit rate and disciplined markdown performance.
The modest SG&A leverage reflected continued infrastructure in store investment in the dual branding strategy.
Second, our Magnolia Audio Video stores led the chain with a 7.2% comp store gain.
Across our brands we saw more activity from consumers with above average household incomes and reduced traffic from more price sensitive consumers.
Magnolia, our 22 store chain of high-end home theater products and services, capitalized on that trend increasing its sales of advanced TVs and other digital products.
You should know that the comparable store sales figures we've reported exclude the results at Magnolia home theater stores inside Best Buy stores which are part of our consumer centricity work.
I would like to thank our Magnolia employees for the support that they have given Best Buy as we explore new concepts for serving our affluent, early adaptor customers.
Similar to the way Geek Squad has supported our Best Buy for business segment Magnolia has worked closely with Best Buy's affluent segment all the while driving above industry results in their core business.
Third, we continue to explore new growth avenues.
I am very pleased to be focusing on new growth avenues in my role as Vice Chairman.
I expect to spend the next year developing our plans in 4 specific areas, the expansion of our service offerings, more innovation in the core business, international expansion opportunities and new store concepts.
These efforts support the long-term growth goals for Best Buy.
While some of our listeners have voiced concerns about 1 or more of these areas we will move deliberately -- deliberatively to develop a point of view on the best opportunities for us to maintain our growth rate while we complete our North American buildout and drive the capabilities that support consumer centricity.
We also want to grow our service businesses because our customers are demanding it.
In fact, we strongly feel that services are a multi-billion dollar opportunity for Best Buy.
With that I will turn you over to Brian Dunn for comments on U.S.
Best Buy stores performance.
- President of Retail North America
Thanks, Al.
I am pleased to be speaking about Best Buy's domestic stores and their performance for the third quarter and I look forward to meeting many of our listeners over the coming year as we spread the message about our multi-brand, multichannel retail strategy.
I've got 4 points for you this morning. 1, Best Buy's stores are known for their instore execution because of quarters like the one we've just finished. 2, we are pleased we invested last quarter in what we call our big 3 reset and I would like to brief you on those results. 3, behind the grand opening figures for the quarter is more good news: A lower cost per square foot.
I will talk more about why that news is important to me.
And, 4, we've lowered our expense rate which is fabulous and I want you to know how we got there.
Then l'll close with a brief perspective on how I believe we can gain from managing our stores as a multi-brand, multichannel business.
One, retailers across the country reported that they saw traffic declines particularly among customers with lower incomes or customers who tend to purchase lower priced items.
Best Buy was no exception.
The good news is that we are an innovative company and we learned from our customer centricity labs that there is more to life than increasing traffic.
At our core stores we applied those lessons and focused on average ticket and close rate, much more than ever before.
The result, a comparable store sales gain of 3.2%, better than the competition in our industry. 2 is our big 3 reset which touched our home theater departments, our digital imaging departments and our computing departments.
We made the changes in response to changes in the marketplace.
While it's still early to assess the reset we believe that the remodels, new assortments and training contributed market share gains in all 3 areas.
Customers have told us that they like the new displays and assortments.
Furthermore our store employees have said they felt that it made them more productive and was a better use of our selling space. 3, we grand opened a host of new stores in the third quarter just in time for the holiday selling season.
It was a result of a monumental effort by our employees, particularly as they launched a segment of stores and completed the big 3 reset in the same quarter we opened these new stores.
Those 43 new stores are performing as expected but what the numbers don't show is that they also had another endearing trait, a lower capital outlay per square foot than the prior generation had.
We will keep focusing our cost to build stores and inventory optimization in an effort to boost our ROIC.
While we are making progress I believe there is more to be made in the future.
I have noted that our Canadian operations have done a much better job of opening very profitable stores in small markets and that is a gap we can and will eliminate. 4, we squeezed out 30 basis points worth of SG&A in the third quarter compared with the prior year's period.
Normally we do not gain leverage on our expenses unless the comparable store sales gain exceeds 3%.
How did we do it without a large comp gain?
The main sources of improvements were productivity gains and the benefits of efficiency initiatives launched earlier in the year.
For example, we reduced a number of times we handled drop ships and started sorting small accessories at the distribution center.
Each of these changes save store employees time.
In addition our SG&A rate benefited from comparisons with last year's third quarter when we wrote off certain technology assets.
Lastly, I am honored, humbled and excited to assume responsibility for all North American stores.
My focus in the next month is actively supporting our stores as they execute their holiday plans which is of course where they excel.
Beyond that I will look for opportunities to share best practices across our organization so that we can optimize all of our brands across all of our channels, including physical stores and our online stores.
I also plan to build on the momentum Best Buy has created from focusing on our strengths, a practice I plan to bring to our other brands.
We have outstanding regional, district and store teams.
I have great confidence in them in their ability to learn from each other.
With their help using their unique talents and their best practices we can truly put the customer at the center of our business model.
Now I will turn the call over to my colleague, John Walden, Executive Vice President Customer Business Group, the new leader of our customer centricity work.
- EVP Customer Business Group
Thank you, Brian.
Good morning, everyone.
I would like to talk to you this morning about our customer centricity transformation with a focus on our segmented stores results.
Then Darren Jackson will wrap it up with our outlook for the fourth quarter including the impact of our customer centricity initiative.
In his portion of the call Brian mentioned a few changes we made in our core stores, such as the improvement in the average ticket and the improvement in close rate.
These improvements came directly out of the successful experiments at our customer centricity stores.
For me it is a clear example of the value we can generate when we apply to all of our brands the lessons we learn through our customer centricity work.
Customer centricity at its very heart is all about innovation.
It's about innovation in connecting with customers and meeting their needs in a unique way.
When all is said and done, I don't want to be measured simply based on same store sales and the operating income rate.
We should look also at the energy and the new ideas coming from our network of store employees who are improving the customer experience every day.
This is the more fundamental driver of financial success and this is the value of customer centricity.
Within that larger context I would like to update you on the outcomes at our segmented stores.
In the third quarter following a 3 month process we launched 67 segmented stores as part of our customer centricity initiative.
The launch went extremely well as each iteration of these platforms improves on the 1 before it.
I am pleased with the work of our west coast region, district and store employees for their ability to adopt a customer centric operating model.
In total we now operate approximately 85 stores in this new model, in California, Nevada, Illinois, Maryland and the District of Columbia.
As we indicated in our news release the results of our 67 segmented stores were strong.
Energized by the chance to put the customer at the center of their operating model the stores and segments teams produced a comparable store sales gain more than double that of other U.S.
Best Buy stores.
Their gross profit rate rose in line with our expectations.
In addition, we made more progress on the expense rate than we had expected and the capital outlays were as anticipated.
As we told you earlier it was our intension to implement only the successful scalable operating model enhancements developed in our lab stores.
The results indicate we may be accomplishing our goal.
Meanwhile we continue to learn more about these customer segments, the value propositions that matter to them and how we can serve them in a differentiated way.
It's important to note that the results I just highlighted are the collective results of all of our segmented stores.
While all 5 segments are performing well, each segment continues to evolve at its own pace.
Overall, we are very encouraged by these results because they indicate we are meeting customers unmet needs and expanding market share for Best Buy.
I am pleased with the work of our segment leadership and store teams which are fine-tuning our value proposition and insuring our effective execution in labs and segmented stores.
I also think our marketing team which is continuing to gather customer insights, develop new targeted marketing approaches and explore new customer segments.
Meanwhile our experienced development group is raising the bar in innovative store designs and experiences that make our stores even more fun to shop.
Knitting the work of these teams together with our communications team should lend momentum to this initiative as we move forward.
Enabling customer centricity in our stores requires meaningful change throughout other parts of the company as well.
In this regard we are building four foundational capabilities.
First, customer data management and insight, or understanding our customers better and using that information to create exceptional customer experiences.
Second, customer driven systems, processes and decision making which enables store owner operators and segment leaders to manage resources around customer needs.
Third, simple, efficient corporate support functions which focus on differentiated customer activities and, fourth, being talent powered, or creating a better system of acquiring, selecting and developing talent and putting employees in the right rolls to maximize their contribution.
I believe these four capabilities will determine whether we deliver on the promise of a customer centric company.
These capabilities also will provide a foundation to achieve other business growth in the future.
And now I will turn the call over to Darren Jackson, our CFO, who will comment on the third quarter results and our outlook for the fourth quarter and fiscal year.
- EVP & CFO
Nice job and thank you, John.
Overall we were very pleased with our 22% bottom line performance in the third quarter of this year, given our 3.2% comparable store sales gain was at the low end of our expectations, and we were up against a strong 8.6% comparable store sales gain in the third quarter of last year.
And I will remind everyone last year in the third quarter our earning grew 42% as well.
The holiday initiatives are working.
The strength of our business has been primarily driven by the big 6 merchandise business categories in combination with outstanding execution from our merchant retail teams.
Their execution with digital TVs, MP3 players, digital cameras, notebooks and major appliances and video games drove the sales gain for the quarter.
Our sales of music and movies were softer than expectations, new releases did not perform up to expectations yet both music and movies were up against extraordinary gains in the prior year's third quarter.
We expect similar drivers of sales performance in the fourth quarter of this year.
I'd like to echo a point that John Walden made.
We were able to use lessons from our customer centricity lab stores to increase our conversion rate and average ticket to offset traffic decline from the quarter.
We are committed to turning traffic turns around and sustaining this higher level of execution in our stores.
Frankly it's the underpinning of our confidence going forward.
The gross profit rate declined a modest 10 basis points to 24.5% in the third quarter.
It was below our expectations but acceptable given the promotional environment.
Reward zone clearly helped our comparable store sales performance but eroded our gross profit rate by 30 basis points in the third quarter of this year versus last year's third quarter.
On a positive note the cost of reward zone actually declined 20 basis points in the third quarter versus our second quarter run rate.
We are pleased with the performance of this program.
The SG&A rate was better than we expected declining 30 basis points in the quarter.
We made adjustments to variable expenses as sales moderated as you would expect.
In addition, we had lower incentive compensation, credit processing and impairment costs in the quarter.
We continue to drive our efficiency initiatives and manage our variable expenses closely as we look to conclude another successful year.
We did benefit from lower interest costs and tax rate in the quarter and we do expect those benefits to continue in the fourth quarter of this year.
These gains will be partially offset by EITF 0408 which will increase the number of outstanding shares related to our convertible debentures.
We expect the impact of 2 cents in the fourth quarter and 3 cents for the fiscal year.
The impact of this accounting change is not included in our guidance in order to keep our guidance comparable with prior guidance and analysts' estimates.
The last point I would make on the third quarter before I turn to our outlook for the balance of the year is that our inventory levels were essentially flat on a comparable store basis versus the prior year.
We are pleased with the level of in stock and the content of the mix as we head into the important holiday selling season.
Turning to our earnings guidance for the fourth quarter and fiscal year.
As you notice we updated our guidance for the year to $2.80 to $2.90 per diluted share based on our third quarter performance and a comparable store sales gain assumption of 3 to 5% for the fourth quarter of this year.
So you may be wondering, how we derived comp guidance?
We use a combination of tops down and bottoms up forecasting.
We tapped the collective wisdom of our merchants, retail teams and executives.
We also take a look at historical trends.
For example, our U.S. stores have 2 extra shopping days post Thanksgiving and history tells us to expect a 1 percentage point comparable store sales benefit from the calendar shift net of the impact of the 2 holidays that occur on Saturdays.
We also pray a lot.
In addition we track rewards zone points outstanding and we have a 50 -- and we have 50% more this year than last year or 60 million in total of reward zone points outstanding as we enter the fourth quarter.
We believe that our best customers will support our results for the fourth quarter because reward zone coupons must be redeemed within 90 days.
Next I would like to turn to the bottom line including the fourth quarter guidance in comparison with our recent trend and our longer term goals.
In the fourth quarter we anticipate a modest improvement in our operating income rate compared with the prior year.
The operating leverage we expected to achieve will be limited by the promotional environment and ongoing initiatives such as reward zone as mentioned earlier.
Yes, we expect to continue to leverage our expenses to offset the impact of the promotional environment and the strategic initiatives.
Finally, I'd like to conclude with a comment on the 7 by 7 goal which refers to our desire for a 7% operating income rate by fiscal 2007.
We have discussed with many of you the four levers we will pull to achieve the 7 by 7 goal.
To remind you they include our internal seg -- our international segment's performance, supply chain and global sourcing efficiency initiatives such as our strategic partnership and IT and customer centricity.
We continue to believe that we have a significant opportunity to improve in all four areas.
Our international business turned in an outstanding quarter as we continue to implement our dual branding strategy.
We have several initiatives underway as a part of the goal -- as a part of this goal including advertising efficiency, labor model enhancements, supply chain initiatives, and projects related to the gross profit rate such as markdowns.
As you saw in our earnings release our Canadian profitability improved significantly primarily due to the improvements in the gross profit rate.
In terms of lower our total costs of ownership and IT we have made progress as well.
For example, we have consolidated a couple hundred servers, reduced the main frame resource utilization, which is very important as we get ready for the holiday season.
More private label goods continue to arrive from Asia including the launch of our Insignia brands television and notebook computers curtesy of our global sourcing offices in China.
We are on track to deliver our internal profit targets for sourcing activities this year.
Last but not least, as John reported, our segment stores are off to a good star with double the comp gain, a gross profit rate lift and progress on the expense side of the equation.
Clearly, though, we are planning to accelerate the rate of improvement of our operating income rate.
Using the four drivers I just describe the goal is important to us and we recognize that we have a distance to travel in the next couple of years.
To conclude I want to thank all of our Best Buy employees for their dedication and passion to meeting customer needs.
Truly we have one of the best retail teams that help drive our 23% increase in earnings and the doubling of our operating cash flow in the first 3 quarters of this year.
We are upbeat about the balance of the year and the future of Best Buy.
As Brad mentioned our optimism is reflected in our reorganization that aligned our resources around our 3 growth engines, our core stores, our Customer Business Group and new growth avenues.
The core stores continue to deliver outstanding performance year in and year out.
This year is no exception.
The successful launch and early read on the performance of the segmented stores is very encouraging.
Our growth opportunities with Geek Squad and services look very promising.
Lastly the key is the talent of our people which gives us tremendous sense of optimism for the long haul.
With that, Maria, we would now like to take questions from our investor audience.
I understand that the queue has already been forming so again we request each caller ask 1 question.
Operator
Thank you.
The floor is now open for questions. (Caller Instructions) Our first question is coming from Mark Rowen of Prudential.
- Analyst
Thanks, good morning.
You mentioned in the release that the fourth quarter is shaping up to be more promotional than it was a year ago.
And I just wonder if you could give us a sense of how that promotional environment is shaping up, what categories are you seeing it in, particularly, are you seeing it in the newer technology televisions or is it not really hitting there yet, you know, especially given the fact that CDs and DVDs were weak, you know, you would think that that would be -- would help your margin somewhat.
So could you just give us some color on that promotional environment?
- VP Investor Relations
Ron, I believe is available by phone.
Ron, could you answer that?
- EVP & General Merchandise Manager
Hi, Mark.
I think that what we are seeing is, and we've seen for a few months now, some general choppiness in the numbers and as you saw from some of our competitors.
We are seeing, I think, a more reactionary environment than a systemic change.
So from week to week we've seen competitors get more aggressive than what would seem reasonable in digital TV or notebook or digital camera.
We don't see a pattern where people are or that there is a general drive to do volume at the expense of margin systemically.
We see more of it as a rifle shotting which frankly if I was in their seat I would do the same thing.
Fortunately our retail team has been executing beautifully in these competitive situations and we believe that we are continuing to take share in the big 6 categories.
We don't see a systemic change as much as we see a rifle shotting and we see markets heating up from time to time.
- Analyst
And, Ron, is it -- is it taking the form of lower ticket prices or is it more financing offers or a combination or just depends on the item and the time?
- EVP & General Merchandise Manager
It really depends on the item and the time and, you know, people are trying to use a variety of tools to show value.
But primarily it's been -- for example, some markets have been more aggressive cut and close by some of our competitors that use that tactic and some markets have been a little more aggressive on a particular category for a very short period of time.
- Analyst
Thanks very much.
- VP Investor Relations
Next question, please.
Operator
Thank you.
Our next question is coming from Matt Fassler from Goldman Sachs.
- Analyst
Thanks a lot and good morning.
I want to dig a little deeper into the music and DVD category.
I know that you've had a lot of offsets to successfully displace any impact on sales and margin that you've seen from erosion in this category but I know that it's been a strategic category for you in terms of driving traffic.
So do you see the declines here as really being a function of the new release schedule?
Do you think it could be a bit more systemic or structural than that and how do you think as we look forward to the fourth quarter and into 2005 that you are going to -- that the best way to cope with this is?
- VP Investor Relations
Ron, like to handle that one as well?
- EVP & General Merchandise Manager
Sure.
We don't necessarily see it as much as systemic as we see it as lower income consumers maybe feeling a little bit of effect of some of the gas prices that have come up in the past quarter or so.
We also see us beginning to get to the top of the curve on some of the deep catalog releases.
So I think the combination of those 2 things are starting to mature the industry in DVD a little bit.
Last year, as you recall, Matt, we had some very strong comps in music so I think the industry was up against some pretty significant readjustments as consumers started to, or the downloading craze started, to soften a little bit as some of the industry activity affected consumer behavior.
We don't see anything like a pull forward of the curve away from packaged media.
What we see, I think, right now is a consumer who, you know, once filled their gas tank for $20 now filling it for $35 and that's a DVD and that's a CD.
So I think as the economy normalizes these consumers will be back in the stores at more traditional rates.
The issue is much more of a -- from a systemic standpoint we see it as much more of a 5 to 7 year issue and as you know we've discussed in previous calls our strategies for replacing that traffic with other traffic drivers.
- Analyst
Great, thank you so much.
- EVP & CFO
And Matt, to put into context, too, is that if you looked at the 2 year comp both in CDs and DVDs, what you 'd find on a 2 year basis is that these businesses are actually running ahead of the company average.
I know we don't give out specifics as to categories but we -- it's fair to say we had extraordinary gains last year.
On a 2 year basis these businesses are much healthier than it appears just in terms of this snapshot in time.
- Analyst
Gotcha.
Thank you so much.
Thank you, Darren.
And callers please do not use your speaker phone, we're getting some feedback.
Next question, please, Holly.
Operator
Thank you.
Our next question is coming from Colin McGranahan of Sanford Bernstein.
- Analyst
Good morning, thank you.
- CEO
Good morning, Colin.
- Analyst
Wanted to focus on the direct sourcing and own brands or private label development.
You know, I noticed, obviously, that some of the Geek Squad cabling has flowed into the stores and looks like it's flowing in greater quantity, you obviously have Insignia in the TVs and PCs, can you tell us -- just give us a general update on where you are, how the flow of that product is going to shape out over the course of the coming quarters in different categories?
- CEO
Sounds like Ron, again.
- VP Investor Relations
Ron, you're a popular guy.
- EVP & General Merchandise Manager
I was expecting a lot more questions for John given he's the new kid on the block.
I think -- good morning, Colin.
I think that as we've said in previous calls what we've seen is us ahead of what our expectations were on profit and being a little more conservative on the expansion of the brands and not trying to drive the revenue number as much.
So we see ourselves as having built a really strong base with the Insignia brand.
We are really excited about the results of Geek accessories, the ability to take that fun little brand and put it on packaging and give a little bit of value add to the customer has paid off tremendously.
So we think we built a nice foundation with Insignia, with Geek, that as you look at next year you are going to see a much more of these entry level price points, commodity and consumable goods and expansion in, I would say, in the first and second quarter of next year you will start to see a lot more clearly what our strategy looks like physically in the stores.
So what we focused on this year is building out the capability in Asia and Mike London and his team from a sourcing standpoint have done a great job with that, starting to establish some of the brands and we think we've landed Geek and we think we've landed Insignia with the stores and Mike Vitelli and his team have done a great job with that.
So we think we've got a foundation that we can build on and much more importantly we believe that the profit yield from this category has been the thing that we focused on more than just growing it as a percent of mix and I know there's been a lot of conversation about mix percentages but we are really much more focused on driving the profitability and building the foundation this year.
- Analyst
Great and should we expect the Geek brand to migrate to other product categories or would you be open to introducing and building other brands as well?
- EVP & General Merchandise Manager
I think we are open to both of those.
As we've discussed previously on some of the calls we are going to be extremely cautious with all of our brands and how we take a brand like Geek that has been tremendously well accepted by the consumer, we are going to be extra cautious with.
- Analyst
Okay, great.
Thank you very much, good luck.
- VP Investor Relations
Thank you.
Operator
Thank you.
Our next question is coming from Danielle Fox of Merrill Lynch.
- Analyst
Thanks, good morning.
- CEO
Good morning, Danielle.
- Analyst
My question is just a followup on your comments about customer centricity.
Just first, a point of clarification, John Walden mentioned that there were 85 stores in the new model and you opened 67 in October on what I thought was a base of 30.
So I was just wondering if there were some stores that were actually taken out of the program but my real question is just if you could discuss the performance of these segmented stores versus other stores that are in the same region since my impression is that the west coast seems to be a relatively strong sales region overall and the majority of the stores are now, I believe, in California or at least on the west coast.
Thank you.
- VP Investor Relations
John, would you like to take that one?
- EVP Customer Business Group
I'd be happy to.
So on your first question in terms of trying to make the math add up, we do have 67 segmented stores.
What we have done over the last year is we've pruned a little bit on our lab stores.
We'll continue to try to figure out what the optimum number of labs are and there's a number of factors we think about in terms of selecting labs.
One of the factors is sort of the capacity to keep learning and keep aggressively testing in the labs while the teams also were introducing segmented stores but we have taken the lab stores down a little bit from their original number which is what explains the difference.
- VP Investor Relations
And that allowed us to reduce cost and also devote more resources to the segmented stores.
- EVP Customer Business Group
Right.
That's right, Jennifer, thanks.
- Analyst
Okay, great.
And then just the comparison versus other stores in -- .
- CEO
West coast.
- Analyst
Yeah.
- EVP Customer Business Group
Yeah, for the most part we took substantial part of the actual region on the west coast which became segmented stores.
So the comparisons that we look at aren't really the few that are remaining but we are really comparing against the whole base.
We are comparing against the base in aggregate and we also try to look at a level of benchmark stores.
But when we look at what we think is the fair comparison we are still seeing pretty much the same numbers that I described to you which is very strong comp store sales, more than half of what we are seeing across the comparison stores, a solid work on the margin rate and as expected on SG&A and operating profit.
So we feel very good about the results pretty much in the same fashion as I described.
- Vice Chairman
Yeah, I think in your comments that the west coast has been doing better but it was also doing better last year, so these improvements are on top of some very good numbers last year as well.
- Analyst
Okay, great.
That's helpful.
Thank you.
- VP Investor Relations
And thanks, Al, for adding to that answer.
Next question, please.
Operator
Thank you.
Our next question is coming from Jack Murphy of Credit Suisse First Boston.
- Analyst
Good morning.
- CEO
Good morning, Jack.
- Analyst
On the centricity stores, what was the impact in basis points?
I think you referred to that earlier on gross margin SG&A.
And if you, you know, don't want to get into that level of detail, I think your guidance on the SG&A was a 50 to 60 basis point drag in the quarter previously.
Is it safe to say that it was better than that?
And then as a followup, what is the pass, you know, in terms of number of quarters to no drag to the overall SG&A?
- EVP & CFO
Let me see if I can take that 6 part question.
In terms of the overall performance of the segmented stores what we would say is in terms of gross margin performance relative to the base we had forecasted, if you remember at Analyst Day, that we would be up roughly 50 basis points.
And we are absolutely in line with those expectations.
In terms of SG&A what we have provided at Analyst Day is that we had expected SG&A from a variable SG&A point of view to be up 50 basis points and roughly 25 basis points were fixed as it relates to capital investments.
To be honest in the math early we are outperforming that, we are closer to 50 basis points than 75.
But I would caution you that the math is early and at no point did we say the SG&A rate would converge back down to flat.
What we said is that, and what we are experiencing, is that the comp store sales lift and the margin rate lift would more than pay for the incremental SG&A because of the enhancements we are making to the operating model.
So it's fair to say that, as John pointed out, we are early in terms of the launch but as it relates to the capital investment that we made in those stores, significantly better than we had expected as to the launch costs in those stores, better than we expected, again, in line with our expectations, SG&A, slightly better.
Now we have the important holiday season that we are approaching and we are approaching it given that primarily results are very upbeat.
- VP Investor Relations
Thank you, Darren.
Holly, could I get the next question, please.
Operator
Thank you.
Our next question is coming from Dan Wewer of CIBC World Markets.
- Analyst
Darren, you'd indicated that you are budgeting, you know, strong sales growth in the second half of December and I'm assuming you are upbeat on January as well with Super Bowl driving your TV business yet if you look at the inventories per stores you noted there they are basically flat.
So why should we not be concerned about, you know, enough inventory to meet this strong anticipated demand?
- EVP & CFO
It's in the content.
So as you would expect the growth areas in terms of our inventory investment are in our big 6 categories.
So we are significantly well positioned in video.
We are well positioned in terms of MP3 players and the reductions that we've seen in inventory at the end of Q3 were principally in our entertainment software areas as we move to more vendor managed inventory we've been able to take more inventory out of the pipeline.
We continue, as we talked about earlier, to make investments in our supply chain initiatives.
Bob Willette and that team continue to make progress in terms of helping us improve customer in stocks and availability while reducing inventory in the system that we'd characterized as nonproductive.
So, I mean, I couldn't be happier to be positioned with the categories that are winning for us being in stock and reducing categories that have been a little more challenging for us.
- Analyst
Great, great.
Thanks and good luck for the rest of the year.
- EVP & CFO
Thank you.
Thank you, Dan.
Next question, Holly.
Operator
Thank you.
Our next question is coming from Gary Balter of UBS.
- CEO
Morning, Gary.
I guess Gary left.
Operator
Gary, could you please take your phone off mute.
We will move on to the next question which is coming from Aram Rubinson of Banc of America.
- Analyst
Thanks.
Gary stole my phone number in my office so I guess I can steal his question.
Do you think it would be more PC to change the Geek name, first of all, to socially challenged?
- CEO
Yeah, we were considering that, yes.
- Analyst
Then I have a follow up.
Within the centricity segment can you give us a flavor of the 5 and how they are fairing vis-a-vis one another, if there's variation amongst regions based upon the segments and if you think there are changes to be made to the categorization of the customers?
- EVP Customer Business Group
It's John.
We are not going to talk specifically about the individual performance of the segments but I can tell you in general they are all performing well to varying degrees but they are all performing better than the base and they are all performing pretty consistently across the other metrics we talked about.
In terms of resegmentation we haven't really made any changes since we started this work in the last -- certainly in the last year we started the roll-out of the segmented stores so right now we are comparing their growth and their performance against the same base we began with.
- CEO
I would also comment that when we started this work we would have expected by now to have eliminated at least one or 2 segments.
So the fact that they are all still in the running and none of them are in danger is kind of a surprise to us.
- Analyst
Thanks.
Thank you, Aram.
Next question, please.
Operator
Thank you.
Our next question is coming from Dana Telsey of Bear Stearns.
- Analyst
Good morning, everyone.
- CEO
Good morning.
- VP Investor Relations
Good morning, Dana.
- Analyst
With the management changes that have occurred over the past few months, any adjustments to processes and procedures and how you are doing things or what you would like to do differently going forward?
- CEO
Thanks, I think that's a real good question.
Yeah, part of the -- there was -- in addition to dealing with Als succession issues part of the reasons we were also making these changes is to get ourselves lined up and have less institutional drag.
As you can tell there's a lot of work for this leadership group to get done and so we've tried to basically make the -- this new architecture is intended to make thing clearer, more linear, less time invested in sort of building the internal linkages and more of a higher percentage of our time devoted on actually doing the work.
So that's a core part of the architecture that -- a core part of the intent of the architecture as we made these changes.
And we've been working on these changes starting back last March.
- Analyst
And is there anything more we should see whether -- as you go forward and develop new concepts whether it's new store concepts or international, is there any other strategic segments that we should see evolve or how you plan to run those segments?
- CEO
Well there are -- the intent, maybe John, you want to comment, but the intent here is to develop other segments.
Do you want to comment?
- EVP Customer Business Group
Yeah, certainly in this customer centricity work itself we will keep evolving segments and look for -- for deeper understanding of new opportunities to go after.
With respect to other businesses which I think was also part of your question, that's all going to evolve as well.
I mean, as Al talked about and Brad has talked about, Al is looking at international opportunities, he is looking at services opportunities and certainly as those start to take shape I think you would expect Al to decide what kind of resource and structure he wants to put against those given whatever the opportunity looks like.
But that's all very much in motion at this point.
- CEO
But compared to say, what -- say looking at international say a short a time as a year and a half ago, what Al now has to look at as he looks at international is a portfolio of brands, a portfolio of customer segments, and a variety of skill sets that just simply weren't there even a year ago that now potentially is leverageable on an international basis.
So that's part of the reason why we are bringing that forward and devoting an executive with sort of Als capacity towards it.
- Analyst
Great.
And just what product are you most excited about for the upcoming CES show in Vegas.
- VP Investor Relations
Ron, would you like to take that one?
- EVP & General Merchandise Manager
I think this show will continue to see devices more effectively networked.
I think there's been a lot of progress in the last year making things work together and moving content DL&A work has finally started to get some teeth.
So I think what's going to be exciting at the show is this stuff finally starting to work together so the first or second step down the road of really networking the devices and the content will be the big news from CES.
- Analyst
Thank you.
- VP Investor Relations
Next question, please.
Operator
Thank you.
Our next question is coming from Bill Sims of Smith Barney.
- Analyst
Good morning, thank you.
- CEO
Morning, Bill.
- Analyst
Now that you're foreign sourcing office has been open for at least a year can you comment on performance of this office beyond just the private label initiative?
And is there any push to expand it into retail, whether it's in China or Asia, more broadly?
Thank you.
- CEO
I think the -- you know, we opened up an office in Shanghai about, I guess, it's a little bit over a year ago.
We've also opened up several other sourcing offices in China, smaller in scale.
With respect to retail in China I think that's, you know, that's something that, you know, we will be looking at that as well as, you know, whatever options or opportunities are going to be out there and really be focusing a lot of effort in terms of what the strategy should be and, you know, what are the markets, what are the countries that provide the biggest opportunity for Best Buy to expands in.
- EVP Customer Business Group
Part of the way we've approached China is to get a staff and a team and develop a skill set in China and have that play a meaningful role in the decisions we ultimately make as to where and how we would approach the Chinese market.
- Analyst
In terms of better buying have you found the gross margin improvement that you were expecting when you first opened this office and, you know, was it enough to offset the promotional -- obviously, but to offset the promotional environment you are seeing right now?
- Vice Chairman
Yeah, I think the plan that we put together this year in terms of both volume as well as gross margin improvements that we were going to be able to bring to the bottom line we are meeting those goals.
And we expect that, you know, again, those goals are going to be increased quite a bit next year as well.
So we think there's a big opportunity but like Ron talked, a lot of this year was kind of getting the foundation in place and understanding what the portfolio needs to be between private label and name brands products and really, you know, kind of more clearly define the strategy in terms what role private label plays in our overall strategy.
We've got that foundation in place and we've got, you know, we're intending to build a skill level over there and the capabilities.
- Analyst
Thank you.
- VP Investor Relations
Thank you, Al.
Next question, please.
Operator
Thank you.
Our next question is coming from Alan Rifkin of Lehman Brothers.
- Analyst
Yeah, Darren, I guess this question is for you.
You know, the 30 basis points of leverage on the SG&A is pretty admirable given the 3.2 comp.
Do you think that, you know, going forward there's a new lower threshold necessary for comp in order to leverage your SG&A?
And if so is that coming predominantly from the lower costs on customer centricity or are there other factors involved there?
- EVP & CFO
Yeah, thanks, Al.
I would say we are constantly trying to lower that breakeven.
So in an environment where you don't have rising gas prices and rising healthcare costs, I would say extraordinary rising healthcare costs and gas prices, I would say the breakeven is coming down modestly as we look forward but it seems, as I'm certain you can understand, that each year that we look to do structural things that improve our overall productivity we are constantly in a fight to offset some of these extraordinary things in terms of the marketplace.
But all in all, as you said it, you know, we are very pleased with progress that we made this quarter in getting 30 basis points out and as I said in my comments in the fourth quarter we remain upbeat to further reduce that SG&A rate as we look to the fourth quarter into the future.
- Vice Chairman
And I think a lot of the things, again just like China where we put the foundation in place, we also put the foundation in place this year in terms of supply chain, IT, outsourcing, things that we are doing in the call center that are going to start having fruition next year.
- Analyst
Okay, thank you.
- VP Investor Relations
Thank you, Alan, and thank you, Alan.
Our next question, please.
Operator
Thank you.
Our next question is coming from David Schick of Legg Mason.
- Analyst
Hi, good morning.
- CEO
Morning, David.
- Analyst
I wanted to drill in a little bit to the Geek stores or maybe Geek markets.
Some markets have had it longer than others.
Some stores have had it longer than others.
Anything you can share about where Geek revenues may be?
I mean, you've -- you mentioned the, you know, the billion language in service revenues one day.
Just -- just help us understand where early Geek stores are and what that means and how we can think about markets or stores or, you know, where you are taking it and how long that time frame?
- VP Investor Relations
Ron, could you answer that for Best Buy?
- EVP & General Merchandise Manager
I don't know that we can talk about specific markets.
I mean, Geek has been established in Minneapolis for many years and clearly that's one of the most robust markets due to the tremendous branding in the marketplace.
The roll-out broadly across the U.S. was extremely successful.
I think it's also fair to say that as you launch any new service we have some stores that are tremendous performers and we are trying to learn from those stores and take that learning into the stores that are not at the top of the curve.
What we are going to do with Geek, I think, is pretty logical as we think about, you know, the next 12 months.
We've been very, very successful in the PC area in particular around home networking and if you think about one of the previous questions is what's going to be exciting at CES this year, what's going to be exciting is networking CE products so there's a very logical extension of the Geek service into the CE space and I think you will see us doing that next year.
- Analyst
So is it -- can you give us some sense of how far ahead of the curve Minneapolis is versus the country in penetration of Geek sales?
- EVP & General Merchandise Manager
Well, I think it's very fair to say that in a market where we've had a brand like Geek and it's been so phenomenally accepted in Minneapolis it's significantly ahead.
However, the learnings from centricity last year and the Best Buy for Business segment in particularly have been scaled extremely rapidly across the country.
The retail team has done a phenomenal job of rolling out Geek so we do not have any orders of magnitude kind of differences.
They are more percentage points kind of differences.
- Vice Chairman
Part of this is, you know, we rolled this thing out to all 600 stores and involved thousands of technicians that we had to get up to speed and train and I would say, Ron, and correct me if I'm wrong that , you know, most of this is -- is work that's being done in the store and the Geek Squads that have been in the stores longer, you know, we can see the business building up in terms of home installation.
And I don't think we've even touched the surface there in terms of what the capabilities are and what the opportunities are but, there again, because it's dealing with human beings it's going to take time to, you know, get these people trained right and get them up to speed.
There's huge opportunities in Best Buy for Business as well as the Varry(ph) segment in terms of the services that Geek Squad provides to both of those segments.
- EVP Customer Business Group
I think to piggyback on Als point, we are seeing some pretty interesting results in those segmented stores where we also have Geek and their principal is, I think, pretty predictable which is when we are tailoring the service offerings of Geek Squad around specific customers as part of a value proposition to satisfy a need we are seeing that business pretty successful.
So we are really excited about what that might mean for Geek Squad as we also couple that with segments in the future in other stores.
- Vice Chairman
You know, and just to give an example, you know, in some of the lab stores where we had, I think, Best Buy for Business or Varry(ph), we've got 6 Geek Mobiles, you know, providing in-home service.
- EVP Customer Business Group
From a single story.
- Vice Chairman
From a single store.
- VP Investor Relations
Okay.
Well, thank you, Al and John, for adding to the answer.
Next question, please.
Operator
Thank you.
Our next question is coming from Gregory Mellick of Morgan Stanley.
- Analyst
Thanks.
I think Brian mentioned in his comments that the new stores that you guys were launching had a lower capital outlay than you were budgeting and you were expecting.
Could you guys take us through what that actually is and how sustainable it is and Darren, just tie it back to what we should expect for total CapEx as a result?
- EVP & CFO
Why don't I frame it and then I will have Brian provide a little color on how we are getting it done.
Overall -- I will start with the last question -- overall CapEx we updated guidance last quarter.
We haven't changed it.
We are expecting anywhere from 550 million to 600 million this year.
And to remind everyone that's down from the beginning of the year guidance of 700 million and what's playing into that is a combination of what Brian will talk about and our efforts to actually reduce the per square foot cost of our stores and our successful launch in reduction in terms of our estimates of how much it would take to convert segmented stores is playing into that as well.
What we are seeing in terms of those lower capital costs in terms of -- and I will focus on our 20K stores at this point because we see, you know, a pretty considerable run way in terms of more 20K stores and potentially if we get the capital costs down, increasing the run way or number of stores that we could launch.
I think at 2 years ago as we began to test those stores what we reported was a sales per square foot that was roughly $600 a foot.
We are seeing those stores approaching $700 a foot now.
And ROICs that were under performing the average 45K, what we are seeing now 2 years later is that the ROICs are equal to and even bettering some of the 45K stores.
Again I would remind you that the math is still relatively young because those stores are young but given how those stores are performing, launch to date we are seeing ROICs that we are very excited about and that's a combination of getting the capital down and the operating costs down.
And why don't I have Brian give you a little color on how that's coming together and how we are doing that?
- President of Retail North America
Thanks, Darren.
We are -- our properties team is doing the work and we are looking at everything that goes into our building from metal fixtures, interactives, inventory, and we are looking at dollar by dollar , what is adding value, what is nice to have, what is important to the customer.
We are putting our customer lens on and we are putting things in the building that matter to the customers.
And that's the lens that we are looking at across brands and channels.
- VP Investor Relations
And we will be announcing our new store opening plan some time in January and we will comment more on it at that time.
Unfortunately I'm looking at the clock, our hour has arrived and that will have to be our last question.
So I know there are others in the queue, I apologize for that.
I will try to give you the first calls back after we finish in the boardroom.
So thank you for participating in our third quarter earnings call.
Before we end may I remind you that this call will be available for replay by dialing (973)341-3480, with 105496304.
The replay will be available from about 1 PM today eastern until midnight next Monday, December 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 third quarter or our fiscal 2005 outlook please call me, Jennifer Driscoll, at (612) 291-6110.
Reporters please contact Sue Busch, Director of Corporate PR.
She's at (612) 291-6114.
That concludes our call.
Happy holidays.
Operator
Thank you.
You may disconnect your lines at this time and have a great day.
Thank you.