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Operator
Welcome to Best Buy's conference call for the third quarter of fiscal 2006. [OPERATOR INSTRUCTIONS] As a reminder, this call is being recorded for playback and will be available by 1:00 p.m.
Eastern time today.
I would now like to turn the conference call over to Jennifer Driscoll, Vice President of Investor Relations.
Jennifer Driscoll - VP, IR
Thank you.
Good morning, everyone.
Thank you for participating in our investor conference call for the fiscal third quarter.
With me here in Richfield this morning are Brad Anderson, our Vice Chairman and CEO who will give you the third quarter highlights;
Brian Dunn, President Retail North America who will update you on our domestic and international segment; and Darren Jackson, Executive Vice President Finance, and CFO who will cover today's results as well as our earnings guidance for the fiscal year.
Joining us by telephone is Ron Boire, Executive Vice President and General Merchandise Manager who will discuss our competitive position in the third quarter.
With me here today and available for our Q&A session are Mike Linton, Executive Vice President and Chief Marketing Officer;
Kal Patel, Executive Vice President of Strategy and International Development;
John Walden, Executive Vice President of our Customer Business Group;
Bob Willett, Executive Vice President of Operations and CIO;
Kevin Layden, President of Best Buy Canada by phone;
Susan Hoff, Senior Vice President and Chief Communications Officer;
Shawn Score, Senior VP of Sales Development; and Charles Marentette, Senior Director of Investor Relations.
I'd like to remind our listening audience 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 our results to differ from management's expectations.
As usual, the media are participating in this call in a listen-only mode.
Also, the call is available for replay.
In case you missed a portion of the call or wish to hear it twice.
Let me give you the replay instructions.
Simply dial 973-341-3080, and then enter the personal identification number which is 6777800.
The replay will be available from approximately 1:00 p.m.
Eastern time today until midnight on Monday, December 19.
I'd like to remind callers that we plan to take your questions after we conclude our prepared remarks which should run 20, 25 minutes.
Please limit yourself to one question so that we can include more callers in our Q&A session.
Consistent with our approach in the last quarter we will move to the end of the Q those who had their question answered in last quarter's call.
We had positive feedback from this change last quarter so we're pressing forward.
With that, I'll turn the call over to Brad Anderson, Vice Chairman and CEO, who will begin our prepared remarks.
Brad.
Brad Anderson - Vice Chairman, CEO
Thank you, Jennifer and good morning, everyone.
My agenda for the call today includes three items.
First, I'll briefly discuss our third quarter financial results.
Second, I'll put our results in the context of our transformation.
And third, I'll give you highlights on the third quarter.
As we announced this morning, our third quarter earnings totaled $0.28 per diluted share on $7.3 billion in revenue.
We also reported a comparable store sales gain of 3.3%.
The good news was that we had a strong start to the holiday season and we believe -- we've continued to grow our market share.
We generated a respectable comp store sales in environment with a great deal of ups and downs, and we also continued to see significant improvement in our gross profit rate.
These variables we consider very encouraging.
We had very ambitious plans for the quarter with strong growth goals and transformation goals going side by side.
Specifically, we made progress on our sourcing, our supply chain, and IT work.
We also opened or converted a record number of stores to customer centricity.
We increased the number of Geek Squad agents by 25% in the quarter, and we opened our first seven stores in Quebec.
In short we made a tremendous number of investments in our portfolio of capabilities.
Some of these investments are paying off, such as our sourcing, supply chain, and IT work, yet others did not perform as expected during the quarter, such as our Canadian expansion and our organic growth drivers which include new store openings, converted stores and services.
As a result our SG&A spending was higher than we expected.
Frankly, our spending rose to what we feel is an unsustainable level.
This is a risk we accepted when we embarked on this journey at such a rapid pace.
And looking forward we realize we must scrutinize our investments and manage the pace of our transformational activities while we rationalize our operating model.
As we transform our stores, the primary investment in change is in the labor model and at all of our stores we've been adding specialized positions.
These include Geek Squad agents, home theater installers.
At our segmented stores, on top of that we've been adding business pros and personal shopping assistants and other positions.
These specialized positions came in addition to our existing labor model, and if the truth be told we have not optimized what was already available in our stores.
I view the decline in productivity as a sign of growing pains in our transformational work.
Looking forward, we're going to find the right balance in our expense structure, including labor.
Identifying the best practices at the most profitable stores and making those standard procedures at all stores, which is something we call gap management, traditionally has been a strong suit at Best Buy.
This approach helped us attain our current position as the number one consumer electronics retailer and we're going to call on these skills once again as we evaluate our entire enterprise and work to optimize our operating model.
Looking back at the third quarter we have many reasons to be excited from the transformational standpoint and an operations standpoint.
In particular I'd like to highlight four points.
First, we significantly expanded our service capability during the third quarter.
If we go back to the early stages of customer centricity we quickly learned that services must be integral to our transformation.
The fact is today's products are more complex than ever and customers want and need more service.
In the third quarter we added 2500 U.S.
Geek Squad agents bringing our total at the quarter's end to 11,900 agents.
We are well prepared for the uptick in demand for services that seasonally occurs in January.
Additionally, we employ nearly 1300 home theater installers, so that we can offer a better customer experience around digital TV in time for Super Bowl XL.
Second, we converted 116 more stores to the customer centric operating model in the quarter and opened 38 new segmented stores.
These stores top line results continued to outperform the balance of the chain.
As a whole, however, we are not seeing the return that we expected, and I think our transformational activities, if you think about our transformational activities as an investment in a portfolio of capabilities and growth opportunities, our job as a company is to manage that process, and manage the team and focus our energy on those initiatives that are yielding the best results, and rationalize or slow down the ones that are not.
We fully intend to do that.
Third, I was very pleased with our revenue results during the week of Thanksgiving, and I'm confident that a competitive offering -- excuse me.
I'm confident that a competitive offering and the relationships that we've built with our customers during the year drove our strong performance.
Our results from that week give me optimism for the fourth quarter and I'd like to thank our employees for their teamwork, their extra effort, and their solid execution overall.
Finally, we believe we continue to gain market share in the United States and in Canada due to the new store openings and comparable store sales gains.
Moreover, our market share gains were not limited to one or two product categories but were broadly based.
So in conclusion, we're encouraged by our progress with the transformation.
We said in the first quarter call the transformations are not linear.
In that quarter we enjoyed the amazing upside results when everything works together, this quarter was on the other end of the range.
Yet this quarter also creates a better opportunity for us to drive change in our operating model.
When I take a step back, what I see is we're getting better at understanding our customers, and we are expanding our capabilities to serve them more profitably over the long term.
With that I will give you Brian Dunn, President of our stores.
Brian.
Brian Dunn - President
Thank you, Brad, and good morning, everyone.
I would like to reiterate Brad's congratulations to the team for its solid finish the week of Thanksgiving.
We stayed focused through a choppy environment early in the quarter and our holiday plan was both well executed and well received by our customers.
I want to walk through a couple of items from the quarter.
First, as Brad mentioned we had ambitious plans for the quarter.
In the United States we opened or converted 154 segmented stores during the quarter.
We also conducted training on customer centricity at hundreds of other stores.
In Canada, we adjusted our labor model and opened 16 new stores including 7 in Quebec, a new market for us.
Then we asked our teams in both countries to ramp up and execute the first phase of our holiday plan.
In short, we asked a lot of our employees, and they still delivered a 3.3% comparable store sales gain in an environment that started out somewhat more challenging than we had anticipated.
Our merchant team improved in-stock levels year-over-year particularly in high-margin goods and accessories which are so critical to completing the total solution sale.
That investment better positioned our retail team to win with our customers, and they ran with it.
In the end, it was a combination of competitive offers, a broad product offering, and a great store experience that got our holiday season off to a very solid start and helped drive the increase in the gross profit rate.
Suffice it to say we have a lot of things working well.
I like our competitive position as we approach the final stretch before the holiday and the quarter that generates roughly half of our annual earnings.
Efforts from across the company are improving the experience for customers in our stores.
For example, we installed a new point of sale systems at more than 200 stores prior to Thanksgiving.
We can process transactions much faster with shortens customers' wait times particularly on high-volume days.
We will install these POS systems in every U.S.
Best Buy store by the middle of next year.
This quarter we also offered consumers more instant rebates, which saved time at checkout as well.
Consumers have told us through their purchases and on-line surveys that they have strongly approved of that decision.
Overall, our customer centric stores' top line performance continues to be performing significantly better than the balance of the chain.
Collectively stores converted for at least one full quarter had a comparable store sales gain of 5.4%.
Frankly, this performance was short of our expectations.
The stores opened six months or longer continue to perform on both the top line and bottom line but we have to work to do -- but we have work to do on the later waves before they meet our expectations.
We also continue to grow in our understanding of our customer segments and their needs and behaviors.
For example, busy moms shopped our stores earlier in the season.
We also learned a lot about our more affluent customers.
We saw exciting top-line results from the segmented stores outfitted with the Magnolia home theater experience.
Customers appreciate the combination of premium brands, specialized labor, and the physical feel of the store.
These stores within a store not only are boosting our home theater business, but they are driving improved results in multiple other product categories at those locations.
As Brad noted, we took a risk in moving as fast as we are.
So it is not a complete surprise that we are experiencing growing pains.
In addition, as we approach the midpoint of our transformation, this is the time when we would naturally begin optimizing the new model.
While this work is complex, Best Buy has a strong track record of scaling new ideas, and I am highly confident that we will strike the right balance in this equation.
Switching gears, I want to touch on our results from Best Buy Canada.
Our challenge in the quarter was a shortfall in our revenue results amid heightened competition and a challenging economy in Canada.
Our operating income results were also below our expectations.
At Future Shop stores we completed the rollout of a new labor model.
The conversion now is behind us and trends improved as the quarter progressed.
What the numbers don't show is that we continued to grow our combined market share in Canada.
Our share rose more than 200 basis points despite these challenges.
Even more encouraging, we have not yet seen the full impact of the seven Montreal grand openings in late October.
Lastly, the critical selling days for Canada are still ahead, particularly boxing day, December 26, our biggest revenue day of the year in Canada.
Now that we have built the necessary scale in Canada, and have established our two brands with consumers, our focus will turn to optimizing our operating model in Canada in order to drive improved profitability.
Back to the U.S.
Magnolia stand-alone stores reported very strong comparable store sales up 19%.
It was the highest quarterly gain since we acquired the chain five years ago.
Moreover, the gain came not only from video, which posted strong results for sometime, but also from audio, which marks a complete turn around.
This business appears to have hit a sweet spot for us.
We are also -- we also are applying what we are learning to the Magnolia home theater stores located in Best Buy stores.
In summary, we have many positive indicators across our business.
Today, three-quarters of the way through the year we are proud of what we have accomplished.
Year to date we have grown revenue by $2 billion or 11%.
Increased the gross profit rate by 130 basis points, and grown earnings per share by 41%.
Our attention is now turned to the most important quarter of the year, when our retail execution will continue to make the difference.
With that, let me turn the call over to Ron.
Ron Boire - EVP, General Merchandise Manager
Thank you, Brian.
Good morning, everyone.
I am certainly pleased by the continued improvement in our gross profit rate as it directly reflects many of the structural changes we are making to our business.
The capabilities we are building in strategic pricing, supply chain, global sourcing, and tailored market assortments continue to drive the year-over-year improvements.
Our private label product continues to play its role very effectively.
It fills in our assortment and gives us cost-effective products while adding to our gross profit rate.
As an indication of the category's strength we easily exceeded our volume expectations for the promoted products during our holiday kickoff.
Our quality, value oriented brand names, such as Geek Squad, Insignia, Dynex, and Init complemented the highly respected brand names of our vendor partners which comprise the majority of our business.
We have now started to lap the launch of these structural changes.
So the year-over-year impact of private label products on the gross profit rate will remain important but will slow in future quarters.
We continue to see benefits from pricing strategies, tailored market assortments, and supply chain work as we expand our capabilities and utilization of these tools, but going forward they become part of the base for comparison, and incremental improvements are harder to achieve.
On a related note, many of you have asked questions about the promotional environment.
The environment in the third quarter was only slightly more promotional than prior year.
I don't expect the promotional environment will materially change during the balance of this selling season.
Others of you have asked about our competitive landscape which increasingly includes the discount channel.
That's not a surprise to us.
We've predicted this sometime ago.
Today we compete based on our authority in categories, our in-store experience, and our ability to deliver the total solution to customers.
Even as we invest in our transformation to further differentiate ourselves, we have remained competitive in the marketplace, as evidenced by how we looked on Black Friday.
We will continue to provide compelling competitive offers to our customers.
We are confident that we are well positioned to win with customers this holiday.
Now I'd like to touch on a few key categories.
First, we are extremely pleased with our third quarter flat-panel TV performance.
It actually exceeded our expectations, which says a lot.
The average selling price decline was in-line with expectations and we continue to see customers trade up to larger screen sizes and better technology.
There are, of course, spotty availability issues, as there always are in such a hot category, but I do not expect these to have a material impact on revenue performance in the fourth quarter.
Second, I want to briefly mention the gaming space.
We were pleased with our Xbox 360 position in the market, and the customer response was obviously overwhelming.
This product is a perfect example of technologies converging and how our retail expertise in gaming, computing, digital televisions, content, and networking is a competitive advantage.
As consumers change how they will enjoy products and services we provide.
This trend plays to our strengths, and it's one of the many reasons we are excited about the beginning of this new gaming cycle.
That said, the total gaming category put modest pressure on the comp gain for the quarter as we saw a slowdown in existing platform hardware and software sales leading up to the launch of Xbox 360.
Additional strong categories included MP3 players with an expanded assortment of products and accessories year-over-year.
We also saw strength in notebook computers, satellite radios, and appliances.
As Brad said earlier we are pleased that we are seeing results across many areas of our business.
It's not just one hot product category driving our results.
With that I'd like to turn it over to Darren who will walk you through the quarter and discuss our outlook.
Darren Jackson - EVP-Finance, CFO
Good morning, everyone.
I'll start by trying to provide some insights into how the quarter unfolded and SG&A trends.
At times the quarter was volatile.
We endured a combination of hurricanes, high gas prices, plummeting consumer confidence.
Yet we finished with robust revenue growth the week of Thanksgiving, which included the launch of Xbox 360.
Candidly, we are pleased with our 3.3% comp gain given how the quarter started.
With that as context, let me walk you through our results.
First, total revenue grew 10% from last year's third quarter to 7.3 billion.
The increase in our average ticket and units per transaction offset modestly the lower customer traffic during the quarter.
That said, I am pleased to add that customer traffic was positive as we closed November for the first time in more than a year.
Next, from a structural perspective, we enjoyed strong double-digit growth in revenue from services.
In addition, comps of the segmented stores outpaced the balance of the chain.
I applaud the team as they managed a lot of operational change and still were able to deliver for our customers.
I continue to believe that the scale of our transformation efforts is causing growing pains, which may be constraining the sales somewhat.
Now turning to our gross profit rate, we saw an improvement of 120 basis points during the quarter which was more than we expected.
Our stores competed in a modestly more promotional environment than last year as Ron mentioned, but this factor was more than offset by further incremental benefits from structural changes in the business.
We benefited from more profitable product mix including more services and an increase in consumer electronics.
We also realized an accounting benefit in the quarter.
This benefit related to gift card breakage and was worth approximately 30 basis points.
This change will add $0.04 to $0.05 of EPS this fiscal year and we expect $0.02 of that to be recurring each year.
Excluding that benefit the gain in our gross profit rate still was above our expectation.
That brings me to our expense rate.
For the quarter the SG&A rate of 21.8% rose 150 basis points.
My comparison versus last year's rate of 20.3% when adjusted to include stock compensation expense.
The increase was higher than expected, so let me highlight the material drivers in that change.
One, the transformation to customer centricity including services added 70 to 80 basis points to our expense rate.
Two, hurricane Katrina and Rita, coupled with the absence of positive one-time events in last year's numbers, added 30 basis points to our expense rate.
Three, deleverage associated with the flat comparable store sales and the new store growth in Canada added approximately 30 basis points.
The balance was principally driven by the sales deleverage in the balance of the United States stores.
Now our move to the new model brings with it a higher level of fixed costs.
Historically we had a simpler model that frankly was easier to adjust in a mixed environment.
As we stand today, we have a more complex and differentiated model, and we have to evolve the capability to make adjustments.
We now have 284 stores operating under this model, and a year under our belt.
Our focus is now on refining the model so that we can better match incremental costs with incremental revenues.
Turning to the operating line, the SG&A rate increase offset the gain in the gross profit rate.
We deleveraged the operating income rate by 30 basis points.
We gained in interest income and taxes consistent with the first six months of the year, our tax rate is benefiting from more efficient tax strategies and we continued to assess additional ways to further make progress on this line.
Our current trend suggests that our income tax rate will be 33 to 34% for the fiscal year.
Taking a step back and looking at the quarter, I'm very encouraged by continued gains in our gross profit rate.
That is the result of many structural changes we are making to our business model.
And while the SG&A rate is concerning, it is within our control.
We are focusing our efforts on building capabilities to adopt the operating model to the environmental and economic changes.
We continue to be optimistic for the remainder of the year.
I still expect we will finish the year in line with our previous guidance.
For the remainder of the year, we reiterate our comparable store sales gain of 3 to 5%.
That is driven by an extra day of holiday shopping, and the gaining importance of the post-holiday selling season.
We expect that the gross margin rate will increase modestly from last year, and that the increases in SG&A rate will offset these gains, resulting in a modest reduction in our fourth quarter operating income rate, versus Q4 of last year.
For the fiscal year, however, we expect an improvement in the operating income rate.
In terms of EPS for Q4, we anticipate $1.06 to $1.16, up from $1.04 last year on a comparable basis.
The IR team has posted on the website a summary that we hope you have already seen.
The summary reconciles last year's reported GAAP Q4 number to the $1.04 number that we're using for comparison purposes.
As you recall last year's fourth quarter had several accounting changes like lease accounting and we've tried to provide what we think is the best comparative number from last year.
Moving to the fiscal year, our outlook would put us at a $2.05 to $2.15 in diluted EPS.
This is the same guidance we gave last quarter, updated to include the direct costs I mentioned from hurricane Katrina and Rita.
This range calculates to an earnings increase of approximately 20% for the year on a comparable basis.
This year's growth rate is consistent with our track record over the past decade as well.
Year to date, as we've said, our earnings are up over 40%, which is gratifying.
There are signs that we must take action to closely evaluate our portfolio of transformation activities.
This senior management team chose the investments, and this team will make the adjustments to deliver the results we all expect.
In summary, we are proud of our employees and their contributions they continue to make.
This is especially true given the amount of constant challenge and change throughout our system.
We have confidence in our ability to implement the strategy because of the hard work and the engagement of our employees.
With that, we would wish all of you a blessed holiday, and thank you for participating on our call today.
Now, I'd like to open the phone lines up for questions.
Operator
Thank you. [OPERATOR INSTRUCTIONS]
Jennifer Driscoll - VP, IR
First question, please.
Operator
[OPERATOR INSTRUCTIONS] Our first question is coming from Alan Rifkin with Lehman Brothers.
Jennifer Driscoll - VP, IR
Good morning, Alan.
Alan Rifkin - Analyst
Good morning.
How are you?
Jennifer Driscoll - VP, IR
Good.
Alan Rifkin - Analyst
Brad, you mentioned that with the centricity stores you're not seeing the returns that you expected.
Brad Anderson - Vice Chairman, CEO
Yes.
Alan Rifkin - Analyst
If you take this statement together with the 5.4 comp, which I think represents the smallest delta between the centricity stores and your corporate average, I was wondering if you can maybe provide a little bit more color as to where the expectations are really falling short.
Are you seeing additional expenses on the centricity side, or do you think that it's just taking a little bit longer for some of these stores to mature.
Brad Anderson - Vice Chairman, CEO
Well, thank you.
Actually, the older stores, as I believe Darren mentioned in his presentation, are continuing to perform best, and so what we knew as we accelerated our growth through -- and decided to do more centricity stores that we were taking the risk that we really had less ability to influence those stores as we opened them, and there was a greater risk that it would take a longer time for those stores to ramp, or we may find that we made mistakes in terms of what we were ramping with because the speed with which we were doing it.
I think what we've seen in this last quarter is evidence that all of those risks have had some impact.
So we saw a lower rate of gain than we had seen with earlier stores.
As we mentioned, both the new stores we opened, and we opened 118 new centricity stores in that mix, we've got the same team that was rolling out a smaller number of stores is charged with a much larger number of stores this year, and we are not seeing the same rate of gain we got from those first stores.
Now, part of the thing with those first stores is it took even those stores awhile to get to the level they got to by last spring.
We started seeing the very good results.
We've got to be very careful as we look -- we honestly face what we're seeing which is we were hoping for better results than we've got currently.
As well as -- so that would argue to pull back on expense structure, and be cautious about any further stores that you open.
So we're doing some of that, but also we've got to be care that we look at the information and give the stores an adequate amount of time to adjust since we had less energy that we could apply to each store that we transformed than we did a year ago when we only did 70 stores.
Alan Rifkin - Analyst
One more question, if I may.
A couple of times in the call it was mentioned that the quarter got off to a slow start.
Yet in mid-September, you issued guidance for 3 to 5.
I would have to believe, having knowing that at that pint in time the quarter was off to a slow start, given the fact that sales did rebound towards the end of the quarter, were you actually expecting a greater rebound?
Brad Anderson - Vice Chairman, CEO
No, we actually -- actually, the -- we saw -- the weakest month of the quarter was October.
So we actually -- and November started relatively weakly, which when we looked at the -- Darren, actually, if you wanted to comment -- when we looked at the--.
Darren Jackson - EVP-Finance, CFO
Alan, I think the word -- you're right -- we used the word both slow start but we also used the word choppy.
Honestly, when we reflect back, one of the things we didn't want have in the forecast was the depth and how our senior management team would have to put energy into managing the hurricane outcomes in the quarter.
And so what you saw, I think is a reflection of how consumer sentiment was dropping, gas prices, and then when that stuff started to stabilize, and quite frankly, as we focused getting into the end of the quarter and into, as we've talked before, November is a generally disproportionate amount of our results in the quarter, our focus turned to November, and quite frankly November was very good.
That's why we had confidence to issue the results that we did, because quite frankly it was still early and a disproportionate amount of the results do come in the November time frame.
Alan Rifkin - Analyst
Thank you.
Thank you, Darren, thank you, Brad.
Brad Anderson - Vice Chairman, CEO
Thanks, Allen.
Jennifer Driscoll - VP, IR
Next question, please.
Operator
Our next question is coming from Mark Rowen with Prudential.
Mark Rowen - Analyst
Thanks.
Couple of questions.
If I could follow up on the customer centricity stores, first of all, how many stores were actually in the comp space that were opened a quarter that were segmented stores?
Brad Anderson - Vice Chairman, CEO
Mark, I'm sorry, how many -- ask me that question again.
Mark Rowen - Analyst
You said the only ones were in the comp base, it wasn't all of the centricity stores, just the ones that were open a full quarter, so I just wanted to know how many were actually--?
Brian Dunn - President
For in the comp base.
Mark Rowen - Analyst
Yes.
Brian Dunn - President
We opened 67 stores in October of last year.
So in terms of if your question is--
Brad Anderson - Vice Chairman, CEO
But you'd also have--.
Brian Dunn - President
It's going to be roughly -- it's like 225, Mark.
Mark Rowen - Analyst
225?
Brian Dunn - President
Yes.
Mark Rowen - Analyst
So my question, Brad, is that given the fact that the comps gap narrowed pretty considerably--.
Brad Anderson - Vice Chairman, CEO
Yes.
Mark Rowen - Analyst
And you've acknowledged that this is a big HR challenge to roll this out across a whole chain, is this just execution?
Did you have problems getting the people in the newer stores to understand what the program's about and up to speed on that, or is it just that as you roll it out to more stores and you have less management to oversee it and people to sort of watch it and make sure it works right, that it just becomes harder to do and it's kind of natural that the comps is going to narrow pretty considerably?
Brad Anderson - Vice Chairman, CEO
Well, I think, first of all, for the first 67 stores this would be their second year of comping on top of the -- with a centricity initiative.
So it's the second year into the centricity initiative.
Secondarily, I think, and to some extent we don't completely know the answer to that question, because with as many stores as new into centricity as we've got and the older stores doing better, we're not -- there's a whole series of things that potentially it could be.
It could be any one of the things you're talking about.
It's probably -- as we get more time, and as we make further refinements with what we're doing with centricity, I think we'll get a better picture.
John, you might want to comment on that.
John Walden - EVP, Customer Business Groups
Sure.
Yes, as Brad had mentioned before, 118 out of our roughly 250, 260 stores just were segmented in this past quarter and represented, so part of them, at the very end of the second quarter, so third quarter is their first quarter, some of them just in November.
So we're looking at some very early results.
But as Brad pointed out, we just didn't see the speed with which we generally saw high revenue comps.
And so what that does, particularly with the higher fixed cost labor model, it puts your SG&A out of whack.
So there's a number of things we have to look at.
Why didn't the sales ramp quicker?
Could we have pulled back on the labor a little quicker?
And could we have--.
Brad Anderson - Vice Chairman, CEO
And is the quality of the implementation lesser than it was before?
John Walden - EVP, Customer Business Groups
Right, could the quality of implementation have helped us ramp quicker, so there's a number of things we're going to look at.
We will look at those, we will adjust them, but we also want to be careful not to conclude that based on one quarter's results of a bunch of stores that we're in the wrong space, we absolutely think we're in the right space.
We just have to optimize this now and anticipate that these kinds of things will happen, and we will deal with them in the future in this fashion.
Brad Anderson - Vice Chairman, CEO
But if I had to guess, I would guess that probably all of the things you mentioned are having some impact at this stage.
Mark Rowen - Analyst
All right.
The other question I had was, given the strength in flat panel TVs, and you've been talking about triple-digit growth now for quite a while in that category, and it seems like the unit profitability on those TVs is pretty high, and the unit volume is starting to become pretty substantial, at least industry wide.
I'm a little surprised that more of that didn't flow through to the bottom line.
When you talked about competitive pressure or promotional environment, is it impacting that category in particular more than you've seen other categories, or not really?
Jennifer Driscoll - VP, IR
Ron, would you like to take that one remotely?
Ron Boire - EVP, General Merchandise Manager
Yes, Mark.
I would say that it is not disproportionately impacting the [Inaudible - audio difficulties] we, again, are extremely pleased with how we mixed out.
We're extremely pleased with both the unit and dollar velocity in the category.
I think ASPs -- ASP declines, to give you a more accurate number than the directional number I gave in the call, were at the low end of our anticipated decline range when we look at the year to date declines and we look at the November declines.
So I would not say that they are disproportionately hit by competitive pricing pressure.
I think they are certainly the highlight, one of the highlight categories in the industry right now, so you're seeing a lot of advertising and promotional attention on it.
But they're also a major driver for us and all of our competitors, so we're not seeing what I would call irrational behavior where people are trying to use this category to disproportionately gain share, or disproportionately drive revenue.
I think we're seeing a competitive environment but good balance in that competitive environment.
Mark Rowen - Analyst
So that -- well, then my original question, so if it's not that those are becoming a lot more promotional, I was surprised that the profitability from those big ticket sales didn't sort of flow through.
So, Darren, can you talk at all about what's offsetting that?
Darren Jackson - EVP-Finance, CFO
Yes.
Sure.
Absolutely.
So if you actually go into the detail of the press release you'll see for consumer electronics, our comparable store increase was 14%.
The largest increase that we've seen in consumer electronics in better than two years.
Offsetting that you can also see that we continue to be challenged in the entertainment software space.
So I think it's fair that, as Ron highlighted in his call, and we see this phenomena in these cycles, that as we enter a new launch cycle, the old platforms begin to dive, and the software with it, and the profitability with it.
We launched the new -- we don't have enough units, quite honestly, to offset the drops, and we've been clear about this, that hardware doesn't come with much margin.
Almost no margin.
So consequently, we give it up in that part of our house, and that's what we saw in the quarter.
Mark Rowen - Analyst
Okay, great.
Brad Anderson - Vice Chairman, CEO
As we look forward -- by the way, as we look forward to software, there's some -- one of the things we referred to is the gaming cycle, which looks very optimistic obviously with both Xbox getting more units in the market and with Sony launching their new PlayStation 3 this year, and we also think there's a good likelihood that HD-DVD launches this year.
So we've got some refreshment coming in terms of some of those cycles but it will be awhile before HD-DVD has a big financial impact.
Jennifer Driscoll - VP, IR
Thank you.
Next question, please.
Operator
Our next question is coming from Scott Ciccarelli with RBC Capital Markets.
Scot Ciccarelli - Analyst
Darren, you used to talk about how 3% was kind of at the 0 leverage point for the Company.
Obviously you've gone through quite a bit of changes.
How should we think about -- where is the 0 leverage point right now?
What is incremental spend as you build infrastructure, and what do we think is going to be kind of the ongoing higher fixed structure.
Darren Jackson - EVP-Finance, CFO
Our current hypothesis is that it's above 3.
Not to be flippant Scot, but I think a great example, last year in the third quarter our comp store sales were up 3.2%, our earnings were up 22%, and we leveraged SG&A by 30 basis points.
I think that's part of the journey we're on and what we talked about today.
Quite honestly, this third quarter was the largest quarter of all quarters of our transformation activities that we've experienced to date.
What we're doing, and I tried to highlight this in my comments is that we're evolving and chasing capabilities to better manage that model.
Scot, when you actually unwind the results, and the risk is we walk away from this call and conclude that customer centricity and that work is just not working.
It is.
So underneath what we're seeing in the initial waves is that we're seeing an accelerant in terms of operating income growth in the initial waves, we're seeing gross margin improvement above the chain in the initial wave, and I think quite frankly what we're not seeing at this point, or we may have just incorrectly assessed, was the productivity gains that we should get as we're launching these additional waves and the drain that it's having across all of management that's being felt in those stores and being felt in the balance of the stores, too.
And so that's affecting all of the numbers.
What we're committed to now, and you would expect this of us is that simultaneously with rolling out and implementing the new waves is to do a better job understanding what it takes to get productivity and balancing and beginning things that, as Brian highlighted, we're really, really quite good at, is beginning to optimize and understand GAAP management.
We've already started that process, as you would expect us, and we're not backing off of our commitments that -- our longer term goal is we should be able to see expense leverage and margin gains at a 3% comp store level.
That's the longer term goal.
What we're currently experiencing is that transition period, and we have to go in and make some choices based upon the evidence that we see now in order to strike that balance going forward.
Is it going to happen in the fourth quarter?
It's not.
Is it going to happen as we go into FY '07?
You bet it is.
Brad Anderson - Vice Chairman, CEO
One other -- just one other thing on that, too.
Both -- the very complex initiatives here that require thousands of people to do them, like customer centricity and service are both places where our expenditures are higher than we had hoped in relationship to the revenue.
I don't think that's a shocking outcome.
It was the biggest risk we took as we drove into this space.
And in both places we're seeing similar results, and as we mentioned earlier, refining things and building GAAP management.
We've got some places where both systems are working extraordinarily well and some places where they're not working at all.
And so that's what we call GAAP management, it's trying to figure out what the difference is between those two and manage the system for the best operating results.
In both of those major areas, we have the same challenge in front of us.
Scot Ciccarelli - Analyst
Got it.
Thanks a lot, guys.
Jennifer Driscoll - VP, IR
Hey, thanks, Brad and Darren.
Next question, please.
Operator
Our next question is coming from Bill Sims with Citigroup.
Bill Sims - Analyst
Good morning, thank you.
Question is on Geek Squad and its impact on comp.
It looks like it's in the home office category for the first time this quarter.
I might be mistaken on that, could you please confirm that, and then if so your overall comp in home office category is still down, and if it was just included this quarter it implied an acceleration and a deceleration of the home office comp.
Can you comment on the contribution Geek Squad is having to that category and what we're seeing in the rest of the category?
Jennifer Driscoll - VP, IR
Ron, could you handle that from the road?
Ron Boire - EVP, General Merchandise Manager
I actually don't have the statistics in front of me but I would say that it is a contributor to the comp, but we are, as you know, lapping last year's launch of Geek Squad.
So we're seeing revenue growth in Geek Squad.
We're extremely happy with the customer satisfaction still on Geek Squad, and we're extremely happy with the way the teams are building services into the total solution.
So I think if you kind of look into the release you'll see that we were pleased with our growth in notebook computers.
What was not highlighted in the release, we were also pleased with, as we were the first quarter of the year, the growth of computing accessories exceeding the growth rate of notebook computing.
We're seeing the desktop business continue to struggle as we're in transition from desktops to a more notebook-oriented business model.
Also, in home office, we saw cellular phones recover nicely to a strong comparable sales gain in the quarter.
So what you're seeing is I think in the home office category as we -- as we illustrated in the release, you're seeing a fundamental mix change and you're seeing -- as it relates to Geek Squad, the teams putting together solutions that include the product and the services much more effectively.
Bill Sims - Analyst
And, Ron, can you confirm, is this the first quarter that Geek Squad was in home office comp category?
Darren Jackson - EVP-Finance, CFO
Always has been.
Bill Sims - Analyst
It always has been.
Ron Boire - EVP, General Merchandise Manager
I think it's always -- I believe, Darren, you can confirm, it's always been there.
Darren Jackson - EVP-Finance, CFO
Always been there.
Brian Dunn - President
This is Brian Dunn.
I would just add one comment to Ron's, and that is we've doubled our Geek revenue in the quarter, and again as Darren mentioned and I mentioned on the call, this plays to a strength of Best Buy's, and that is our ability to gap manage to find things, capabilities that are working well and to export them to the stores that are not grabbing them as quickly.
Our confidence is unshaken and the focus of the Company is clearly in both our customer centricity scale and our Geek Squad scale, and our ability to gap manage we have a great deal of confidence in.
Bill Sims - Analyst
One quick follow-up for Brian.
Brian, you commented on heightened competition coming from Canada contributing to the comp weakness.
Can you just suggest where this competition is coming from?
Brian Dunn - President
Yes, I think what I'd like to do is ask Kevin Layden, who is on the call, Kevin, would you like to comment on the marketplace.
Kevin Layden - COO
Well, certainly not unlike the U.S. a lot of the mass merchants are definitely looking at consumer electronics.
That's added a level of competition in Canada that has been higher than normal.
It's not -- would not be unusual for us to quote the source at this point who have been spending quite a bit more on advertising as well.
So those are the two primary factors.
Bill Sims - Analyst
Thank you.
Brian Dunn - President
And I would just remind the call, remind everyone, that our market share gain was significant in Canada in the quarter and again that plays to our strength now of gap managing our operating model in Canada.
Jennifer Driscoll - VP, IR
Thank you, Brian, and thank you, Kevin.
I'd like to take the next question, please.
Operator
Our next question is coming from Matthew Fassler with Goldman Sachs.
Matthew Fassler - Analyst
Thanks a lot and good morning.
Brad Anderson - Vice Chairman, CEO
Good morning, Matt.
Matthew Fassler - Analyst
I guess my question relates to costs and some of the investments that you're making.
Do you see the outcome of this as actually scaling back on some of the investments, whether they be labor within the stores or the magnitude of conversion as opposed to kind of waiting out the improvement, and to the extent that you think we're likely to see some scaling back, in that investment, what's the time frame at which you think you might start to alter your investment framework and your investment levels?
Brad Anderson - Vice Chairman, CEO
Well, we're going to respond to what we see in the data, and so if the data tells us that something is not working as well as the hypothesis, then we've got to look at is it just a matter of time or was there a fundamental flaw in the analysis.
In some places we will be scaling back.
In other place we'll be taking a very careful look in relationship to what we actually see as an outcome and adjust accordingly.
I think one of the strongest things, and one of the reasons we move so aggressively in this space is, you can look at all of these areas that are challenging for us, they're challenging in part because they're based on labor, and they're based on thousands of people, we're also in a system with relatively high turnover.
So it's a relatively easy place for us to adjust based on what we find in the marketplace compared to if this was a lot of fixed investment.
So you'll watch us.
We'll see what happens.
We'll be watching both the time, we'll try to figure out what the gap -- one of the things, we keep referring to gap management, gap management if somebody is doing really well with the same strategy and somebody else is not, historically that's been an opportunity to try to bring up the average.
So in those cases we probably would not disinvest.
If nobody is doing well in this space, then we probably will back off on the investment.
Matthew Fassler - Analyst
And are there some areas of investment where you found that to be the case?
Brad Anderson - Vice Chairman, CEO
Oh, yes, there's absolutely -- that's kind of an ongoing -- I wouldn't say there's a customer that fits that description.
We don't see that at all.
Actually, we thought we would be -- when we started with the five segments we thought some of those segments would be gone.
None of the customer segments are gone.
We're finding value in every segment.
But there are a lot of -- part of this process is you're constantly trying new things, and there are a lot of things you try that just don't work, and you have to back off of, and that's a living part of the process.
So if we had, like in the first quarter, where results were better than what we anticipated, we did what we did during the balance of the year, we would double down in macro on the investment.
In a quarter like this where the results are not quite as good as we hoped for then we're going to do some culling of various kinds of investments.
Matthew Fassler - Analyst
Has that started now in the fourth quarter given that you've had probably some insight as to where the payback has made sense and those areas where it hadn't?
Brad Anderson - Vice Chairman, CEO
About 30 seconds into the fourth quarter.
Matthew Fassler - Analyst
Fair enough.
And then just finally, given that the comp was within your range, and given that the gross margin rate was within your range, it would seem like net-net, the expense dollars and the magnitude of costs you're putting in are sort of more of a problem, if you will, than the payout that you're getting on that.
Is that accurate to say, or is it really both the return on that investment as well as the investment level that are not meeting your expectation?
Darren Jackson - EVP-Finance, CFO
Yes, Matt.
Can I road map it for you?
Matthew Fassler - Analyst
Sure.
Darren Jackson - EVP-Finance, CFO
We reported $0.28 this morning.
And, up, and we're not trying to hide from what's in that $0.28. $0.04 of that was gift card breakage, and we weren't counting on that.
So you could say we did $0.24.
The things are different than we expected honestly is that we had about a $0.03 miss in our Canadian business.
We probably over -- we didn't probably, we overspent our expenses by about $0.03.
And so when we back up -- we delivered the comp that we said and we have a couple of places that we got surprised.
And so that's essentially the breakdown of how we're looking at it, and what you hear from us is that we are absolutely -- we see benefits in the strategies that we're pursuing.
We have some editing to do.
We shouldn't be $0.03 overspent.
And we're going to fix that.
And in Canada, quite frankly, we were surprised.
And similarly what you heard from Brian and Kevin is they're going to work to turn that around, too.
Matthew Fassler - Analyst
And, Darren, just to close that $0.03 of overspending is $0.03 that you're willing to pull back on?
That's not subject to contemplation and further research.
You just feel like that's $0.03 you can identify it and you know where you need to scale it back or is it a little bit of a more complicated process?
Brian Dunn - President
This is Brian.
We are very committed that we have that $0.03 to pull back.
Matthew Fassler - Analyst
Thank you very much.
Jennifer Driscoll - VP, IR
Thank you, Brian, and thank you, Darren.
Next question, please.
Operator
Our next question is coming from Colin McGranahan with Bernstein.
Colin McGranahan - Analyst
Good morning.
I wanted to focus on the Geek Squad business.
Can you help us understand whether that was an expense problem?
You mentioned that it came up a little bit short as well relative to your expectations.
Whether that was an expense problem and you overspent there as well, or whether you were putting Geeks in stores and you didn't get the revenue lift?
Just comment on the utilization, both the in-store business and the in the field business relative to your expectations and what you've seen with demand so far.
Darren Jackson - EVP-Finance, CFO
So, Colin, here's what -- I'm looking at the P&L.
We are absolutely on our expense plan in terms of dollars.
I tell you, we more than doubled the business in terms of Geek, but in terms of our revenue forecast, which was, as Brad said early, very ambitious in the quarter, we came up a little short in terms of the top line versus our forecast for the quarter.
Now that being said, in a business that's growing by 100%-plus we should be that good in our ability to forecast something above that where we're trying to hire, trying to increase the sales force by 25% in a quarter.
So I think at this point when we look across the expenses overall, versus what we had planned for, I think we still feel okay about that business.
I think it's to John's earlier point, in many of these areas what we're trying to sort out is what the productivity curve of those additions look like and when they're going to come.
And we're going to get better with that in every quarter, and we're going to edit the things where the productivity is not coming.
Brad Anderson - Vice Chairman, CEO
One of the things that I think we got to -- is when you grow a business as fast as we're growing that business, when you're estimating your sales, it's an informed guess, because you don't have a historical pattern in which you're looking at.
So you're taking a look at what you have, and then trying to guess, if I change at this rate what would it be, and what does it take.
The second thing is that business because of the newness of the business, has not had a chance to be refined at all yet.
So there is a lot of opportunity for refinement in that business.
Colin McGranahan - Analyst
And just to clarify, the lower revenue than expected, was that in0store or in the field, and do you think it had anything to do with the quality of the hires as you're getting now into the 12,000 Geek range?
Jennifer Driscoll - VP, IR
Something like 90% of the Geeks work in the stores.
Brian Dunn - President
We don't have -- I don't have the numbers, this is Brian, I don't have the numbers right in front of me.
I can tell you that our in-home business accelerated from where it had been running but we don't have the numbers in front of us.
Jennifer Driscoll - VP, IR
That's not how we manage the revenue.
Apologize for that.
So thank you, for your answers to the questions.
Looking at the time I think I've got enough minutes left for one more caller to ask a question.
Operator
Our next question is coming from Steve Chick with JP Morgan.
Steve Chick - Analyst
Good morning.
I guess Darren, your guidance for the first quarter for operating margins being down, I guess I was a little surprised by that given the year-over-year comparison, because fourth quarter of a year ago your margins were down, and specifically with gross, can you speak to what -- what you -- a little more specifically what you think your gross would look like I guess relative to what you reported for the third quarter?
And I guess I'm looking at the third quarter as 90 basis points of expansion without the breakage.
Darren Jackson - EVP-Finance, CFO
Yes.
To frame that question, you're absolutely on to the right point.
As we look into the fourth quarter, and I'll have Ron give you a little more color, we're expecting gross margin rates to increase, no doubt about that, but at a lesser rate.
And in the fourth quarter, what we're recognizing, quarter over quarter what's different is that we know Xbox will be significantly more in terms of the mix this year.
MP3 players more, and that's putting, honestly, more of a -- somewhat of a cap in terms of margin mix, and the other thing, as Ron talked about is we are starting to lap some of the benefits.
As we look at some of the key drivers that are a little less important in December, and the lapping of some of those capabilities, it is constraining the gross margin rate from its year to date trends of 100-plus basis points.
Jennifer Driscoll - VP, IR
And now before, Ron, you add to Darren's answer, Steve, if you could put your phone on mute, we're hearing a clicking sound.
Ron Boire - EVP, General Merchandise Manager
Steve, I would just amplify some of the things Darren said.
I think we, number one, we are lapping some of the structural improvements we made in pricing, market assortment, sourcing, and private label which had been driving a lot of the margin.
We will continue to see improvements in those categories, but they're not the initial step change improvements we've seen over the last 12 months.
Additionally, as Darren said, we're going to mix a little bit differently, so gaming with Xbox we expect to be a growth category and a comp driver in the quarter. iPod/MP3 continues to be a significant comp driver at lower mark-on margin rates, but we, again, do expect to see a gain in margin rate in Q4 but not the kind of blistering pace you've seen the last few quarters.
Steve Chick - Analyst
So should I compare that, I guess, if we assume adjusted gross for Q3 was up 90 basis points, as we look at the fourth quarter, are you assuming right now that the fourth will be up less than that?
Darren Jackson - EVP-Finance, CFO
Yes.
Ron Boire - EVP, General Merchandise Manager
Yes, we think that's a safe assumption.
Steve Chick - Analyst
That's helpful.
Second thing, if I could, so if we're assuming down EBIT margins for the second half here, I guess it looks like you might be a little bit up for the year.
I know you're not ready to give FY '07 guidance until later but you're a far cry from your 7% operating margin target as you head into FY '07.
Can you speak a little bit to how much up you might think FY '07 might look like at this point?
Jennifer Driscoll - VP, IR
Sorry, we're out of time, Darren.
Darren Jackson - EVP-Finance, CFO
I think that's an absolutely fair question.
Brad Anderson - Vice Chairman, CEO
I do, too.
Darren Jackson - EVP-Finance, CFO
Absolutely fair question.
And so here's what I'd say.
We are right in the throes of our strategic planning process.
When we look at the things that are driving margin improvement, we, clearly, we have not lost any confidence around the supply -- we haven't lost any confidence, honestly, around the four initiatives and what we'll evaluate as the timing of them.
So we're clearly--.
Brad Anderson - Vice Chairman, CEO
Let's go specifically through each four of those.
For instance, the challenge we had in Canada was one of the places where we're going.
Some of the reason we had a challenge in Canada is that there's like the payroll initiative that went on in the quarter, put the system through a lot of change to try to improve the earnings result to get to the 7 by 7.
As they're doing that, as you go through that process, we're looking for what the impact has been, and so -- in a number of these places, we're not getting the outcome that we were looking for, which is why we're not getting the results.
So we're sharing with you as we go in terms of our objective.
In Canada we didn't quite get the results we're seeing, with centricity we were also looking or basically -- centricity and service we're also looking for an improvement in gross margin rate.
That did not also happen in the third quarter.
Did happen, by the way, in the first quarter.
So the question is going to be whether we can -- whether we see as these things mature, the change that we initiated in this quarter has a maturing positive result that actually drives the outcome.
If it doesn't, then obviously it puts some challenge to our ability to get to that 7% objective or moves it way back from a time standpoint.
So other things like the sourcing and IT initiative gave us the benefit that we were looking for.
Steve Chick - Analyst
Yes.
Brad Anderson - Vice Chairman, CEO
So we've got -- that's part of what you see in terms of the margin rate growth.
Some of the stuff that was in there is giving us good indicators, and other things are not at this stage, and we'll continue to give you a read as we get those results and we certainly -- on none of these initiatives, have we lost faith that we can get there.
But obviously some of them are not going as well as we hoped at this moment.
Steve Chick - Analyst
Okay.
That's helpful.
Thank you.
Brad Anderson - Vice Chairman, CEO
Thanks very much.
Charles Marentette - Senior Director, IR
Thank you Darren and Brad for that, and thank you, and thanks to our audience participating in our third quarter earnings conference call.
Before we end, may I remind you that this conference call will be available to you for replay by dialing 973-341-3080, and entering the personal identification number of 6777800.
The replay will be available from about 1:00 p.m.
Eastern time today until next Monday, December 19.
To hear the replay on the web visit us at our website, www.bestbuy.com and go to the Investor Relations section.
If you have additional questions about our third quarter earnings, or our fourth quarter outlook, please call Jennifer Driscoll at 612-291-6110, or you are welcome to call me, Charles Marentette, at 612-291-6184, and reporters should contact Sue Busch, Director of Corporate Public Relations at 612-291-6114, and I think that's probably enough phone numbers, so we are going to conclude the call.
Thank you.
Operator
Thank you.
This does conclude today's teleconference.
You may disconnect your lines at this time, and have a wonderful day.