百思買 (BBY) 2007 Q2 法說會逐字稿

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  • Operator

  • Welcome to Best Buy's conference call for second quarter of fiscal 2007. [OPERATOR INSTRUCTIONS] As a reminder, this call is being recorded for playback and will be available by 12:00 p.m. eastern time today.

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

  • - VP, IR

  • Thank you.

  • Good morning, everyone.

  • I hope you enjoyed the on hold music by [Karin Daly Wright].

  • Thank you for participating in our fiscal second quarter conference call.

  • This morning, we have several speakers.

  • We have Brian Dunn, President and Chief Operating Officer, he will connect today's earnings highlights with our ongoing customer centricity strategy;

  • Mike Vitelli, Senior Vice President Merchandising will give an update on current trends and flat panel TV and our new pledge;

  • Kevin Layden, President of Best Buy Canada will join us by phone to follow Mike and help you understand how we're driving results in our international business;

  • Jim Muehlbauer, Senior Vice President of Finance will cover the Company's quarterly results and our fiscal 2007 outlook; last, Brad Anderson, our CEO, will wrap up with comments on our corporate governance before we go into Q&A; and as usual, we also have a broad management group here to answer your questions.

  • 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 are participating in this call in a listen-only mode.

  • Also, the call is available for replay.

  • All you have to do is dial 973-341-3080 and then enter the personal identification number of 7734097.

  • The replay will be available from approximately 1:00 p.m.

  • Eastern time today until midnight on Tuesday September 19.

  • With that, I'll turn the call over to Brian Dunn, President and Chief Operating officer who will begin our prepared remarks.

  • - President, COO

  • Thank you, Jennifer.

  • Good morning, everyone and thanks for joining us on the call.

  • We are pleased with our second quarter results and I want to start by thanking those responsible for that performance, our people.

  • To our employees, I want to say thank you for the energy and passion you bring to work every day, for your creativity in building end to end solutions for our customers and to leading us to a terrific first half of fiscal 2007.

  • Now let's talk about some of those accomplishments.

  • Our earnings per diluted share rose 27% to $0.47 per share.

  • We also reported solid revenue growth coupled with expense reductions.

  • Our second quarter and frankly our first half went pretty well at Best Buy and I would like to tell you why, in my view.

  • We're tremendously excited about our Home Theater business this year, but the earnings growth we're seeing was not just driven by flat panel TVs.

  • Likewise, we believe service is the centerpiece of our future, but our success last quarter was not spurred only by the growth of services, it wasn't even new store openings, new Magnolia locations, or expense reductions.

  • All of those things contributed, of course, but something much deeper than that is going on here, something not easily captured in spread sheets.

  • Here it is.

  • Best Buy is performing well and growing because we're learning to listen to our customers.

  • Best Buy today reported an increase in earnings in large part because customers want something different and we're listening and changing to meet their needs.

  • Our topline showed that customers like what we're doing.

  • They voted with their wallets and gave us respectable revenue growth and comparable store sales amid mixed signals in the economy.

  • Customer insights drove what we did for the bottom line.

  • We maintained customer facing labor levels in our stores, as customer wanted, but we still kept a lid on our SG&A.

  • We continued to look in every corner of our business for inefficiency and signs of slowing growth and we continue to redeploy those investments, moving them to areas we believe have the greatest potential.

  • This is not a one-quarter phenomenon, but something you'll get used to with Best Buy.

  • It's one where we're going to fuel earnings growth.

  • But as in all things, the number one way we fuel growth is through our people.

  • We're learning to put our employees in a better position to serve our customer, to engage them more fully in the work and to listen to them better.

  • And our employees are responding by working smarter and more productively than ever before.

  • While we continue to see mixed signals in the economy, we are more optimistic today than we were six months ago.

  • We hope we are conservative in reiterating our guidance , that's a good position for us.

  • Now let's talk about one of my favorite things, Home Theater.

  • Mike Vitelli will dive in later with greater detail, but I want to pass along a few thoughts to show how customer centricity has laid the foundation for us in this business.

  • Home Theater is the new heart for the North American home.

  • Customers want flat panel TVs because the picture quality is so much better, and because they look so good in their homes, plus, they're a good value.

  • Increased supplies are bringing down the average selling price right into our wheelhouse.

  • So the product cycle is helping us.

  • But the real challenge is in making sure that customers get the same exact Home Theater experience at home that they get in our stores.

  • In a nutshell, that's our job.

  • It's our job to create an experience for customers that starts when they walk in the store and doesn't end until they get home, push that button, and watch their favorite entertainment explode to life in vivid color and sound right in their own living room.

  • That's what we mean by end to end solutions.

  • That's why we're here, and we know it.

  • Mike will tell you about our HD done right pledge, which we think hits the bull's-eye in meeting this need for customers.

  • But most importantly, in my view, we're meeting this need by turning customer insights into action.

  • It comes back to listening to what the customer is saying and we believe our ability to do that will mean Best Buy and our customers will win this holiday shopping season.

  • All of this year's strategic priorities tie back to customer insights.

  • For example, customers want convenience.

  • We're constantly looking for ways to make it easier for them to interact with us.

  • As part of that effort we're building more Best Buy stores and reaching even smaller, more remote areas.

  • In the coming quarter, we'll open 42 new stores just in time for the holiday shopping season.

  • Customers have also told us they want premium assortments and highly trained professionals, and they've responded with high fives to our Magnolia Home Theater concept.

  • So we're adding 142 additional Magnolia Home Theater locations next quarter, our biggest push of the year.

  • Here's another customer insight.

  • Customers love the idea of gathering around their new TV, but they're understandably nervous about do it yourself installation, about drilling holes in expensive real estate.

  • So we're expanding our Home Theater installation capabilities.

  • We hired approximately 300 more installers this quarter and we're clarifying our installation offers in the store as well.

  • The insights we've discovered are not limited to Home Theater, of course.

  • We've learned that many small business owners don't know what they don't know about technology.

  • They don't now how it can improve their productivity and profitability.

  • What's more, many of these people, even though they shop us for cool stuff like flat panel TVs and fast notebooks don't think of Best Buy when it comes to their small business, but we believe we can help them like no one else can.

  • So we're investing even further in our ability to serve small businesses.

  • While I'm talking about customer insights, let me point out not all of the customers with technology and entertainment needs live in North America.

  • Millions of them live someplace where they have far fewer brands from which to choose, some place where the retail experience may leave something to be be desired.

  • Do we have something to offer them, something different, something they might actually love and not just endure?

  • We believe the answer is yes.

  • We see tremendous opportunity internationally, but you'll see us go slowly, in part because international growth is new for us and in part because we firmly believe we must take the time to develop local talent wherever the customer meets the brand.

  • Customer centricity has taught us the value of really knowing our customer and creating end to end solutions for them.

  • But maybe most importantly, customer centricity has taught us the power of engaging local leaders in building store teams that authentically reflect the communities they serve.

  • We're talking a lot about bottom lines today.

  • As I look at the second quarter, I see one bottom line below them all.

  • Customer centricity is not only alive and well at Best Buy, it's working and making a huge difference in our business.

  • It's not firing on all cylinders yet, but we're learning how to drive it.

  • Once we've got it fine tuned, we believe it will drive our business and accelerate our points of differentiation.

  • I believe customer centricity is the single most important factor in our success during the first half of this year and it's the reason we remain so optimistic about the future.

  • With that, I give you Mike Vitelli, Senior Vice President of Merchandising.

  • - SVP, Merchandising

  • Thank you, Brian, and good morning, everyone.

  • I'm going to discuss our progress on one of our strategic priorities this year, the scaling of our Magnolia Home Theater experience to 200 additional stores.

  • Our end goal is to deliver a world class Home Theater purchase experience to every customer in every store, every single time.

  • And in truth that Best Buy fashion side, I want to start with a story.

  • One of our senior Home Theater personnel was invited to a housewarming and he went to that housewarming and the new owner actually had a home theater that was part of the house when he purchased it.

  • And the new homeowner was proudly showing it off and our Best Buy employee, we'll call him Best Buy Bob was standing there and noticed the high definition picture was horrible and he mentioned it to his wife who quickly elbowed him and said, you won't say a word, and he honored that request as he went through the evening.

  • But finally, the owner couldn't take it anymore and knowing where Best Buy Bob came from said, Bob, so what do you think of the setup here.

  • And Bob, in the truest of Best Buy truth and helping said, well, the setup is terrific, but I'm a little concerned about the picture.

  • Who are you getting your high definition video source from?

  • And there was a bit of an awkward silence and the wife turned to the husband and said, see, I told you.

  • And that experience -- that awful experience is being repeated time and time again all over the country.

  • These are not happy customers because they're not getting what they thought they purchased.

  • And by the way, Best Buy Bob was able to hook the customer, that neighbor up with their high definition service from their cable company.

  • At Best Buy, we're focused on how satisfied our customers are in our stores and once the products are up and running in their homes.

  • Something we're uniquely positioned to do with the largest national home theater installation team in the country.

  • We believe we must create trusted relationships between our employees and our customers all the way into their homes.

  • In doing that, we're building long-term opportunities with these customers and that should translate into long-term value creation for shareholders as well.

  • So how do we deliver?

  • Pun intended, on this promise.

  • I think about three key elements to our success and why we believe we continue to grow market share as we did the first two quarters of this year.

  • The first key element, of course, is our frontline customer facing employees.

  • It's difficult to be a consumer these days.

  • There are so many choices of technology, so many different ways to connect them.

  • Consumers need help.

  • And as a specialty retailer, this territory is Best Buy's home turf.

  • We're investing in home theater training to ensure our employees have all the knowledge and information they need to help customers get the experience they want in their homes.

  • We also now employ 1900 home theater installs.

  • These are Best Buy employees, not third parties which are difficult to manage.

  • The final steps of delivery and installation, create a lasting impression in the customer's mind and we want to manage that relationship all the way to the end.

  • The second element that matters is our in store experience.

  • We can teach customers the difference between plasma, LCD, and microdisplay devices.

  • We can show you the difference between the same channel in high definition versus standard definition, which is what that neighbor in my early story was seeing.

  • We have plexiglass covered wall displays that quickly communicate the complexity that home installation entails.

  • In addition, we have terrific product assortment.

  • In the quarter, we added 29 Magnolia Home Theater experiences at our stores.

  • We now offer a total of 162 that have those premium brands and premium service, and we've also added some new brands to our core selection as well.

  • In the second half, we'll add another 150 Magnolia Home Theater experiences.

  • Most of them launching in the third quarter Additionally, we'll transform the TV department in 300 Best Buy stores.

  • All this is being done with the aid of creating this strong relationship between the Best Buy employees and their customers.

  • I should add that many of these ideas and initiatives, like the side-by side high definition and SD comparison, and the consultation desk in the Home Theater department, the Plexiglas installation display, and the Home Theater transformation itself were all born in our stores from our employees.

  • They told us what they needed to meet the needs of their customers.

  • Third is our customer focus.

  • Consumers have never spent this kind of money on a TV before, and it's a big deal.

  • When you make an investment like this, you want it to be great.

  • Moreover, you need all the pieces of the puzzle to have a great experience, and therefore a fully satisfied customer.

  • That's why you see us trying to educate the customer to our HD done right pledge.

  • HD done right gives customers financial incentives to do what's actually in their best interest.

  • It encourages them to get what they really need, to get that home theater experience that they always wanted.

  • It works like this.

  • Come to Best Buy and purchase an HD TV that's 37 inches or larger, let us install it for you and upgrade your signal to high definition and right now we'll give you up to $400 off the price of your TV.

  • We believe this strategy will materially reduce returns and increase the needed attachments of accessories and subscription service centers that are needed.

  • More important, it will deliver that experience that the customer was looking for, so it's a win for everybody.

  • So to wrap up, our TV business is off to a great start this year.

  • It's on track with our plans.

  • We have not seen any decline in the consumer's interest in this important category.

  • With supplies up, we continue to expect average selling prices to drop between 25 and 30% year-over-year on identical SKUs and that's good news for consumers and for retailers, because as prices drop, more customers enter the high definition TV space and we see and expect to continue to see customers to trade up to the biggest screen size and best technology that they can afford.

  • So taken together all these factors we expect that the lower prices will drive tremendous unit demand, far outweighing the negative impact of any price declines.

  • So obviously we can't control the macro environment, and we also recognize that we're fighting for a share of consumer spending, which has other pressures, but we're very bullish on the flat panel Home Theater space and we're confident that we're making the right investments here.

  • So now to talk about the space a little bit further north, we have Kevin Layden, the President and COO of Best Buy, Canada.

  • - President, COO, Best Buy Canada

  • Thanks, Mike, and good morning, everyone.

  • The Canadian team is excited to be on the call today to discuss the positive momentum in our business.

  • Our journey with our dual brand strategy in Canada has gained significant traction since we reorganized at the end of the last of the fiscal year.

  • We are growing our market share in both brands and in fact we set a new record in July with a combined share of 33%.

  • The past few years have been about an accelerated growth plan to land the Best Buy brand across Canada.

  • We now have 44 new Best Buy stores in all major markets, including eight bilingual stores in Montreal and an English and French website, BestBuy.CA.

  • Our market share for the Best Buy chain has gone from 0 to approximately 10% in just four years.

  • In addition, we continue to grow the Future Shop brand and have added 23 new stores.

  • Since the acquisition, we have more than doubled the annual volume of the Company in Canada.

  • We are very pleased with our second quarter results.

  • Top sales -- total sales growth in the quarter was 17% in local currency and we enjoyed a comparable sales gain of 9.3%.

  • That was driven by flat panel televisions, digital audio, notebooks, and video games.

  • Our underlying gross profit rates were essentially flat, however, total gross profit rate was down since our capitalization rate for vendor support was higher in the quarter compared to the second quarter of last year.

  • Additionally, our operating income rate was negatively impacted by costs associated with the closure of our Geek Squad stand-alone stores in Canada.

  • Our underlying business performance is strong and we expect to increase our operating income rate by 80 to 100 basis points this year as we pursue our longer term goal of 5% operating profit.

  • In order to reach that goal, we need to both control growth and optimization.

  • It is difficult to optimize when you have an explosive growth strategy.

  • This year we're concentrating on the existing store platform, which we're working to optimize.

  • We are doing this by driving brand differentiation, focusing on the core business, and leveraging the enterprise where possible.

  • Over the last few years, we have determined that distinct brand differentiation benefits our employees and customers.

  • We learned that it is difficult for corporate employees in some functions such as merchandising, marketing, and training to serve two brands equally without some biases.

  • Therefore, we separated the two brand teams to facilitate employees working distinctly on behalf of Best Buy or Future Shop..

  • This change was part of our restruction mentioned earlier.

  • It has significantly reduced the number of what we referred to as dual hat corporate employees who work for both brands.

  • And as a result, we have been creating brand champions who better support the uniqueness of each brand and are far more emotionally engaged and connected with our customers.

  • It reduces many of the difficult choices that naturally occur when working for two.

  • It also increases the ability to know your customer and strive to meet his or her needs better.

  • This brand distinction is driving energy, teamwork, execution, and our results.

  • We are also benefiting from all the work we did last year, such as our Home Theater reset, where we reset every Home Theater department in the Company to maximize the flat panel TV business.

  • We're also benefiting from last year's digital audio changes and the Future Shop operating model changes.

  • We will continue to work toward our goal of 5% operating profit rate by further differentiating our brands and delivering solutions to our unique customers.

  • We will leverage our scale as well as the capabilities and tools of the U.S. enterprise.

  • We will expand higher margin services and optimize the operating model.

  • In addition, we will learn from the customer centricity work that has been underway in the U.S.

  • However, we know we cannot blindly adopt concepts from our U.S. counterparts, as we will continue to learn about our unique customers and the solutions they desire.

  • Our topline results demonstrate that the Canadian business is healthy.

  • We are on track and with only half the year behind us, we know that we must continue to execute.

  • We are cautiously optimistic about the remainder of the year, but we're not taking anything for granted.

  • I would like to take this time to thank the entire Canadian team for their hard work and dedication.

  • I'm amazed by their ideas, talents, and passion for serving our brands and customers.

  • Now I would like to turn the call over to Jim Muehlbauer, Senior VP of finance, who will discuss the second quarter financial results of the enterprise.

  • - SVP, Finance

  • Thank you, Kevin.

  • And good morning, everyone.

  • This quarter was a continuation of the positive results we saw in the first quarter.

  • Fiscal year to date, our earnings per diluted share rose 32%.

  • We are off to a very solid start to the year and are on track to deliver our annual EPS growth objective.

  • I plan to discuss the key drivers of the second quarter performance and our outlook for the balance of the year.

  • Starting with our topline, in the second quarter, revenue grew 13% versus last year to $7.6 billion.

  • The gain came from a combination of new store openings and a 3.7% comparable store sales improvement.

  • We saw continued strong growth in our Home Theater business and improved performance in our international business in Canada, as Mike and Kevin just indicated.

  • Also, I'd be remiss if I failed to mention that this quarter is the first time our results have included revenue from our Five Star acquisition in China.

  • Overall, we were pleased with our sales performance in the quarter.

  • Especially with the improvement in July and August, which has continued into the start of the third quarter.

  • The story for the second quarter was the same as the first quarter.

  • Outstanding SG&A rate improvement, partially offset by a modest decline in the gross profit rate.

  • The 25% gross profit rate was slightly below our expectations.

  • As you recall, we expanded the gross profit rate by 130 basis points in the second quarter of last year.

  • We continue to sustain the benefits from structural changes in our model, examples include price optimization, private label, supply chain improvements, and a growing computer services business.

  • More than offsetting these margin gains, however, was the impact of the promotions in the quarter.

  • Particularly in movies and notebooks computers.

  • Results also reflected growth in gaming hardware, as that business carries a lower gross profit rate.

  • Finally, we begin to see the impact -- we have begun to see the impact on our operating model of Five Star, which is expected to be neutral to earnings for the year, but also carries a lower gross profit rate.

  • We continued our efforts to reduce the SG&A run rate while investing in key growth initiatives.

  • Candidly, our SG&A improvement in the quarter was slightly better than expected at 90 basis points.

  • The savings came from lower advertising spending, the continued optimization of our investments in labor, and curtailed use of outside consultants.

  • This brings me to a more important point.

  • We continue to improve our store experience for both customers and employees.

  • During the quarter, we completed the implementation of a faster U.S. point of sale system.

  • The new system reduces checkout times by 20%.

  • We also boosted inventory levels, positioning our stores to serve customers in the back half.

  • Comparable inventory levels increased approximately 10% during the quarter, driven by investments in high growth product categories, such as Home Theater, and notebook computers.

  • The increase reflects our additional Home Theater assortments and new Magnolia home Theater locations.

  • Overall, we are satisfied with both the level and the quality of our inventory.

  • Our differentiation strategy hinges on the successful interactions of employees with customers, and we are not cutting back on that relationship.

  • An important part of the customer experience is our ability to offer end to end solutions, which is why we continue to invest in services.

  • Looking beyond the near term, we are also investing in long-term growth opportunities, like Best Buy for business and China.

  • In short, we are getting strong, short-term financial results, we are differentiating ourselves from the competition, and we are building the new growth platforms that we need for the future.

  • We are very proud of our 32% EPS increase in the first half, yet I'm sure you are more interested in our outlook for the balance of the year.

  • We remain confident in our outlook for the year as fundamentally unchanged from previous expectations.

  • We continue to expect annual EPS of $2.65 to $2.80 per diluted share.

  • And we are certainly encouraged by our first half results and share our customer's continued excitement about the strong Home Theater and gaming product cycles ahead.

  • We are pleased with our position at this point in the year and the flexibility it provides us.

  • We have several strong product cycles and a strategy to provide end to end solutions that no one else can deliver.

  • And while second half comparisons will start to include last year's higher gas prices, we continue to see the same head winds in the market that we've discussed all year.

  • Namely higher interest rates and a slower housing market.

  • We cannot predict the impact of all of these factors on consumer spending in the short-term.

  • We plan to focus on our strategy and continue to invest in areas that our customers prioritize today and which position us for growth, like services, Best Buy for business, and international.

  • For the year, we continue to expect revenue growth of approximately 14%, including a comparable store sales gain of 3 to 5%, plus the impact of new store openings, Pacific sales, and Five Star appliances.

  • From a growth profit rate perspective, we now anticipate a year-over-year decline for the fiscal year similar in magnitude to what we experienced in the second quarter.

  • Let me break down the key drivers behind this outlook.

  • From a mix perspective, we expect our second half gross profit rate to be constrained by the inclusion of Five Star which generates a lower gross profit range.

  • In addition, the acceleration of the gaming cycle in the second half will also constrain margin rates, as our mix shifts towards video game hardware, which I've mentioned is lower margin.

  • As we indicated last quarter, we expect to offset the lower gross profit rate by the excellent progress we are making on the SG&A line.

  • To be clear, we are not expecting the continuation of the 100 basis points of SG&A leverage that we saw in the first half.

  • A primary reason is that we plan to increase advertising spending to support the business during the important holiday shopping season.

  • The timing of this spending matches our business strategy.

  • We are also ramping up our Home Theater efforts in the third quarter, with 142 new Magnolia Home Theater locations and 263 expanded Home Theater departments inside U.S.

  • Best Buy stores.

  • We will also continue to invest in our services business.

  • However, we remain confident that we can obtain sufficient SG&A leverage and achieve our targeted operating profit rate improvement for the fiscal year of approximately 40 basis points.

  • We continue to believe that it is best to share with you an outlook that does not encompass a dramatic change in consumer spending in either direction.

  • We began the year with a middle of the road approach and we are reiterating that perspective.

  • We hope we are being conservative.

  • With the continued mixed signals in the macroeconomic environment and with almost 60% of our annual revenue still in front of us, we believe this approach remains prudent.

  • Most importantly, we continue to focus on delivering results that meet or exceed our expectations for the year.

  • Now I would like to turn the call over to Brad Anderson, our Chief Executive Officer.

  • - CEO, Vice Chairman

  • Thanks, Tim.

  • Before we take questions from our audience, we have one other highlight from the quarter to mention, the addition of two new Board members.

  • Best Buy has always been a growth company and we place a high value of the benefits of growth.

  • Benefits that accrue to our employees our customers, our shareholders and our communities.

  • And as Brian mentioned we recognize that over time more Best Buy's growth may come from new businesses.

  • Whether that be the small business market, the services business, new customer segments, or markets outside of North America.

  • Given our aspirations, we need to build our capabilities in certain areas, such as international growth.

  • And this need includes attracting new outside Board members who would bring us the expertise we need, while supporting our efforts to strengthen our corporate governance.

  • So this summer, the Company was greatly pleased to introduce two new outside members of our Board, Ari Bousbib and Rogelio Rebolledo.

  • Sorry, Rogelio, your last name.

  • Bring to the company impressive track records in international expansion.

  • Ari is a talented global business leader who excels at providing the operating discipline and strategic thinking to transform the organization.

  • The President and CEO of Otis, Ari has developed knowledge of the global markets and significant expertise in China.

  • Rogelio is the President and CEO of Pepsi Bottling Group Mexico and is an accomplished consumer packaging goods leader who can be described as a global citizen and a true internationalist.

  • Entrepreneurial by nature, he possesses expertise in opening businesses in emerging markets, as well as a deep understanding of the multicultural consumer.

  • Both executives also exemplify our company's values on a personal value.

  • So on behalf of our shareholders, we welcome Ari and Rogelio who will stand for election at our next shareholder meeting.

  • We anticipate that both will be invaluable as we pursue the continuation of our growth history, including controlled international expansion.

  • And with that, we'll open the floor to questions, starting with those who did not get their questions answered last time.

  • Operator

  • [OPERATOR INSTRUCTIONS] Our first question is coming from Gregory Melich with Morgan Stanley.

  • - Analyst

  • A question really on TVs, but probably about ten parts, I'll try and cut down to two parts.

  • Flat panels were still up triple digits, which suggests that the rest of the store was probably down in terms of comps.

  • Did that have any impact on margins and then the second part of that question would be, what impact does it have on margins when you layer in attachments and warranties and how have they been trending?

  • - SVP, Merchandising

  • So, Gregory, to answer your question, it's Mike Vitelli.

  • The margins overall with flat panel have been positive for us.

  • The basket has been a positive thing for us.

  • As you can see, the high definition advantage pledge that we're offering is in a sense trying to encourage that in a positive way with our customers.

  • When I look at the second quarter, the issues that impacted the margin were more mix changes than they were the category of television.

  • - Analyst

  • So television's net net were still -- they didn't hurt gross margins and they probably helped?

  • - SVP, Merchandising

  • Correct.

  • And if you layer on warranties, did they increase as you're selling more of these higher priced items, is that helping?

  • Clearly as you sell higher priced items and new technologies, customers look at the warranties as a positive thing when they put the basket together.

  • - CEO, Vice Chairman

  • But in response to the early question, we're looking at a whole transaction when we evaluate it.

  • So we're not just looking at a piece of the transaction.

  • Warranties--.

  • - Analyst

  • To answer the margin question, initially it's looking at a attachments included?

  • - President, COO

  • Absolutely.

  • We're looking at the end to end solution for the customer.

  • We look at the basket of that entire transaction to provide not only benefits to the customer, but also that benefit our operating model.

  • - Analyst

  • And the inventory increase, what would it be if you exclude the acquisitions?

  • - President, COO

  • Well, including the acquisition of year-over-year, we have both Pacific sales in the inventory increase number and we have the Five Star acquisition.

  • About half of the inventory increase, Greg, was based off of the growth in our U.S. business primarily in Home Theater, getting ready for the Magnolia additional stores and the growth in the Home Theater cycle and in the notebook computer portion of our business.

  • - Analyst

  • Okay, I'll let someone else have a chance.

  • Thanks.

  • - IR

  • Next question, please.

  • Operator

  • Our next question is coming from Gary Balter with Credit Suisse.

  • - Analyst

  • Thank you.

  • One question with, of course, a couple parts.

  • All unrelated.

  • - President, COO

  • In other circles known as two questions.

  • - Analyst

  • I learned from Matt, actually.

  • You talked about inventory levels and you mentioned it was mostly in television.

  • This is basically planned, right.

  • We're not looking at softer sales in the categories.

  • That's not part of the question, but I just wanted to follow-up on what Greg just said?

  • - President, COO

  • That's absolutely correct, Gary.

  • As Mike mentioned, our television business is tracking where we thought it would.

  • We are mixing into higher ASP sales, especially as we transition to more Magnolia Home Theater stores within the Best Buy stores which carry a higher inventory value.

  • - CEO, Vice Chairman

  • Yes.

  • Gary, another perspective on quality is when we look at our at-risk inventories in terms of absolute dollars.

  • They are down about 10% year-over-year.

  • - Analyst

  • Okay.

  • - CEO, Vice Chairman

  • Content is strong as well.

  • - Analyst

  • In the first quarter, you talked about lower advertising and you've suggested you'd be picking it up as the year went on and this was a big driver again this quarter.

  • Is that mostly ROP adds, is that circulars?

  • Where are you saving that?

  • And are you planning it -- like, when we look year-over-year for the full year, how much will you have saved on advertising?

  • - CEO, Vice Chairman

  • Principally, Gary, I would say the savings have come in the ROP areas of the business.

  • Again, it's principally because of shift.

  • As Jim highlighted, as we look to the back half of the year, it's not a secret in terms of the energy we're putting behind Home Theater and reconstructing and putting in our Home Theater experience.

  • Along with that, I think you can probably experience as you're watching your TVs and watching your we pledge ads starting to air in the last 30 days.

  • So we've made a deliberate attempt to actually shift those dollars -- not necessarily shift and save all those dollars into the second half of the year.

  • The other thing I wouldn't lose sight of is that when we think about the customer experience and touching more customers, we're actually making more investments in places like Reward Zone.

  • What you can't see in terms of those numbers, I think our overall membership year-over-year is up almost 3 million customers.

  • So there's other types of ways we're reaching customers that quite frankly we think have a higher payback.

  • - President, COO

  • And it's likely that that kind of thing you'll continue to see in subsequent years.

  • Because we're getting a better handle on what the productivity of our spending is.

  • - Analyst

  • You may have talked about this on the call, but did you talk about the monthly trends?

  • - IR

  • Yes we did.

  • - President, COO

  • So, Jim, do you want to repeat?

  • - SVP, Finance

  • Yes.

  • Gary, what I had told is that we're very happy with our overall sales in the quarter, especially with the progression in sales that we saw in July and August, which has continued into early in the third quarter.

  • - Analyst

  • Okay.

  • And this is my question, now and then I'll get off.

  • - CEO, Vice Chairman

  • We appreciate the context of the first four questions.

  • - Analyst

  • You see like AT&T made an announcement today about being able to converge the PC and the TV.

  • And I think Apple, I'm overseas, so I'm not sure id Apple has put out something yet, what they're doing, but how do you think about the convergence -- and obviously that's been something you've been playing towards for years now, how do you think that's going to impact the sales of certain product categories and how are you positioning yourselves as more and more content will be available -- more TV content will be available on PCs?

  • Thanks?

  • - CEO, Vice Chairman

  • Gary, I'll try the first one, the TV side.

  • First off, you're accurate, that there's more places for consumers to consume content than ever before.

  • It's part of what we're doing every day with end to end solutions.

  • We are demonstrating today how MCPC computers can actually get source and content to your TV whether it's licensed content or personal content.

  • Those options are going to proliferate over the next several years.

  • In the short-term, it probably won't have a major impact other than to get people continually excited about the category and their potential sources for high definition and other content.

  • - SVP, Merchandising

  • Lastly, it's also the reason why we're investing so heavily in services because we're going to be connecting it.

  • And that's why we believe that Geek Squad from a computer service and Magnolia Home Theater from an install standpoint are the two critical competencies to make it come together for the customer.

  • - CEO, Vice Chairman

  • And I think an example of that is what you're seeing in the market right now.

  • Where we are putting the skill sets we've got together to do I pledge, which we think is a unique value proposition.

  • We're trying to engineer the enterprise, as that computer integration occurs, we'll also be able to do that in a unique way that no one else can do.

  • - President, COO

  • It also gives, this is Brian, it creates some complexity in the marketplace from the consumer's view, and we think it underscores the importance of our deepening our relationship with the customer and what we're doing with customer centricity to make sure that we're positioned to help the customer navigate.

  • The promise of technology is that it's going to make your life simple and exciting and the paradox is, it's complex to get to the benefits and we think centricity and our connection with the customers is the avenue that we can provide value.

  • - IR

  • And the fourth part of that question was answered by Vitelli, Anderson, and Dunn.

  • - Analyst

  • Thank you very much.

  • - VP, IR

  • Next question, please.

  • Operator

  • Our next question is coming from Steve Turnkraut with Berman Capital.

  • - Analyst

  • Just one question that's not as multifaceted as Gary's.

  • But it's on the online sales.

  • That's growing 35%, it's a growing piece of your business.

  • If you can give us some order of magnitude of how big that is relative to your stores, whether or not it's eating into comp store sales as best you can see, whether or not there's a mix issue, whether or not you're getting as much flat screen TVs sold on that?

  • Things along those lines.

  • Whether or not it will have the similar margins as you'd have in the store?

  • - EVP, Customer Business Group

  • It's John Walden, I might be able to help with that.

  • It's important to keep in mind that the purpose of the online channel is not just to get direct sales.

  • In fact, from the get go, it's really been to be part of a customer experience and leave it up to the customers to decide how and when they want to find information, make purchases et cetera.

  • It's a very important channel.

  • It is important from a direct sales perspective, but it's not overwhelming in terms of its materiality.

  • It is critical in terms of the information it provides and the impact it has on purchases made in the store.

  • So when you look at the whole experience, yes, it's material.

  • When you look just at the direct sales, you get a smaller picture of what the value of that thing really is.

  • - Analyst

  • So it's not necessarily going to change the dynamics of the margin or the SG&A ratios of the overall business?

  • - EVP, Customer Business Group

  • Yes, that's fair, Steve.

  • Maybe context, we've been talking quarter after quarter about different traffic trends in the store.

  • Maybe perspective would be when we look at our traffic trends in the store and we look at our traffic trends online and you actually put those two together, what we're seeing is that we've got positive traffic, no doubt about it, that the customer is using that online channel and the traffic to that channel, I think it's 60% plus are using that channel to do their research and understanding of products before they show up in our stores.

  • So you have to look at them in an integrated way in order to see what's unfolding in terms of both our store performance and our dot com performance.

  • - Analyst

  • Thanks very much.

  • - IR

  • You're welcome.

  • Thanks.

  • Operator

  • Thank you.

  • Our next question is coming from Colin McGranahan with Bernstein.

  • - Analyst

  • Wanted to focus on the gross margin in a couple different ways.

  • First, can you verify, is my math right thinking about the Five Star business with $80 million in revenue in the quarter, obviously that was just for a month and 15 basis point impact.

  • Does that imply that that business is like an 11 to 12% gross margin business?

  • And if so, is there seasonality to that gross margin rate at all?

  • - SVP, Finance

  • Good job with the math.

  • We think you're off by a tenth.

  • - Analyst

  • It's early yet, I haven't had all my coffee.

  • - President, COO, Best Buy Canada

  • So, Bob do you want to answer -- I'm happy to, so that's about right, Colin.

  • And there's publicly available information regarding some of the publicly traded retailers in China.

  • And you'd see that the business model is just very, very different.

  • The gross margins in that business, I'd say you're not far off.

  • Now the good news is, as Jim alluded to, is that we see it for this year as a break even proposition.

  • I don't want to mislead you.

  • We have investing to do in China over the long-term.

  • We see a growth runway in China.

  • So you can see that the way the business model is shaping up, it's a lower margin model today, in part because that's how the marketplace is, but it's also a lower SG&A model as well.

  • - SVP, Finance

  • Because then the supplier assume more of the cost than they do in North America.

  • - Analyst

  • Right.

  • And so if I think about then, just international, I think Kevin said he expects margins in Canada to be up 80 to 100 basis points, so the international should be up something less than that, clearly?

  • - President, COO, Best Buy Canada

  • Yes, in part because you're waiting in China.

  • - Analyst

  • Right.

  • And you didn't disaggregate any impact on SG&A, but I'm, again, assuming it's less than the 15 basis point impact on gross margin because it's less profitable.

  • - President, COO, Best Buy Canada

  • That's correct.

  • - Analyst

  • Is there in the gross margin change year-over-year, is there any change in how you're accounting for vendor funding between gross margin and SG&A?

  • It looks like, have you started to disclose that, not all of that is in cost of goods sold as EITF seemed to kind of push towards.

  • - SVP, Finance

  • Colin, it's Jim Muehlbauer, no, we have not made any changes in our vendor support accounting year-over-year.

  • The trends that we've seen in the U.S. business are consistent with what we saw in the second quarter of last year.

  • - Analyst

  • So of the 35 basis points gross margin erosion, it wasn't just that vendor funding shifted to the SG&A line at all?

  • - SVP, Finance

  • That is correct.

  • - Analyst

  • And then finally, you didn't really comment at all on promotional financing and the overall contribution of the credit card business.

  • Can you comment on that at all?

  • - EVP, CFO

  • Colin, we use that vehicle along with the other tools in our arsenal around reward zone and other promotions as a part of our mix in serving customers and we really haven't seen a dramatic change in the number of customers that have been adopting the financing programs.

  • Clearly, we mix in different offers throughout the year as part of our total customer solution, but clearly the mix of that business has not changed materially.

  • - Analyst

  • And then finally, just Darren, maybe if you could comment on the gross margin I think started out the year as being kind of flat at the end of the first quarter.

  • I think you were saying it would be down 10, 20 basis points now.

  • Back half will be down 50.

  • It looks like the trend is continuing to surprise you a little bit to the downside.

  • Where is the risk to the down 50 in the back half in your mind?

  • - EVP, CFO

  • So Colin, your articulation is right in terms of what we saw in progress.

  • I think we started the year and we said we expected a flat type of year.

  • In the first quarter, as you remember, we were down 10 basis points principally driven as we talked about in the appliance.

  • We had an appliance that helped drag it down a little bit, and then we suggested at that point that it would come down some more because in part, we could see the trends and understand things like what would China effect the gross margin rate.

  • We said in this call I think the math on it is 15 to 20 basis points for the balance of the year.

  • So the core margin of being down 30 basis points is not too far off what we were intimating as we came out of the first quarter in terms of what we could see.

  • That's principally driven by what we can see in the mix of business, in terms of how the businesses will wait out.

  • I think we've talked before.

  • We are looking at the mix of business every month in terms of where the mix of business is going and where the trends are.

  • The good news is, as we look at our overall sales.

  • Our sales are in line with about what we expected.

  • So we're seeing little shifts in the mix.

  • As we look at the balance of the year and we see things coming online from video game and what that will mean in the mix, to Vista to balancing out what the price points will be in flat panel TV, our best view, China included as Jim intimated is that for the balance, we'll see about a 50 basis point erosion the rest of the way.

  • - Analyst

  • That's very helpful.

  • And if limited availability on PS3 that would negatively impact comp, but maybe you do a little bit better on gross?

  • - EVP, CFO

  • That would be the math.

  • - Analyst

  • Okay, thank you, good luck.

  • - IR

  • Thanks, Colin, and thanks Darren for your answer.

  • Next question, please.

  • Operator

  • Our next question is coming from Bill Sims with Citigroup.

  • - Analyst

  • Thank you, good morning.

  • I have one question and one follow-up.

  • First, can you give us any color on LCD supply in the market today and the outlook into the holidays and its impact on ASP declines going into the holidays?

  • - SVP, Merchandising

  • Yes.

  • Bill, this is Mike.

  • The LCD category as more of the major manufacturers are coming on line with their new fabrications are starting, the supply is starting to improve.

  • Last year, we went through the cycle where we actually had a lot of shortages, we don't think we're going to have that situation this year.

  • Plus, probably equally exciting for us, is that the larger screen-sized LCDs are becoming available.

  • Those can be spottily not as available as we would like them to be, as attractive as they are, depending on which manufacturer they're coming from, but in general, LCD availability is solid and good, particularly in the largest screen sizes which we're most concerned about and we're looking forward to that being -- really getting exciting from a customer's point of view in the back half.

  • - Analyst

  • What should we look at from an ASP perspective going forward for the remainder of the year?

  • - SVP, Merchandising

  • ASPs overall have been dropping by 25 to 30% comparable.

  • What's very interesting about it, of course, is everything is getting larger.

  • I liken it a little bit to notebooks.

  • One year a notebook is $2,000, next year, that same $2,000 notebook has a lot more features and options in it, but $2,000 is kind of the mind-set the customer walks in with.

  • Flat panel is getting to a similar position.

  • If you walked in last year with $3,000, you were buying a good 42 inch, now you can walk in with $3,000 and start looking at 50 inch.

  • So people can step to -- the largest screen size, the best technology they can afford. 10 ADP is coming into the market which gets average selling prices up as well.

  • It's a really dynamic and exciting time.

  • The growth in television is really in essence just beginning.

  • - Analyst

  • Thank you.

  • Just one quick follow-up.

  • Can you comment on the appliance business, what are you seeing there, both from a sales comp perspective and any promotional pricing drag and what -- how are you taking steps to address it?

  • Thank you.

  • - SVP, Finance

  • Bill, this is Jim Muehlbauer.

  • I think as we discussed in our release that we did see the comps in that business come down this quarter.

  • Clearly we are seeing an impact based on the housing market overall.

  • We anticipated that when he looked into the back half of the year starting as early as last quarter.

  • Also, from a promotional environment standpoint, we do see competitors continuing to be promotional in the home appliance space.

  • - Analyst

  • Thank you.

  • Thank you, Jim.

  • Next question please.

  • Operator

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

  • - Analyst

  • Good morning.

  • Can you talk a little bit about the profitability profile for the services business and how it's changing.

  • This year, is the services business accretive to operating margins and EPS and is it more or less so than last year given some of the investments that you mentioned you were making in things like Best Buy for business and the Magnolia Home Theater installers?

  • - SVP, Finance

  • I'd be happy -- Jim Muehlbauer again, I'd be happy to talk about that.

  • I think as we've talked before, we are still in the early days of our services business.

  • If it's a nine inning ball game, we're in the first couple innings.

  • But we continue to see enhanced profitability from a gross profit standpoint on the enterprise based on the growth in that services business.

  • We've also talked about our continued desire to invest in the infrastructure to support that business.

  • The technological improvements that we're providing our agents to serve customers, we continue to see opportunities to invest around those and Shawn has talked before about really focusing on the productivity of our agents this year, using some of those tools and capabilities.

  • So we continue to see gross profit enhancements for the enterprise as that business grows in our mix, but we also continue to invest in the future because it is very early in our business cycle with services business.

  • - CEO, Vice Chairman

  • It also should be apparent now with why our current campaign of HD done right, that we couldn't begin to make that claim without the investment we're making in the services business.

  • - Analyst

  • And I just have one follow-up question on the promotional environment.

  • Can you just clarify a little bit some of what you said about the changes in the credit offers?

  • Because we've seen a step up in the length of the deals for home theater, but I think on the call you mentioned that the promotional intensity has actually increased in notebooks and DVDs.

  • So what exactly is happening in terms of credit offers in TVs?

  • Because I wasn't entirely clear on that, whether or not it's become more promotional or not?

  • - SVP, Finance

  • So let me start that response and maybe I'll have Mike Vitelli round off with some of that.

  • As we look overall at the level of financing offers that we utilize in our business model, they have been flat.

  • So we move that financing offer around at different times of the year and within different product categories.

  • So my earlier comments were basically focused on the enterprise year-over-year.

  • Certainly within the home theater space, we've been using different offers from a financing standpoint, but our overall attachment of financing to transactions has not changed in our portfolio year-over-year.

  • - SVP, Merchandising

  • Yes.

  • Jim, I think that's right.

  • We use different levers at different times.

  • Right now, this week, we're at 36 month financing and another week we'll be 12.

  • It will go in and out based upon what we're trying to do that particular week.

  • - Analyst

  • So you're saying even though you might increase the length of the deal, maybe it would be offset by the fact that fewer people would take advantage.

  • So year-over-year, there wouldn't be any change in the impact?

  • - EVP, CFO

  • Yes.

  • So maybe the button is right down to the core -- when we look at our gross margin rate year-over-year this quarter versus last quarter, the impact on our gross margin rate was essentially no impact.

  • So it was no more costly this year than last year on a rate basis.

  • As interest rates move, there are incentives that we have with our banking partner based upon the different plans that consumers choose.

  • But ultimately, as Mike alluded to, we will move those based upon what the consumer is looking for and based upon what they're looking for in working with our banking partner, what we can see in the numbers for this quarter for sure is that there's no impact essentially year-over-year in our gross margin rate related to financing.

  • - IR

  • Those answers came from Jim, Mike, and Darren respectively.

  • Now for our last question, please.

  • Operator

  • Our next question is coming from David Strasser with Banc of America Securities.

  • - Analyst

  • I may have missed it, but I was wondering within the consumer electronics category, where some of the deceleration was in the second quarter and how MP3 players in particular did?

  • And if you can follow-up, the relative percent of the overall mix of MP3 players in the mix, and how that has changed over the last year or so or two years?

  • - IR

  • Well, David, you know, we don't give product mix percentages, but, Mike, would you like to comment?

  • - SVP, Merchandising

  • The second quarter, MP3 players in general as an industry were flat to down and we experienced modest single digit increases there from a comp sales point of view.

  • And we're hoping that there's going to be some exciting announcements in the marketplace in the next several hours.

  • - Analyst

  • Yes, because everyone is kind of hoping that.

  • Are you seeing anything change as far as a mix between say, Microsoft and other MP3 players within your store?

  • Is there any traction being gained outside of iPods?

  • - SVP, Merchandising

  • It's limited and Microsoft specifically hasn't introduced their new product yet, but in general the media player or your plays for sure type of devices is still modest as a part of the mix compared to Apple's.

  • - Analyst

  • And just going into the back half of the year, how are you thinking of this category within the context of your guidance?

  • I don't know if you know what they're going to say today or not, but how are you thinking about this category within the context of the guidance going into the back half?

  • - EVP, CFO

  • The way I'd say it is that as I talked about earlier, and I'll have Mike jump in is that we're trending the business every 12 months.

  • As Mike said, as we close out the second quarter, in this space, the space in general is slightly down.

  • We were up.

  • And we feel good about that.

  • Part of it is, if you can tell us how the launch will do, we will factor that in as we turn the next month and the next month and the next month in terms of the trends of the business and how the consumers are reacting to the new launches.

  • I think in total, honestly given the strength of this category for the last 18 months, we feel good about where we're at and what it will contribute for the back half of the year.

  • - VP, IR

  • Okay, thank you.

  • - Analyst

  • Appreciate it.

  • - SVP, Merchandising

  • Thank you.

  • - EVP, CFO

  • Thank you.

  • - IR

  • Thanks, Mike and Darren, and thanks to our audience for participating in our second quarter earnings conference call.

  • As a reminder, a replay will be available by dialing 973-341-3080 and entering the personal identification number of 7734097.

  • The replay will be available from about 1:00 p.m.

  • Eastern time today until midnight next Tuesday, September 19.

  • You can also hear the replay on www.bestbuy.com, just click on, for our investors.

  • If you have additional questions, please call Jennifer Driscoll at 612-291-6110, Charles Marentette at 612-291-6184 or me, Karla Haugen at 612-291-6146.

  • Reporters on the other hand should contact Sue Busch, Director of Corporate Public Relations at 612-291-6114 and that concludes our call.

  • Operator

  • Thank you, that does conclude today's teleconference.

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