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Operator
Welcome to Best Buy's conference call for the second quarter of fiscal 2013.
At this time, all participants are in a listen-only mode.
Later, we will conduct a question-and-answer session.
(Operator Instructions)
As a reminder, this call is being recorded for playback and will be available by 12 PM Eastern time today.
(Operator Instructions)
I would now like to turn the conference call over to Bill Seymour, Vice President of Investor Relations.
Please go ahead, sir.
- VP, IR
(Technical difficulty) -- conference call.
We have two speakers today, Mike Mikan, our Interim CEO and Jim Muehlbauer, our CFO.
After our prepared remarks, we'll be happy to take Q&A.
A few items before we get started, as usually the media are participating in this call on a listen-only mode.
Let me remind you that comments made by me or by others representing Best Buy may contain forward-looking statements, which are subject to risk and uncertainties.
Our SEC filings contain additional information about factors that could cause actual results to differ from Management's expectations.
Please note that our reported results this morning include non-GAAP financial measures.
These results should not be confused with the GAAP numbers we reported this morning in our earnings release or with the GAAP numbers we will report in our 10-Q.
For GAAP to non-GAAP reconciliations of our reported to adjusted results and guidance, please refer to the supplemental schedules in this morning's news release.
Now, I'd like to turn the call over to Mike.
- Interim CEO
Thanks, Bill.
Thanks to all for joining the call.
Last spring, Best Buy's Board of Directors established an independent search process to name a successor to former CEO Brian Dunn, who resigned in April.
That process has been conducted thoroughly and with great care and has resulted in the Board's decision, announced yesterday, to name Hubert Joly as Best Buy's new Chief Executive.
We are all very excited about the prospects of Hubert joining this organization.
Hubert brings tremendous experience to the job.
He has served the last eight years at Carlson, a global company based right here in Minneapolis.
He's got local roots, but he's also got a great deal of international experience.
He has specific experience in corporate turnarounds, exactly what Best Buy needs at this moment.
Over the last three months, Best Buy's management team has worked to define opportunities, initiatives and actions to move the Company forward.
Hubert will inherit a good deal of advanced work on that front.
The team has begun to confront the challenges Best Buy faces.
We have examined ways to expand our services in digital offerings, while reducing costs and cutting square footage.
This work will be shared with the Company's new CEO as he comes on-board.
I know you will understand, it would not be fair to him to discuss the details today, while rest assured, the work will be shared with Hubert as he transitions into the Company.
I, along with the full Executive team, will do everything we can do to ensure a smooth transition, to provide continuity of leadership and to make sure he has the benefits of the good work done to date so that he hits the ground running.
Let me briefly discuss the performance of the Company.
As we've been discussing for some time now, the Company continues to face significant challenges.
As is widely known, markets in China and Europe are facing enormous difficulties and that has had a negative impact on us.
In the US, economic conditions are soft and will probably remain so for the indefinite future.
Consumers remain very cautious and sales in the industry may be dampened at the moment by those who are holding back on spending as they await some highly anticipated new technology releases.
Like virtually every other competitor in the consumer electronics sector, Best Buy's second quarter reflects these realities.
However, we have made progress and we are building on it.
For instance, even in a weak economy and a challenging environment for retailers, our domestic US comp sales trend improved 210 basis points from the first quarter.
We also maintain our market share.
Best Buy continued to expand our services offerings, signing partnership deals with Verizon and Target, which underscores the Company's move beyond the traditional big box.
We reduced costs, big box square footage was down 4% and revenue per square foot was up slightly.
Moreover, we continued to see strong growth in connection and revenue generated online.
Each of these are areas where we have provided deliberate focus and actions over the past several months.
All that said, Best Buy clearly remains in turnaround, which will take time to come out of.
Given that reality and the fact that we've just welcomed a new CEO to the Company, we are suspending Best Buy's share repurchases and earnings guidance for fiscal year 2013.
In taking these actions, we are, as you would expect, providing Hubert with the flexibility and the opportunity to make decisions on these and other important matters as he addresses the broader challenges ahead.
I will now turn it over to Jim.
- CFO
Thanks, Mike.
As Mike said, our second quarter performance is a reflection of the current product cycle challenges in CE hardware, highlighted by industry weakness across several large categories.
Q2 did see an improvement in comparable store sales trends compared to Q1, but this was overshadowed by lower gross profit rates, driven by unfavorable mix of sales within mobile phones and televisions, additional promotional activity in the computing category and weak performance in our international business.
I'll cover each of these items in more detail shortly.
From a revenue perspective, consumer demand in several large categories continues to be challenged, but our domestic market share during the quarter was up a little from the prior year.
In fact, according to external sources, our market share for the quarter, year-to-date and trailing 12 months are all at or above levels of the previous year.
The domestic segment comp sales decline of 1.6% in Q2 represented improvement over the 3.7% decline in Q1, strong growth from tablets, mobile phones, appliances and eReaders was more than offset by weakness in categories like gaming, digital imaging, televisions and notebooks.
The product categories having the most notable improvement from Q1 to Q2 were stronger growth in mobile phones and smaller declines from notebooks and gaming products.
There's speculation by some, that a portion of the current industry softness may be from customers holding off purchases until some of the highly anticipated new product launches hit later this year.
It remains to be seen how much customers are truly waiting, but what we do know is that we have seen this phenomena play out before and there are significant product launches expected in the second half that will provide some tailwind to sales.
We continue to make progress on expanding our online sales.
During Q2, online sales increased 14%, ahead of the industry, led by traffic growth and a strong increase in conversion rate.
Q2 comparable store sales in the international segment declined approximately 8%, showing modest sequential improvement from Q1, but still did not deliver at the levels planned for the quarter.
The weak results in international clearly continue to weigh on the Company's overall sales and operating income performance in the first half.
Specifically, comp sales in our Five Star business improved modestly from Q1, when it was down 28%.
We're seeing continued weakness in the China CE market that appears to be consistent across major competitors.
This decline is attributable to lower consumer spending as growth in the Chinese economy slows, weakness in the housing market and by the absence of government-sponsored rebate programs for appliances and other products.
In Canada, a high single-digit comp decline was a result of continued industry softness in notebooks, digital imaging and home theater, similar to trends in our business in the US.
Like the US, overall market share in Canada was also about flat.
Our business in Europe posted a low single-digit comp sales decline in Q2, improving from the mid-single digit decline experienced in Q1.
The sequential improvement was driven by increased promotional activity in a competitive environment.
The largest change in the quarter's performance was from the decline in the gross profit rate.
We planned Q2 gross margins to be below last year, but the actual decline was more than we anticipated.
Given the significant impact on our results, I want to make sure that we spend some time clearly laying out the key drivers.
Let's start with our domestic segment.
First, we saw improvements in sales mix between product categories that favorably impacted year-over-year gross profit rate, driven by strong mobile phone growth and lower notebook sales in the mix.
However, this favorable impact was offset by three factors that reduced our rates in the domestic segment.
First, in mobile phones, where we achieved strong comp sales of 35%.
We sold a significantly greater mix of higher ASP smartphones as compared to last year, which led to a strong increase in gross profit dollars, although at a lower gross profit rate.
Second, as Q2 progressed, we saw lower industry unit volumes in notebooks than we anticipated.
In response, we added promotional activity to stimulate consumer demand.
While these actions improved sales trends, added market share and helped manage our inventory levels, they also reduced rates.
We consider these moves necessary as we position ourselves for the second half, which will include the important launch of Windows 8. Finally, in televisions, we saw mid single-digit unit growth in the quarter.
However, the growth was driven by more consumer demand in small and mid-sized screens, where ASP compression has been most prominent and where margin rates are traditionally lower.
Moving to the international segment.
The gross profit rate declined 130 basis points in Q2.
Predominantly driven by increased mix in the wholesale business and promotional activity to stimulate demand on mobile phones in Europe.
Looking forward into the second half, there are several factors which indicate that the level of gross profit rate decline experienced in Q2 will improve.
These items include -- lower promotional activity in computing, given new product launches; benefits from tech support services beginning to contribute meaningfully to gross profit rate; and eased margin compression within mobile phones, as the mix of handsets sold becomes very comparable to last year.
We continue to control SG&A and spending during the second quarter was below our plan.
Q2 SG&A decreased 2%, as we benefited from previously announced actions to reduce costs through changes in our corporate and field operating models, by adjusting labor to match demand and from store closures.
For the year, our cost reduction programs remain on track and total SG&A spending is now expected to be lower than our original plans.
Looking back at the first half of the year in total, here's what we've seen.
Performance weakness from our international segment has led to an operating loss of $83 million in the first half.
Macroeconomic conditions in Europe and China and lower sales in Canada continue to provide challenging headwinds.
Our domestic business is generally in line with our original first half expectations, and we have successfully maintained domestic market share.
SG&A spending is down versus last year and is below plan.
However, we also see potential trends that indicate a more challenging industry and consumer demand environment than we had anticipated at the beginning of the year.
Looking into the second half of the year, there are some positive tailwinds as we sit here today.
There are multiple new product releases that we expect to drive increased consumer demand in key categories.
SG&A spending is expected to come in below our original plan.
We also have headwinds to confront.
We are not expecting major improvements in our key international businesses.
We now expect lower industry revenue than our original expectations in computing, digital cameras, and gaming and less favorable sales mix in key hardware categories.
We see indicators suggesting improved domestic gross margins in the second half as outlined earlier, but still expect gross margins to be down for the full year.
Moving to our full year outlook, as you know, we have a vast majority of our annual earnings still in front of us.
As I've just covered, there's a lot of variability as the second half industry and consumer demand plays out.
However, based on our current outlook, we have lowered our earnings expectations for the full year results.
Given these expectations and in light of the CEO announcement that we made yesterday, we believe that it is appropriate to remove our annual guidance for fiscal 2013.
We will, of course, continue to provide qualitative forward-looking commentary on the business.
For example, we do expect our free cash flow for fiscal 2013 to be in the range of $1.25 billion to $1.5 billion.
I've covered a lot today and we're happy to provide more color during the Q&A.
For now, I'll turn the call back to Mike.
- Interim CEO
Thanks, Jim.
Let me offer just one final reflection.
Having spent the last four months operating on the inside of this great Company, I've had the opportunity to learn about the business in detail.
I've talked to customers.
I've met with store employees, gained a deeper understanding of the distinctive assets and the power of the brand and the partnerships we have with vendors.
Based on these experiences, I'm more optimistic than ever about Best Buy's future.
I look forward to continuing that journey as I return to the Board as Chairman of the Audit Committee.
Thank you everyone.
Now, we'll turn it over to the operator for Q&A.
Operator
(Operator Instructions)
Alan Rifkin, Barclays.
- Analyst
I guess if I'm permitted just one question, it's kind of a philosophical one.
If your domestic business essentially came in line your expectations and Europe on a sequential basis actually improved, I'm trying to understand why are you suspending your official earnings guidance as well as the share buyback program?
Is it a function of greater uncertainty in the marketplace or does the potential exist that Mr Joly will have a different strategic plan for the second half, which may impact your earnings and your buyback activity?
- CFO
Hi, Alan.
It's Jim Muehlbauer.
Two things.
First off, as we talk about the domestic business being in line with our first half expectations.
As we discussed, we were over our planned expectations in Q1 in our domestic business.
The business started to soften from an industry standpoint in Q2.
When I put the two quarters together, we're basically in line.
Looking forward, as we talked about on the call, we certainly have a lot of variability in how the year is going to play out from a consumer demand standpoint, especially with the key product launches we see in the back half of the year.
Candidly, the visibility to the magnitude of the impact of those launches is very variable at this point in time, especially given the concentration of sales we have over the holiday season.
That coupled with giving Hubert some time to come in and understand the business and assess where he wants to take the organization long term, we believe that the best thing to do in light of those two circumstances was to give him the flexibility, which basically resulted in us deciding to take guidance away for the balance of the year, really to give him a chance to digest what's happening in the business model.
- Analyst
Okay.
So can we expect to hear on your third quarter call if not before, a detailed strategic plan for Mr Joly as to where he wants to take your business going forward?
- Interim CEO
Hi, Alan.
It's Mike.
I don't want to get ahead of Hubert and his digestion of all the work that we've been doing and the impact that he will choose to take.
But I can assure you that Hubert is a decision maker.
He's action-oriented and he will come to the marketplace as appropriate.
So, he'll hit the ground running and take on all the great work that has been done over the last several months.
Operator
Greg Melich, ISI Group.
- Analyst
I want to focus on the margin trends, Jim, versus your plan.
You said SG&A, in particular, came in a little better than expected, getting some costs out faster.
Could you relay what those costs were and if we think this rate that you've done, the down 2%, can be maintained?
- CFO
Yes, Greg.
As you know, from the beginning of the year, we put plans in place to dramatically lower our cost structure.
We made several of those moves starting at the end of last year and through Q1 around some of the organizational changes we made in our operating model, both in our corporate offices and our field locations.
We've also been trimming back expenses in a variety of areas of the business, so that we can make sure that we fund the important investments around the growing and profitable parts of the portfolio, especially in our Best Buy mobile business and our service business.
So, the good news is that we continue to invest in those businesses.
As you saw from our results in the second quarter, we continue to see strong growth in our services business and in our phone business and we're investing SG&A behind that.
We continue to expect to take costs out as we go throughout the year.
Our plans for the year are actually more bullish on the amount of costs that we can take out and we've reflected that in our forward-looking view as well.
Candidly, we've got a lot of work to do over the long-term in taking costs and right-sizing the business to the opportunities you see going forward.
So we still certainly believe that what we're doing in FY 2013 is just a good start on those fronts.
There's more opportunities to take costs out for the long-term.
- Interim CEO
Greg, it's Mike.
I would also suggest that as we go forward, reflecting the actions that we -- the aggressive actions we're starting to take with our cost structure in terms of our store portfolio and footprint, we also want to be looking at the store productivity and revenue per square foot and seeing that improve.
You started to see that this quarter with an improvement of 1%.
It's slightly up.
But our intention is to demonstrate that improvement over time.
Operator
David Schick, Stifel Nicolaus.
- Analyst
I want to talk about the global sales slowdown that you're talking about.
Do you think that there's a new -- and some of the product cycle discussion around that.
Is it a new pattern that's forming, in terms of purchases?
Is there a longer duration between television purchases?
Your insights as to how consumers are looking at purchases of some of the higher ticket stuff outside of the obvious Windows 8 cycle would be helpful.
- President, Americas - Enterprise EVP
Good morning.
This is Mike Vitelli.
Thank you for the question.
What we're seeing, is we focus a tremendous amount of our attention in the first half and in fact, globally on some of the key categories that we've seen tremendous consumer interest in, mobile and connected products.
So we've grown our revenue in mobile phones and tablets.
We grew our share in both of those categories and into computing; those are areas that we're seeing strong consumer interest.
We wanted to make sure that we were positioning ourselves in that place for the second half of those launches came out.
Appliances as an industry are relatively stable.
We grew our -- we grew both our comps and our share in that category as well.
So the place where you're seeing slowdown has been in some of the more traditional categories like television and that's right we were in our plan.
We expected this year, there to be a decline there.
That's playing out to be true.
Units are up, ASPs are down.
That's something that's playing out literally around the globe in the television category.
- Analyst
So Mike, do you think that's a change in how often -- historically, there was an idea that there was a replacement cycle.
Is that replacement cycle changing due to cord cutting or changing due to technology or is there something changing in that?
- President, Americas - Enterprise EVP
Well, I think it's actually more -- if you think of the fact that units are actually up year over year, consumers are buying as many televisions -- more televisions than they were a year ago.
Their costs are lower.
In that sense, the interest in television and the interest in entertainment is actually continuing to grow.
There are more devices to choose from.
We've got tablets, we've got mobile phones that have that capability.
So there are more products that are there.
But there's really no new data that we have that's suggesting that replacement cycles are changing.
Operator
Scot Ciccarelli, RBC Capital Markets.
- Analyst
I do understand you guys have suspended guidance.
I think we all understand that.
But given the look -- the comments you've made regarding the broad sales slowdown as well as the gross margin degradation, is there any reason to believe that the year over year trends in operating income will be much different in the second half from what we saw in the second quarter?
- CFO
Yes, we certainly expect that the trends that we saw in the second quarter, based on what we see right now going forward, are not going to extend in the back half of the year in the same way.
I do want to highlight specifically in what we've talked about in the sales trends and margin trends in our business, are not things that we see unique to Best Buy.
We certainly see them being driven by the same industry mix factors that are happening in the business and basically being driven by what consumers are currently interested in buying in key categories, whether it's smartphones, whether it's the activity we see in the tablets and current notebook space.
Once again, just given the vast amount of consumer activity in the back half of the year around the holidays, it's difficult to predict around where consumers are actually going to go during that period, especially with all new releases that are coming out.
Quite candidly, we just don't want to get out too far in front of us, given the uncertainty around demand in the environment and the impact of those releases in general.
Operator
Michael Baker, Deutsche Bank.
- Analyst
I wonder if you guys are going to be willing to address any of the movement around the buyout offer from your former Chairman and CEO?
If so, just wondering the thought process on what occurred over the weekend in terms of the disagreement and some of the language in terms of the standstill agreements.
It sounded to me, as if the Board was open to discussing things with Dick Schultz, but couldn't come to an agreement on some of the language around that.
Is that a correct characterization?
- Interim CEO
You know, Michael, I appreciate the question.
We've been -- we've issued release -- the Board has issued responses to that and releases.
As of now, the only thing I would add to what's been out there in the public marketplace is, our proposal still stands.
We feel it's up to Dick to respond from there.
But that's all I really have to add at this time.
Operator
Michael Lasser, UBS.
- Analyst
Along those lines, Mike, can you just expand and shed a little light on how the Board is thinking about maximizing shareholder value?
We're getting snippets of a lot of different things right now and it's hard to dimension what the strategy is.
- Interim CEO
Well, thanks for the question.
As we've been talking about for several months now, we're focused on building out a strategic plan that is what we believe to be a better Best Buy for the future.
As I stated earlier, Hubert will come in and take a look at the elements of the things we've been working on and bring those to further action as appropriate, so that's first.
Second, getting a permanent CEO in place was a big objective of the Board.
As you know, originally when we discussed the transition to interim and ultimately to permanent, we talked about six to nine months.
The Board has acted -- in our mind, we've acted swiftly in getting what we think is a great candidate in that role for the future in about a four month time period.
So a lot of heavy work has been there.
But with respect to long-term value, I'd also just have you look at where we believe we are today.
You're seeing some of the improvements that we've been working on with our cost structure, which is important.
But we've got a very strong financial position.
We remain with a strong balance sheet with significant assets to leverage, strong free cash flow with diversified businesses.
So the Board continues to focus on the strategic plan with a permanent CEO to execute against that.
We'll do that swiftly as Hubert comes in at his time line.
Operator
David Strasser, Janney Capital Markets.
- Analyst
So there's a lot obviously going on whether it's the offer, it's the new CEO transition, it's tough business environment.
What's the mood as you walk around the headquarters?
Even more importantly, as you visit stores -- I mean, how impaired do you think the mood is around the Company?
How hard is that going to be to get back or do you feel relatively comfortable there?
- Interim CEO
Obviously Best Buy has gone through -- has had -- we've had our challenges.
The things that are playing out in the public marketplace is a distraction.
I can't say that it isn't impacting the -- I'll call it, the engagement of employees.
That being said, everyone's focused on improving business performance.
There's a great passion and belief in the brand of Best Buy.
So, for the most part, we believe that whether it's in the stores or within the corporate campus here, that people are looking to the future and are excited about the prospects.
We're going to continue to stay focused at and I believe that with the announcement of a permanent CEO, that brings additional stability to the organization and people feel good about that.
So overall, we feel like we're in positive territory with respect to employee engagement.
Operator
Matthew Fassler, Goldman Sachs.
- Interim CEO
Matt, Vitelli wanted to add something on the end of that, just real quick.
Then you can ask your question.
Thanks.
- Analyst
No problem.
- President, Americas - Enterprise EVP
Michael, I just wanted to add -- you talked about the mood in the field.
I wanted to emphasize -- because we did talk about what the sales performance has been.
We had double-digit comps in cell phones, tablets and e-Readers, major appliances and our services group.
We just put in a new operating model in our stores that's starting right now in our second half.
We're incentivizing team-based performance in our mobile department, our computer and tablet department and our home department.
We've put training in place that we're now bringing all of our people through.
Our teams are excited about that.
We've also started to open some of our new stores.
Our Richfield store is open.
Our Territory General Managers, the eight of them, were in yesterday and actually took a tour there.
Some of them had not seen it before -- although several had, some hadn't.
It's a very exciting environment.
We are so pleased with the early reaction that our employees are having, our customers are having, the comp sales performance, our services growth, all things that we're expecting.
It's very early.
It's been open for a month.
But the US operating model that we put in place, the incentives and training we have for our salespeople, our supervisors as coaches, our assistant managers focusing on our services, connectivity and home business and the new stores, we're excited as we move into the second half.
- Analyst
I guess it's my turn now.
You made a point of having held market share this quarter, but your gross margin obviously came under some unanticipated pressure.
I realize that the answer to this question will probably evolve over the next number of months.
But are you running the business these days with share in mind or profit in mind and how are you prioritizing the two?
- CFO
Matt, it's Jim.
We're running the business with both in mind.
We have to be cognizant of what customers are interested in buying in different windows of time and when you look at the margin in any one individual quarter, you could get mixed messages in what the long-term business plan looks like.
The reality of our margins in the quarter, we expected them to be down.
It was down more than we thought, primarily because we had fewer smartphones available last year.
If you remember in Q2 last year, there was -- we were in between launch cycles on smartphones.
We're more fully in stock this year.
The reality of those higher priced smartphones, they still come with the same margin value for the connection we get, but the price point's higher, that which drives the margin rate down.
That's just an industry phenomenon, doesn't speak any different than how we're running the mobile phone business year over year.
In the computing space, we've seen all first half of the year, that the notebook industry is just softer than was anticipated heading into the launch of Windows 8 in the back half of the year.
We'll see if that volume comes back as part of that launch, but in the meantime what we're doing is, we're making sure that we remain competitive and that we drive foot steps into our store and that we have relevant, strong market share in that important category as customers come in and begin shopping for Windows 8. The value of the inventory we have in categories like that, we have to stay on top of those levels as well.
We did some prudent things during the quarter to manage that.
So we don't anticipate those activities going forward, given the product cycle we'll see in the back half of the year.
Then specifically, also from a market standpoint in televisions, when consumers mix into lower ASP TVs in the mid size and small size TV, that's a market phenomenon across the board.
We just get lower margin rates for those and we have less attach of our services and other products on those items.
So, really none of those are changes in strategies from Best Buy's standpoint.
We're trying to maximize gross profit dollars based on what consumers want to buy and we see that mix of sales improving in the back half of the year.
It's just difficult once again, given the range of potential outcomes around the various new product launches to see exactly where that's going to go.
Operator
Peter Keith, Piper Jaffray.
- Analyst
Jim, just a follow-on to what you had mentioned with a range of product launches -- clearly in mentioning Windows 8. Could you give us an idea though, of what some of these product launches are that are coming out and where you have some uncertainty around the timing?
- President, Americas - Enterprise EVP
This is Mike Vitelli.
Thanks.
What's exciting, there are launches in all the categories that we focus on.
There are launches coming out in tablets.
There's launches coming out in smartphones, launches in e-Readers.
There's a gaming launch that's scheduled.
So there are launches in a lot of key categories that we focused our attention on that we've grown with double-digit comps and that we've grown share in.
So we're looking forward to that as they come out.
A lot will begin to happen in the third quarter when you get into that October period.
So October, November are always significant, but they seem to be more significant and concentrated this year.
Operator
David Magee, SunTrust Robinson Humphrey.
- Analyst
Just a quick question on how important you think the UPP pricing structure might be in the second half of the year and what might drive better large screen TV demand.
- President, Americas - Enterprise EVP
This is Mike Vitelli again.
So UPP, Unilateral Pricing Policies, the intent there is from whatever category it is, is to stabilize the pricing of the product under those categories.
What we've seen is that's succeeding.
We're seeing manufacturers hold onto those plans.
There's a greater focus in profitability particularly at our TV vendors, but we're seeing it in other categories as well.
So, manufacturers trying to bring value for their products and our sales team that's well trained to be able to present those values to consumers, we think is a good combination.
- Analyst
Do you see anything that would improve large screen TV demand?
- President, Americas - Enterprise EVP
Large TV demand is going to based on the prices that they're putting in the marketplace and what they're competing against.
So, UPP is not looking to create demand but to stabilize value.
But we think the balance between demand creation and profitability will be a better one for the industry overall in the second half.
Operator
Thank you.
Ladies and gentlemen, this does conclude today's conference call.
Thank you for your participation.
You may now disconnect.