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Best Buy Co., Inc. (NYSE:BBY)

F1Q07 Earnings Conference Call

June 13, 2006 10:00 am EST

Executives

Jennifer Driscoll - VP, IR

Brad Anderson – Vice Chairman, CEO

Brian Dunn – President, COO

Darren Jackson – EVP, CFO

John Walden – EVP, Customer Business Groups

Ron Boire – EVP, Gen. Merch. Manager

Analysts

Matthew Fassler – Goldman Sachs

Brian Nagel – UBS

David Magee – SunTrust Robinson Humphrey

Mark Rowen – Prudential

Rex Henderson – Raymond James

Mitch Kaiser – Piper Jaffray

Andy Hargreaves – Pacific Crest Securities

Scot Ciccarelli – RBC Capital Markets

Steve Chick – JP Morgan

Mike Baker – Deutsche Bank

Presentation

Operator

Ladies and gentlemen, thank you for standing by. Welcome to Best Buy’s conference call for the first quarter of fiscal 2007. (Operator Instructions) I would now like to turn the call over to Jennifer Driscoll, Vice President of Investor Relations.

Jennifer Driscoll

Thank you, Jackie. Good morning, everyone. Thank you for participating in our first quarter conference call. This morning we have three main speakers: Brad Anderson, CEO, who will provide his context on this quarter’s results. He’ll also explain the three philosophies that define our customer centricity work at Best Buy. We have Brian Dunn, President and Chief Operating Officer, who is joining us by phone to describe how we’re changing how we make decisions about resources and to give you an update on one of our strategic priorities for the year. Last we have Darren Jackson, Executive Vice President of Finance and CFO, who will cover our quarterly results and our fiscal 2007 outlook. As usual, we also have a broad management group here to answer your questions at the end of our formal remarks.

I’d like to remind you that comments made by me or by others representing Best Buy may contain forward-looking statements which are, of course, 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 in case you miss a portion of the call.

Let me give you the replay instructions. Simply dial 973-341-3080 and then enter our personal identification number for this call, 7456420. The replay will be available from approximately 1 p.m. Eastern time today until midnight on Tuesday, June 20.

I’d like to remind all of our callers that we plan to take your questions after we conclude our prepared remarks. Please limit yourself to one question. That way we can include more callers in our Q&A session. Consistent with our approach in prior calls, we will move to the end of the queue those who were able to ask a question on last quarter’s call.

With that I’ll turn the call over to Brad Anderson, Vice Chairman and CEO, who will begin our prepared remarks.

Brad Anderson

Thank you, Jennifer. I thought I’d start off with trying to put some context around our results. We’ve been saying the transformations are not linear and I think we just illustrated it with this first quarter. We’re very proud, obviously, of the 38% earnings increase and it’s obviously significantly better than we expected to do.

The thrust, the core story for a long-term shareholder is what we’re trying to do as an institution. What I’d like to do is give you some context about whether we’re making progress on that core agenda.

The Company, when we started this transformation -- the word we’re using in terms of transformation is the fundamental change in where we’re going as an organization -- really came at it with two fundamental challenges. The first of which is we were running to the end of the horizon on the growth strategy that we’d used throughout the 90s and the first part of 2000, and the Company has a history as a growth culture and one we strongly wanted to retain and affirm.

Second is, we knew that large enterprises have enormous challenges with growth. As we looked into why large enterprises have challenges with growth, we thought there were really essentially two core problems, one of which is that the organizations have trouble using the insight of the people with the best context in the organization, which are people closest to the customer.

They have trouble using that for a very good reason, which is that the bigger the Company gets, the harder it is for people in those jobs to actually understand enough about the organization to be able to use their input in the very ways that help refine and grow a company. As a smaller company that had used that insight regularly to grow, we knew this was a major problem.

We thought that there was a hypothesis, that is the central hypothesis we’re using as an organization, which is that at the very moment in time we are selling literally the tools that potentially provide the information to the people with the greatest insight - who are the people in our organization who are closest to the customers - to be able to overcome that challenge and be able to use that creativity to allow us to grow and reinvent the Company.

Sounds like a relatively complex point of view. It’s actually very simple. One part of it is the people closest to the customer have the greatest context and the best ability to create.

The second part of it is that one of the other things that happens is if you don’t get a chance to be heard, your incentive to do great work diminishes. We believe that the potential to disseminate information and be able to hear our employees better, using the very technology that we sell, provides us with an enormous opportunity to have a growth engine as a large enterprise that has been very hard for other companies to produce.

So as you watch our story of this transformation move forward, we suggest you look at whether or not the evidence is that we are able to do this. We are still at the very early stages of trying to accomplish this. What we have been able to do at this point is define specifically the core measurements for us that are going to tell us whether we’re making progress or not.

The first of these directly connects to what I was talking about before, that we are harnessing the power of our employees. There’s evidence that we’re harnessing the power of our employees because we are using their particular insight in growing the enterprise. So, core measurement in terms of what kind of progress are we making on that front. As Brian and Darren discuss the kind of progress that we’ve made in the first quarter, I think you’ll be able to see evidence that we’re beginning to be able to use that insight very effectively, and that it’s also effective in terms of the engagement of our employees.

The second is that we’re treating each customer uniquely and honoring the differences between our customers. We’ve got to stay in close contact with our customers; obviously, the closer our employee is to that contact point, the better. By providing them with increased financial information about the results and more information about what we’re trying to achieve, we believe that we can make more consistently unique offerings to our customers.

The third is that we’re attempting to meet our customer’s unique needs from an end to end perspective. We know that our products are very complex, but the challenge of sorting through and making the product simpler and more fun to use is a core challenge that we’re taking on as an enterprise.

So those three core things you’ll hear us talk about again and again. An engaged employee that’s helping us recreate the enterprise, treating each customer as unique and third, trying to meet the customer’s needs from an end to end basis.

In conclusion, this morning’s earnings report shows a couple of things. First it shows we’re reaping the benefits from our prior investments in customer centricity. Second, our bottom line shows that we are redeploying our investments to fund initiatives that will fund future growth. As we grow, we intend to apply the three core customer centric philosophies across all of our new investments and strategy with careful adherence to these philosophies that we believe will not only give us focus but also reduce the risk of new ventures.

An example of this for us in the investment we’re making in China, where we plan to apply the same lens I talked about earlier in the Chinese market and one that we think will give us a significant competitive advantage, similar to the advantage that we’ve had in North America.

With that I’d like to turn it over to Brian Dunn so Brian can talk about a couple of specific examples of how we’re beginning to harness this advantage.

Brian Dunn

Thanks, Brad. Good morning, everyone. I’d like to use my time on the call to give everyone a real life example of how these three philosophies shape the specific Company priority. But before I do that, I’d like to share with you my point of view about our work to lower SG&A expenses, what it’s really about and what it’s not about.

Last year we accelerated customer centricity. We planted seeds in every garden where we saw the potential for growth. At the end of the third quarter, we had an SG&A bill that showed it. But we also had a rich landscape of growth opportunities. We told you that we would prioritize our growth initiatives and make choices. We’ve done that. Our choices are reflected in our six priorities for the year.

We also said we’d focus on efficiency and effectiveness. In the fourth quarter, we started to redeploy resources and this work has gained momentum in the first quarter.

Cost cutting gets the headlines, but I want to be clear about this. This work is not about cutting costs; it’s about focusing our people and our financial resources on the things that matter. It’s about harvesting resources from areas that have matured so that we can reinvest in growth initiatives with higher potential returns, like Geek Squad services, like small business capabilities, like total solution selling and international expansion.

That’s what it’s about. It’s about figuring out what we need to do to differentiate Best Buy and grow the Company over 5, 10, 15, 20 years and beyond. It’s about freeing up capacity to fuel new initiatives and continue our long tradition as a growth company.

One more thing this work was not: it was not a top down initiative. In the true spirit of the philosophies Brad just discussed, we engaged our employees in the process. People from all parts of the Company and from all levels of the organization. People who are close to the customer.

It’s easy to say, but I can back it up with an example. I’d like to tell you about just one of the internal groups that played a key role in deploying our resources more effectively. It’s a group of store managers, general managers, assistant managers and district staff members who call themselves the Watchdog Network. They believe that if we just listen to each other, we can come up with better plans that satisfy headquarters and work in the field. That’s how the Watchdog Network approach their work. They came back with some really powerful, really simple ideas.

At their recommendation, we made some changes that those of us at headquarters might not have considered. We might have even ruled some of them out. The Watchdog group felt that most stores could operate with five assistant managers rather than seven. They recommended redeploying the headcount to fund new supervisory positions at Geek Squad Precincts, which we really needed, given the growth in our services business. Their recommendations also let us preserve funding for customer-facing employees. I appreciate their work; I applaud it, and I’m pleased to publicly acknowledge them for it.

Next, as I alluded to earlier, I’d like to give you an update on our progress with our strategic priorities. But rather than run through a laundry list of all six which you can read about in our annual report, I’d like to focus on one strategic priority. This one, like the others, was shaped by and reflects the three philosophies of customer centricity Brad just described.

The strategic priority I want to talk about is focused on bringing a differentiated home theater experience to more customers. We’ve told you that we intend to increase the number of locations with Magnolia Home Theater this year to about 300 stores, up from 127 stores today.

But here’s something we haven’t told you: this priority goes well beyond Magnolia Home Theater. It’s also about improving the entire Best Buy home theater experience at these locations. We didn’t start out with the idea that we would makeover our whole home theater department, but that’s the point and what is special about customer centricity. Here’s how it went:

When our home theater employees saw that we treated customers uniquely inside Magnolia Home Theater locations, saw us meeting their unique needs end to end, they had a natural question: Why would we offer a home theater experience anywhere else in the store that’s any different?

They made another important observation. They noticed who was coming into the Magnolia room. It wasn’t just the affluent, early-adopter male customer we’d expected. Time-starved suburban moms loved the Magnolia rooms. Our young entertainment enthusiasts raved about it. And the value-oriented family man aspired to it, even if he eventually made his purchase in the Best Buy home theater area.

So hundred of Best Buy home theater employees were making their own observations, drawing their own conclusions about what we should do as a Company with this part of our business. We had an opportunity to listen to each other and to our customers, and we did it.

Let me back up for a minute to remind you of the history. When we acquired Magnolia in 2000, we saw the accolades and the industry awards Magnolia won year after year. But customer traffic was declining, and earnings were below plan. I think that blinded us a bit, so we didn’t fully appreciate the growth opportunity inside Magnolia.

We didn’t recognize that other customers would appreciate what Magnolia offers and frankly, we doubted vendors would let us bring the business inside Best Buy stores. And then, coincidentally, we launched ourselves into customer centricity and a Best Buy team was assembled to get a better understanding of the affluent early adopter.

Somehow the people at Magnolia got wind of this work. They asked “Hey, we own a company that’s being doing this for decades. Can we talk?” The Best Buy team listened and adapted. That was the beginning of what later became the Magnolia Home Theater concept, but it was more than just that. The people who led that first team, people like Jim [Tweeten], Julie Gilbert, Sean [Score] and Dean Kimberly gave us all a blueprint for how a diverse team of people can get things done in a great big company.

That brings me back to my point. After we launched the first Magnolia Home Theaters, our customers and our employees were both screaming for a better home theater experience at Best Buy outside the walls of Magnolia Home Theater. Their voices are leading us down a path different from the one we would have traveled.

In fact, what we’re scaling today is substantially different from the experience we initially tested. What we’re scaling today at 200 more stores this year, is home theater how customers want to experience it and how employees said to do it. It is the quintessential Magnolia Home Theater experience, coupled with an equally compelling but more accessible experience in the home theater department of Best Buy.

We have created an end to end powerhouse: the right brands, and the right presentation. We believe it will appeal to a broader range of customers and allow the creation of a unique customized solution for each individual.

We have a terrific story unfolding. I’ve described what’s happening in home theater. It’s just one example of how customer centricity works. We have the same opportunity for collaboration with other parts of our business: Pacific Sales, Five Star Appliances, Best Buy Canada, Best Buy for Business, Geek Squad. Customer centricity keeps us nimble. It keeps us connected to our customers. All we have to do is to keep listening to those closest to the customer and focus like a laser on those last ten feet, where it really counts.

With that, I’ll turn the call over to Darren.

Darren Jackson

Great. Thank you, Brian. Good morning, everyone. Our year is off to a terrific start as our top line and our bottom line exceeded our expectations. This is three years in a row that our first quarter results have significantly outperformed our expectations.

Starting with our top line, our revenue grew 14% versus last year, to $7 billion. The combination of new stores, the solid 4.9% comparable store sales improvement and the acquisition of Pacific Sales supported the revenue gain. The 4.9% comp was modestly above our expectations. We had expected a slowdown from the fourth quarter’s 7.3% comp run rate on account of macroeconomic factors including higher interest rates and gas prices.

Yet our international segment showed no signs of slowdown. They generated a 7.1% comparable store sales gain for the first quarter.

Similarly, our dot com business posted a gain of over 30% and our high-end Magnolia standalone stores posted a 22% comparable store gain in the quarter.

The gross profit rate declined a modest 10 basis points in Q1 compared to last year. In the first quarter of last year we enjoyed a stellar 150 basis point increase in our gross profit rate. We expected a 10 basis point improvement in this first quarter.

The good news is, we continue to see year over year structural gains from Geek Squad, sourcing and other supply chain initiatives.

The bad news is the appliance business experienced a significant decline in its gross profit rate. Overall, the decline reduced our Company gross profit rate by nearly 30 basis points in the quarter. A combination of a more price competitive environment and higher product costs related to steel accounted for the erosion.

But overall, we are content with our gross profit rate for the Company in the quarter.

Gross profit rate for the balance of the year is more likely to be flat or down modestly. Our revised outlook is based upon the mix of product sales versus a step change in the competitive environment. We anticipate offsetting the gross profit rate impact with sales volume and SG&A savings.

The SG&A rate improved 110 basis points, despite severance and restructuring costs of approximately $26 million, or $0.03 per share. These costs added nearly 40 basis points to the rate for the quarter.

We cannot cut our way to prosperity, but we certainly are in better shape to make the trip. The savings came from across the pea patch. The principal drivers of the savings were advertising, outside service reductions, occupancy cost savings and reduced levels of travel. Collectively, these cost reductions accounted for 90% of the savings.

Equally important, we protected our investments where they matter most, closest to the customer, as we kept our store payroll and benefits rate essentially flat year over year. We systematically edited our SG&A run rate over the last two quarters, while delivering sales above our expectations. That’s tough to do and I want to thank all of our employees for their focus and execution, which delivered these results.

So what does the balance of the year hold for the SG&A rate? Originally we guided to 30 to 40 basis points of SG&A rate improvement for the year. Clearly, we are more bullish on meeting or exceeding the high end of our expectations. Some may ask, why not 100 basis points for the year? It’s pretty straightforward. The last two quarters have been about surgical editing and reallocation of costs. The balance of the year will be a combination of further editing and investing, so we would expect the leverage to moderate.

In addition, we constrained certain strategic areas in the first quarter, a pattern we expect to amend during the balance of the year. Specifically, our material investments will land in the second and third quarters as we scale our expanded home theater solution to approximately 300 stores, add elements of Best Buy for Business to approximately 220 stores, add to our service capabilities and further invest in our advertising related to key initiative launches.

We are deploying our resources to maximize the spaces that important to our customers. As flat-panel TVs become increasingly popular and more affordable we are investing in home theater experience, which Brian described earlier. As consumers begin to learn about and ultimately adopt Vista, we are also investing in service capabilities to help customers maximize and customize this new platform. As young technology-loving customers gear up for three new gaming platforms, we are investing in building out great experiences in our store to capture that opportunity.

I know many of you are pushing the phone buttons right now to ask, “What about the economic outlook?” so I want to give you our perspective.

In short, the landscape has not fundamentally changed since the start of the year. Our fiscal 2007 guidance that we gave a couple of months ago contemplated mixed signals that we saw in the economic landscape. Gas prices, interest rates and housing starts were headwinds then and they are today.

At the same time, we have tailwinds from the unemployment level, consumer confidence and a remarkably strong product cycle. As Ron tells me, wants can be more powerful than needs sometimes. We cannot forecast or control the external factors, but we are obviously very encouraged by our results thus far and are making investments to capitalize on what we can control and what customers are prioritizing.

To conclude, we are encouraged with the start to the year. Candidly, we are ahead of where we expected. Practically, we remain upbeat about the balance of the year. Our strong start gives us more flexibility as we evaluate investments for the remainder of the year.

Realistically, we think it’s too early in the year to change our view on earnings. We have more than 80% of the year still ahead of us. More importantly, we are not changing our focus on delivering results that meet or exceed our expectations for the year.

With that, we’ll now take questions for our investor audience.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from Matthew Fassler of Goldman Sachs.

Matthew Fassler – Goldman Sachs

Thanks a lot, and good morning. Darren, thanks for that detailed accounting of the quarter.

Darren Jackson

Good morning, Matt.

Matthew Fassler – Goldman Sachs

Good morning. How are you? I’d like my question to focus on SG&A. In the press release they had on your commentary you really called out two specific areas. One was advertising and one was strategic investments. Those seem to be the biggest line items, other than simple expense leverage from better sales, that drove the improvement.

Can you help us understand the relative importance of each of those? On the strategic investment side, centricity formats I guess, in particular, sort of understand, you know, the magnitude of the decline year-to-year in the first quarter? And perhaps how you’re spending on those initiatives in the middle of the year will compare with where they were a year go.

Darren Jackson

Matt, a way to think about our SG&A rate -- I’ll talk about the first quarter specifically -- is that, if you add back the restructuring charges, our SG&A rate leverage was 150 basis points. A way to think about it is a third, a third, a third. You know, a third of it principally in the advertising area, a third of it due to the sale leverage in terms of productivity gains on the business, and a third in terms of absolute cuts that we made in places like outside services, travel and some occupancy cost areas. So that’s how it’s made up.

I think one of the things that doesn’t necessarily come out when you just look at the SG&A save that I think is critical to understand is that what we saw in the quarter is a sequential pickup that we’ve seen from the third quarter to the fourth quarter to the first quarter now, in our overall labor productivity.

And you can see that, that shows up in the top line when we do nearly a 5% comp and we’re able to moderate some of our advertising. So I think there was a healthy balance between making some of the adjustments that we made and seeing the productivity pickup sequentially quarter to quarter as we finished out this first quarter.

Matthew Fassler – Goldman Sachs

Darren, if I can just follow up on that answer with two just real quick ones. The one-third of the reductions that related to advertising, are those going to be reversed, if you will, or at least returned to something more like last year’s run rate through the remainder of the year, since you talked to short-term cuts, if you will, in the release?

Secondly, among the three items you gave you didn’t specifically talk to format conversion. Is that one of those three buckets, or is that separate?

Darren Jackson

So that was six questions, Matt, so I’ll try to break that down. The advertising I would say, Matt, I don’t think we should locked on a permanent 50 point basis point savings.

If you look at strategically where we’re going to make our investments in the second and third quarter in home theater solutions, the growth of Geek related to Vista and those capabilities, you would ask yourself, should we be moderating our advertising and applying it to the quarters with the combined launch of the three game platforms? You would expect us to be moderating those investments, consistent with where we see opportunities to support evolutions in the brand, evolutions in launches and where we see bigger opportunities as we go throughout the balance of the year.

So that’s one. So I wouldn’t write down, say, 50 basis points through the end of time. We’re going to save a chunk of that because the team is finding different ways to apply advertising dollars that are more productive and we’re going to strategically use that consistent with our strategic investments across the balance of the year.

Two, because there were six questions –

John Walden

Format conversions. Matt, it’s John Walden. Maybe I can help with that question. You know, we’ve talked before about how we’ve moved from a smaller scale adoption of customer centricity where we deployed it in waves of stores, where we invested in converting specific stores, and that made sense early because we could measure results compared to the balance of the Company.

We can no longer do that because we’re now touching virtually every store in the Company with some customer centricity conversion. Every store is trained on customers they should focus on. Every store has been trained on how to operate with a model that talks to customers and is conscious of what they’re needs are.

And, as we deploy Magnolia Home Theater, other home theater experience upgrades, Best Buy for Business, services changes, we’re pretty much touching every store. So we no longer are converting individual stores and measuring the cost the way we did last year.

We’re really now adopting every store as a customer-centric store, and deciding which solutions to deploy based on which ones have demonstrated success in our customer labs and which ones we think will be more successful out in the field.

Darren Jackson

We’re also doing initial work on new segments as well.

John Walden

We have to look at customer centricity different. It’s the whole chain now and every store; it’s not certain stores versus others.

Operator

Thank you. Your next question is from Brian Nagel of UBS.

Brian Nagel – UBS

Hi. Good morning. I wanted to ask a question regarding the demand environment for flat-screen TVs in the first quarter. Over the past few weeks we’ve had a few reports from various manufacturers that talk about seriously weaker demand. But your numbers today still show demand as strong. Can you just articulate upon the trends in the quarter to help us square up with what we’re hearing from both you and some of the manufacturers overseas? Thanks.

Ron Boire

Hi, Brian. This is Ron. I’m surprised it took so long to get to flat panel today. We think obviously there’s been some shift in worldwide demand. LG made an announcement, [inaudible] made an announcement. The two big components of those announcements really are around, I think, smaller screen flat panel aimed at the computer market. So if you think about the global desktop environment on one side of the equation. And probably a little bit bigger expectations than would have been reasonable in the European market from the other side of the equation.

We are still, as you’ve already noted, seeing significant growth in flat panel. We are on or above our plan and our expectations in the flat-panel space. We’re, as Brian spoke about in the call, continuing to really lean into this cycle with the acceleration of our Magnolia strategy in 300 stores by the back half of this year.

And finally, I met personally with one of the largest global producers that had a factory in the global business for one of the largest LCD producers, yesterday and as larger panels come online, there’s still some struggle to meet demand on the largest panel size. So I think you’re seeing a blend of things going on here.

Fundamentally, this is a market that is growing extremely rapidly and we’re working hard to stay ahead of the curve on it.

Brian Nagel – UBS

Just to follow up on that, as far as your business went did you see any -- as far as price declines at retail through the quarter or any changes in margin -- did anything deviate significantly from your plan there?

Ron Boire

No. I think the price trend was pretty much right on our plan. We went through a transition in the back half of the quarter which affected price but simply a standard kind of transitional pricing issues. We’re staying with our 15% to 25% annualized expected decline in price.

Brian, for you and the balance of the people on the call, we look at prices on a kind of a per inch basis; we’re not looking at it like the manufacturing side looks at it. But in aggregate, our trends should be pretty similar to what the manufacturers are reporting to you.

Operator

We’ll move on to the next question, which is from Mark Rowen of Prudential.

Mark Rowen - Prudential

Thank you. Good morning. Congratulations on a nice quarter.

Darren Jackson

Thank you.

Mark Rowen - Prudential

A couple of questions. The revenue out-performance that you saw in the first part of the quarter, that suggests that you saw a slowdown maybe mid April when a lot of other retailers saw a slowdown. Can you confirm that and then talk about what you saw in May and early June; has that picked up from that slowdown?

Darren Jackson

Mark, I don’t ever remember talking about a slowdown so . . .

Mark Rowen - Prudential

Well, a slowdown from the revenue out-performance in the first part of the quarter you talked about.

Darren Jackson

Nope. So when we look across the quarter in terms of the three months that comprise the first quarter, with each month we exceeded our plan and so early on, when we saw the year coming, I think in my comments as I shared with you, we anticipated a sequential slowdown from the fourth quarter to the first quarter for the reasons we talked about.

I think our planning teams did a nice job recognizing calendar shifts and as I look across each month of the quarter we beat our expectations, honestly.

As to second quarter and beyond, you know, we’ll talk about those at the end of the second quarter call at this point. But I think what you should glean from our comments were we expected a mixed environment and we’re planning the business that way and we’re pleased that in light of what we expected, we’re able to outperform in terms of our own internal expectations for the first quarter.

Mark Rowen - Prudential

So Darren, are you saying that you didn’t see a slowdown that other retailers saw at middle of April? That just didn’t affect you?

Darren Jackson

Yeah, what I’m saying Mark is that our plans anticipated the seasonality of the business and whether it was up in the beginning and down at the end, in the middle, our seasonality forecasted those bumps and we were able to exceed those in each month; at least modestly in each month.

Operator

Thank you. Your next question is from Rex Henderson of Raymond James.

Rex Henderson – Raymond James

Thank you, and congratulations on a great quarter. I had a clarifying question on the SG&A issue. I was wondering about the reduction year over year in the spending on customer centricity conversions and how much of your SG&A is reflective of that particular issue? And I’m not sure I got a clear understanding of that prior to this.

Darren Jackson

So why don’t I frame it and then maybe John will add a few comments going forward. One of the clear benefits in the first quarter is really the absence of the level of investment spending that we had a year ago. If you actually look back to our year ago results, we said on average we added not less than 60 basis points across the year in terms of investment spending in terms of building -- not just, we tend to think of segmented stores or customer centricity, but we also had the launch of Geek Squad and other initiatives last year.

We clearly benefit in this first quarter because honestly we spent more time editing than investing. And we spent more time working with the stores and the teams to build productivity at the store level than layering on new things that tend to bog down productivity and increase our SG&A rate.

So that’s why we had guided as we looked to the second and third quarter, which will have the bulk of our new home theater solutions, Best Buy for Business, new service capabilities, we would expect as we layer on some of those investments that initially, what we learned last year is there is a productivity dip before there is a productivity increase.

I think the first quarter experienced a lot of the increases from the things that we invested in in Q3 and Q4, and I think going forward the good news is we’ve edited the expense base so we can moderate some of those dips in productivity and we have things coming through the pipeline that keep improving in their productivity.

Rex Henderson – Raymond James

Okay. Thank you.

A second follow up on the flat-panel television question and that is on ASP. You said that your prices per square inch continue to decline in the 25% range, but what about the average selling price? Are customers trading up to bigger and more features so that your ASP holds up or rises?

Ron Boire

I think what we said is that we’re on plan for ASP decline. We expect the year to be in the 15 to 25 range, and we continue to mix up in ASP broadly.

The third comment around mixing up we hadn’t specifically addressed, but that’s been about a four-year trend for us and that continued in Q1.

Operator

Thank you. Your next question is from Mitch Kaiser of Piper Jaffray.

Mitch Kaiser – Piper Jaffray

Good morning, guys. Congratulations. I was wondering if you could comment, I know you’ve launched a couple of key initiatives within Geek Squad, namely Geek Squad City and also testing service depots in Office Depot stores so I was wondering if you could elaborate a little bit on those and what opportunities those might give to the services business?

Darren Jackson

Yeah, thanks Mitch. So why don’t I explain Geek Squad City to those who may not know. Geek Squad City is, we have made a decision to centralize some of our service depot capabilities in Memphis. What that allows us to do honestly is improve productivity, improve the customer experience and improve turn times.

I’d say at this point it’s early because the teams are busy putting together the center and getting it fully staffed and the good news is we see further productivity gains and a better customer experience down the road. So early at this point.

Question two . . .

Mitch Kaiser – Piper Jaffray

On Office Depot and the strategic rationale. Was that more to get into the small business segment in a more meaningful way?

Brad Anderson

Maybe I’ll comment on that. One of the things you should see are themes for Best Buy as we continue to develop new brands. It’s because new brands are going to be part of our growth story with Geek Squad being one of those. It’s our overall intent not to constrain the brand from growing where the brand would grow because of its association with Best Buy.

So at this point the Office Depot is a test to find out if its beneficial for Geek Squad and for Office Depot. But that will be the basis on which we make a determination as to whether we go forward and what kind of configuration in terms of how both companies look at it.

But essentially this was an opportunity for Geek Squad to reach new customers and as a growing business, part of our portfolio, that would be a very encouraging thing for us to pursue.

Jennifer Driscoll

Thank you, Brad. Next question, please.

Operator

Thank you. Your next question is from Andy Hargreaves of Pacific Crest Securities.

Andy Hargreaves – Pacific Crest Securities

Hi. I’m just wondering, you know this time last year we had a similar quarter in terms of beating expectations and you were raising guidance. So now you talk about quite a few things that are a little bit different this year but wondering if you could just clarify exactly what it is that’s keeping you steady this year as opposed to last year?

Brad Anderson

Well, we said last year at the first quarter that we didn’t actually raise guidance for the year except for some adjustments of what we’d seen already in the first quarter.

We basically are saying the same argument, that essentially transformations are not linear and that we cannot predict exactly what happens with – take Brian’s portion of the presentation. If we have the benefit that Brian believes we’ll have – I share that belief – but if we have the benefit out of those, those benefits will occur during the course of the year, but they’re a hypothesis as to what the benefit is.

So as we’re trying to forecast, the reason we stepped away from forecasting quarterly, is we’re trying to forecast with as many new initiatives as this Company has which I think, I hope, will be an ongoing brand or trademark of the Company because we want to stay a growth company, you can’t forecast precisely what’s going to happen on something that’s genuinely new.

So we’ve always got this kind of rough degree of – we can forecast expenses fairly well. We can’t forecast revenue growth on things that do not have a track record.

So we’re leaving ourselves some room with a desire to outperform, but we also know we’re capable of having things like the surprise, the negative surprise we had in the third quarter last year when we find investments we make don’t work out as fast, or as we had hypothesized initially.

Andy Hargreaves – Pacific Crest Securities

On the flat panels can I ask just if you’ve seen any change in the accessory attach rate or the attach rate of audio or anything like that?

Ron Boire

Well we certainly with Magnolia have some leading indicators that there’s a big opportunity for attaching better audio. If you actually look at the total wallet available to home theater, as those TV prices, or specifically flat panel, become more attainable, more of that wallet is available to wrap things around them such as home theater installation; such as walking out of the store with a digital or high definition source or home audio.

We’ve seen strong leading indicators from our Magnolia business that that could be a cycle that we finally begin to lean in a little bit after the last four or five years of struggling with audio.

Brad Anderson

And it gives us the chance to do a little translation of the earlier points we were making in the call. When Brian’s talking about the sales force in the stores seeing what’s happening with whole solutions at Magnolia and saying why aren’t we bringing those to the Best Buy customers? The way you’ll see it if you’re looking at financial results ultimately is in improved sales of other products surrounding home theater.

So it’s from a product centric standpoint when you ultimately see the outcome of this work. You’ll see it in increased sales of things like home theater and other related products. But the genesis point we were trying to reveal was how we got to the point where we start to eventually get that benefit in product.

Ron Boire

That’s the fundamental output of customer centricity. You go from engaged employees to meeting each customer’s unique needs to an end to end solution. That should be the output. We’ve seen that in our MP3 business. We’ve seen that in our notebook business as the quality of the sale over, specifically at transaction time but also over time becomes better and better. We’re also I think starting to see that in flat panel.

Operator

Thank you. Your next question is from Scot Ciccarelli of RBC Capital Markets.

Scot Ciccarelli – RBC Capital Markets

Hey, guys. How are you? Can you comment on the performance and outlook for Geek Squad as you start to assimilate all the infrastructure you’ve built up over the last few years? In other words, with the Office Depot experience, do you guys still consider yourselves in an investment phase or are we at the point on the maturity curve where you can really start to leverage that piece of the business? Thanks.

Ron Boire

Hi, Scot, this is Ron. I would say that we are still in the investment stage. We are building out the brand, the capability, the infrastructure around services broadly.

What you see now is the tip of the spear which is really Geek Squad. This is the most visible thing. We’ve talked about our home theater strategy and the investment in infrastructure that is supporting Geek Squad, will support that strategy as well. The investments you’re seeing in Geek Squad City we think will make a material change in the customer experience in the store and the employee experience.

So we are, as you know, we feel getting great returns from our current Geek Squad business but that really is, I would describe it as the tip of the spear in a much bigger strategy around services and we are certainly very early in that strategy.

Scot Ciccarelli – RBC Capital Markets

So theoretically that’s a business that should become increasingly profitable as we kind of move down the timeline?

Ron Boire

I would say increasingly accretive and increasingly material to the total enterprise.

Darren Jackson

So it may be a little hard at this stage to see, like as you see with the experiment with Office Depot, it may be hard at this stage to see where the investment stages may be in that business. It depends on what the ultimate size and scale of the business will grow to.

Ron Boire

Scot, some of the expectations out there for Geek and services we would characterize as very ambitious in terms of what we’re reading. Candidly, what we’re thrilled with is the progress that they’re making in terms of both top line margin growth in the quarter and bottom line profitability. We just want to make sure they don’t get too far ahead of reality.

What we’re recognizing is service is a complex business and we’re building new capabilities both in terms of how to train and develop service technicians. We’re going through right now a major systems investment to enable it. We’re putting a whole centralized depot and I’ll tell you our past experience in centralized depot management, we’re going to learn our way through that.

All that being said, it’s one of the few businesses that starts from essentially nothing to what we’d say is a level of profitability, both principally in profit rate and now it’s becoming more meaningful in profit dollars, that we’re very pleased with.

What we want to make sure is that we continue to recognize where it is in the growth curve. It’s still probably closer to the second inning than the seventh inning, and it’s key at this point to continue to balance both the capability maturation process and making sure that the customer experience isn’t damaged. So I’d say we’re still early but excited in terms of progress that we’re making.

Scot Ciccarelli – RBC Capital Markets

Helpful. Thank you.

Jennifer Driscoll

Thank you; that was Ron and Darren. Next question, please.

Operator

Thank you. Your next question is from Steve Chick of JP Morgan.

Steve Chick – JP Morgan

Hi. Thanks. Good quarter. Darren, just a follow-up question to I guess the sales progression during the quarter, you know, maybe to Mark’s question. If you could get a little bit more granular, I know that you mentioned how sales performed relative to your expectations, but what exactly were your expectations as the quarter went on when you talk about expecting a softer environment?

I know there are only a couple of weeks but post quarter end, where [inaudible] kind of relative to where you exited?

Darren Jackson

Steve, maybe I wasn’t clear. Our expectations were three to five in the quarter and for the year. And so if we’re performing within that band, quite frankly, that’s how we position the profit formula to get the results we were.

You know as to post -- and I’m not trying to be evasive at this point but I’ll give you an example -- You have seasonality in the calendar. We have a small event that I appreciate every year called Father’s Day coming up. That will shift any one daily performance at this point. We’re a few weeks into the quarter; got Father’s Day coming up. I don’t know; they like flat-panel TVs. You know, that will shift in terms of performance day to day.

I’d say the way to read our numbers -- and again we are not trying to be evasive -- is that if we’re managing the business between a three and a five throughout the balance of the year, we’re feeling good about that. We think in some months, could it be below three? You bet. In some months has it been above five? You bet. We think that it will continue to be bumpy for the reasons that we talked about.

All that being said, you can glean from our comments that the quarter in total was above where we expected it to be. As we look to the balance of the year, we continue to have confidence in the top line; as Brian suggested, that there’d be a little more pressure in terms of the margin line. But we think that that will be offset by our confidence in the top line.

Steve Chick – JP Morgan

Okay. I was just thinking with the consumer confidence number that came out in May I was really trying to see if there was a noted deceleration in the last month of the quarter, but I think you’ve been clear enough.

So I guess a second question is, you mentioned the expectations on services were a little bit ambitious. Can you give us a little more granularity possibly on what Geek or what services in total represent as a percentage of your total revenues? Are you guys ready to speak to it in that type of fashion?

Ron Boire

This is Ron. I’ll speak to expectations. I think what Darren was saying is that the external expectations seem to be outsized from time to time. I think internally we are on our expectations. We know that we’re a couple years into this strategy. Darren talked about the significant investments we’re making in infrastructure. Some of them have been talked about on this call already. To build out a services platform that you can plug in not just Geek Squad, but multiple different services offerings.

So our expectations are large, but we’re right on them. I think what Darren was trying to say is externally there’s been perhaps some outsized expectations or unrealistic expectations as to what Geek or services may represent.

As to what we report, I’ll let Darren comment a little bit on the plans there.

Darren Jackson

I would say this. Geek is just one element of services. Home theater installation is another element of services. If you think about how that integrates into the greater strategy of end-to-end solutions [going], I think there’s this desire to say breakout services and that is a different part of your business. It’s not. It’s absolutely integral to the thing that is the biggest part of the Best Buy engine today, which is the products it supports and the customers it supports.

As we look to the future we see an integrated product in selling solutions for our customers that’s services, just like accessories before that, software before that and the product come together within the categories of business that form the profitability of that end to end solution.

Brad Anderson

And this is the heart of what we’re trying to talk about.

Darren Jackson

Exactly.

Brad Anderson

That’s why we keep talking about customer centricity, because the customer does not define the solution by its pieces. We can’t take a piece out and say, this is what’s actually happening with the transaction and give you any kind of realistic picture of what’s actually happening with the business.

Darren Jackson

So I’ll give you a little live ammo on that. This fall, in our Q4, Microsoft will launch Vista. You know we could carve out Vista and say, you know, X number of agents, this many PCs installed this many Vista solutions. That’s the wrong point of view. The right point of view is these customers need a solution; they need the upgrade path or an easy installation path and it’s going to be the end-to-end solution which is enabled in part by services, by Geek Squad and by frankly, the talented people on the floor engaging the customer and really digging out what the need is.

The customer is not coming in saying give me a service rep. They’re coming in saying help me make my computer work. And by the way I’d really love to be able to see my family pictures on this cool, high-def flat-panel TV I just bought. So it’s broader than just having people that can make wireless work for you. It’s about what the people do with it.

Brad Anderson

An example might be to watch what’s happened as other mass market guys have talked about the difficulty of selling flat-panel TVs based on the return rate. If you look at a transaction without looking at it holistically and its component points, you won’t get a financial outcome that makes sense.

Darren Jackson

It really hurts me that they’re having such a hard time.

Jennifer Driscoll

Okay. One lucky caller is going to get to ask the last question.

Operator

Your final question is from Mike Baker of Deutsche Bank.

Mike Baker – Deutsche Bank

Hi, how are you guys? A couple of questions on the gross margin. So I think, Darren, you had said that something in the mix is what you think will lead to flattish margins over the coming quarters? So can you tell us what you’re seeing that is different in the mix?

Related to the gross margin, the promotional activity, you spoke about the appliance promotions. What do see in terms of the TV promotional activity? Thanks.

Darren Jackson

Yeah, we think the mix of digital, specifically you’re talking about TV mix and the continued mix of MP3 will be contributors to the margin and flatten out a little bit.

From a promotional environment standpoint, we have not seen anything overly aggressive in flat panel to date, but as we’ve talked about in previous calls, things like the mix of gaming into the balance of the year, the launch of Vista, we expect the acceleration from the PC business in the balance of the year. A continued aggressive driving of the flat panel and MP3 business. We think all bode to a change in mix that could see a flat rate, if you will, and better margin dollars in the balance of the year.

Mike Baker – Deutsche Bank

So MP3, gaming, Vista, things along those lines are lower margin. Is flat panel still a higher margin business, or is that sort of trending back towards, you know, average or below even?

Darren Jackson

Well, we don’t comment on specific category margin rates. And again, on balance, to put it in perspective, when we gave guidance I think we said up 10 basis points. We’re now saying flat to modestly down.

You know, we’re looking at the mix of business, every day practically, but every 30 days. And it’s just our best view based upon the velocity charts that we see today that suggests there is just - fundamentally, the velocity suggests that it could be flat to down this year.

But we didn’t want the group to walk away with that there’s just been this step change in the pricing environment because there hasn’t been. Where there has been a change in appliances, we’ve highlighted that for you. But we just wanted to provide that context as we look out the balance of the year.

Jennifer Driscoll

Thank you, Darren. And thank you, Jackie, and thanks to our audience for participating in our first quarter earnings conference call.

As a reminder, the replay will be available by dialing 973 341 3080 and entering the personal identification number of 7456420. The replay will be available from about 1:00 Eastern Time today until midnight next Tuesday, June 20. You can also hear the replay on www.bestbuy.com. Just click on For Our Investors.

If you have additional questions please call me at 612 291 6110. Charles is also available, 612-291-6184; and Carla Howgen at 6146. Reporters, on the other hand, should contact Sue Bush, our Director of Corporate PR, at 612 291 6114.

That concludes our call.

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Source: Best Buy Co., Inc. F1Q07 (Qtr Ending May 27, 2006 ) Earnings Conference Call Transcript (BBY)
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