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Best Buy Co., Inc. (BBY)

F2Q07 Earnings Conference Call

September 12, 2006 10:00 am ET

Executives

Jennifer Driscoll - Vice President, Investor Relations

Brian Dunn - President and Chief Operating Officer

Mike Vitelli - Senior Vice President of Merchandising

Kevin Layden - President and Chief Operating Officer - Best Buy Canada

Jim Muehlbauer - Senior Vice President of Finance

Brad Anderson - Chief Executive Officer

John Walden - Executive Vice President - Customer Business Groups

Darren Jackson - Executive Vice President - Chief Financial Officer

Carla Haugen - Investor Relations

Analysts

Gregory Melich - Morgan Stanley

Gary Balter - Credit Suisse

Steve [Hirka] - Berman Capital

Colin McGranahan - Bernstein

Bill Sims - Citigroup Investment Research

Danielle Fox - Merrill Lynch

David Strasser - Banc of America

Presentation

Operator

Ladies and gentlemen, thank you for standing by. Welcome to Best Buy’s conference call for second quarter of fiscal 2007. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session.

(Operator Instructions)

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

Jennifer Driscoll

Thank you, Elsa. Good morning, everyone. I hope you enjoyed the on-hold music by Corinne Bailey Rae. 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 conduct today’s earnings highlights with our ongoing customer centricity strategy; Mike Vitelli, Senior Vice President of Merchandising, will give an update on current trends in 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 are 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. As usual, we also have a broad management group here to answer your questions.

I would like to remind you the comments made by me or by other 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.

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 19th.

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

Brian Dunn

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 for 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 are tremendously excited about our home theatre business this year, but the earnings growth we are 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 was not 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 spreadsheets -- here it is: Best Buy is performing well and growing because we are learning to listen to our customers. Best Buy today reported an increase in earnings in large part because customers want something different, and we are listening and changing to meet their needs.

Our top line showed that customers like what we are doing. They voted with their wallets and gave us respectable revenue growth in comparable store sales amid mixed signals in the economy. Customer insights drove what we did for the bottom line. We maintained customer-facing label level in our stores, as customers 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 we get used to with Best Buy. It is one way we are going to fuel earnings growth, but as in all things, the number one way we fuel growth is through our people. We are learning to put our employees in a better position to serve our customers, to engage them more fully in the work, and to listen to them better. 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 is 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 of 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 are a good value. Increased supplies are bringing down the average selling price right into our wheel house, 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 is our job. It is our job to create an experience for the customers that starts when they walk in the store and does not 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 is what we mean by end-to-end solutions. That is why we are 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 are 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 are constantly looking for ways to make it easier for them to interact with us. As part of that effort, we are building more Best Buy stores and reaching even smaller, more remote areas. In the coming quarter, we will 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 have responded with high-fives to our Magnolia home theater concept, so we are adding 142 additional Magnolia home theater locations next quarter, our biggest push of the year.

Here is another customer insight -- customers love the idea of gathering around their new TV, but they are understandably nervous about do-it-yourself installation, about drilling holes in expensive real estate. So we are expanding our home theater installation capabilities. We hired approximately 300 more installers this quarter, and we are clarifying our installation offers in the store as well.

The insights we discovered are not limited to home theater, of course. We have learned that many small business owners do not know what they do not know about technology. They do not know 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, do not 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 are investing even further in our ability to serve small businesses.

While I am talking about customer insights, let me point out that 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, someplace where the retail experience may leave something to 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 will see us go slowly, in part because international growth is new for us, and in part because we firmly believe that 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 are 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 is working and making a huge difference in our business. It is not firing on all cylinders yet, but we are learning how to drive it. Once we have 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 is the reason we remain so optimistic about the future.

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

Mike Vitelli

Thank you, Brian, and good morning, everyone. I am going to discuss our progress on one of our strategic priorities this year, the scaling of our Magnolia home theater experience at 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. In the truest of Best Buy fashions, 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. The new homeowner was proudly showing it off. Our Best Buy employee -- we’ll call him Best Buy Bob -- was standing there and noticed that the high definition picture was horrible. 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.

Finally, the owner could not take it anymore, and knowing where Best Buy Bob came from, said “Bob, so what do you think for the set-up here?” Bob, in the truest of Best Buy truest in helping, said “Well, the set-up is terrific, but I am a little concerned about the picture. Who are you getting your high-definition video source from?” 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 are not getting what they thought they purchased.

By the way, Best Buy Bob was able to hook the neighbor up with their high-definition service from their cable company.

At Best Buy, we are focused on how satisfied our customers are in our stores and once the products are up and running in their homes, something we are 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 are 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 front-line customer facing employees. You know, it is 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 are 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 installers. 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 micro-display devices. We can show you the difference between the same channel in high definition versus standard definition, which is what that neighbor in my earlier story was seeing. We have plexi-glass covered wall displays that quickly communicate the complexity that home installation entails.

In addition, we have terrific product assortments. In the quarter, we added 29 Magnolia home theater experiences in our stores. We now offer a total of 162 that have those premium brands and premium service, and we have also added some new brands to our core selection as well.

In the second half, we will add another 150 Magnolia home theater experiences, most of them launching in the third quarter. Additionally, we will transform the TV department in 300 Best Buy stores. All this is being done with the aim of creating a 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 in the consultation desk in the Home Theater Department, the plexi-glass 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 is 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 is why you see us trying to educate the customer through our HD Done Right pledge. HD Done Right gives customers financial incentives to do what is 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 is 37 inches or larger, let us install it for you and upgrade your signal to high definition, and right now, we will 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 importantly, it will deliver that experience that the customer was looking for, so it is a win for everybody.

So to wrap up, our TV business is off to a great start this year. It is on track with our plans. We have not seen any decline in the consumer’s interest in this important category and with supplies up, we continue to expect average selling prices to drop between 25% and 30%, year over year on identical SKUs, and that is good both 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 cannot control the macro environment and we also recognize that we are fighting for a share of consumer spending, which has other pressures, but we are very bullish on the flat panel home theater space and we are confident that we are making the right investments here.

Now, to talk about the stakes a little bit further north, we have Kevin Layden, the President and COO of Best Buy Canada.

Kevin Layden

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 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 zero 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. 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 standalone 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 are concentrating on the existing store platform, which we are 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 restructure mentioned earlier.

It has significantly reduced the number of what we refer to as dual hat corporate employees who work for both brands. 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 increased 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 are 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 top-line 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 are 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 am 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.

Jim Muehlbauer

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 top line, 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 a 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 would 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 notebook computers. Results also reflected growth in gaming hardware, as that business carries a lower gross profit rate.

Finally, 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 authorization of our investments in labor, and curtailed use of outside consultants.

This brings me to a more important point -- we continued 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. The 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 am sure you are more interested in our outlook for the balance of the year.

We remain confident and our outlook for the year is fundamentally unchanged from previous expectations. We continue to expect annual EPS of $2.65 to $2.80 per diluted share. We are certainly encouraged by our first-half results and share our customers’ 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 headwinds in the market that we have 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 gross 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 rate. In addition, the acceleration of the gaming cycle in the second half will also constrain margin rates, as our mix shifts toward video game hardware which, as 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 and the macro-economic 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.

Brad Anderson

Thanks, Jim. 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, as you know, has always been a growth company, and we place a high value on the benefits of growth -- benefits that accrue to our employees, our customers, our shareholders, and our community.

As Brian mentioned, we recognize that over time, more of Best Buy’s growth may come from new businesses, whether that be the small business market, the services business, new customer segment, or markets outside of North America.

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

This summer, the company was greatly pleased to announce two new outside members of our board. Ari Bousbib and Rogelio Rebolledo 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 level. 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.

With that, we will open the floor to questions, starting with those who did not get their questions answered last time.

Question-and-Answer Session

Operator

(Operator Instructions)

Our first question is coming from Gregory Melich with Morgan Stanley. Please go ahead.

Gregory Melich - Morgan Stanley

I just have a question on TVs, but probably about 10 parts. I will try and cut it 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?

The second part of that question would be, what impact does it have on margins when you layer in attachments and warranties and how that is trended?

Mike Vitelli

Gregory, to answer your question, the margins overall in 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 are offering is in a sense trying to encourage that in a positive way with our customers. So when I look at the second quarter, the issues that impacted the margin were more mix changes than they were the category of television.

Gregory Melich - Morgan Stanley

Okay, so televisions net net, were still -- they did not hurt gross margins, and they probably helped?

Mike Vitelli

Correct.

Gregory Melich - Morgan Stanley

If you layer on warranties, did they increase as you are selling more of these higher priced items? Is that helping?

Mike Vitelli

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.

Brad Anderson

But as a response to your earlier question, we are looking at the whole transaction when we evaluate it, so we are not just looking at a piece of the transaction.

Gregory Melich - Morgan Stanley

Okay, so the answer to the margin question initially is looking at the attachments included.

Brad Anderson

Yes. We are looking at the end-to-end solution for the customer and we look at the basket of that entire transaction to provide not only benefits to the customer but also that benefit our operating model.

Gregory Melich - Morgan Stanley

The inventory increase, what would it be if we exclude the acquisitions?

Brad Anderson

Well, excluding the acquisition, 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.

Gregory Melich - Morgan Stanley

Thank you.

Jennifer Driscoll

Next question.

Operator

Our next question is coming from Gary Balter with Credit Suisse. Please go ahead.

Gary Balter - Credit Suisse

Thank you. One question, of course with a couple of parts, all unrelated. You talked about inventory levels, and you mentioned it is mostly in televisions. This is basically planned, correct? We are not looking at softer sales in the category. That is not part of the question. I just want to follow-up on what Greg just said.

Brad Anderson

That is absolutely correct. 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.

Brian Dunn

Another perspective on quality is when we look at our at-risk inventories in terms of absolute dollars. We are down about 10% year over year, so the content is strong as well.

Gary Balter - Credit Suisse

In the first quarter, you talked about lower advertising and suggested you would be picking it up as the year went on, and this was a big driver again this quarter. Is that mostly ROP ads? Is that circulars? Where are you saving that? When we look year over year for the full year, how much will you have saved on advertising?

Brad Anderson

Principally, Gary, I would say the savings had come in the ROP areas of the business. Again, it is principally because of shift. As Jim highlighted, as we look to the back half of the year, it is not a secret in terms of the energy we are putting behind home theater and reconstructing and putting in our home theater experience. Along with that, I think you can probably experience, as you are watching your TVs and watching our “We Pledge” ads starting to air in the last 30 days, we have 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 would not lose sight of is that when we think about the customer experience and touching more customers, we are actually making more investments in places like Reward Zone. You know, what you cannot see in terms of those numbers, I think our overall membership year over year is up almost 3 million customers. There are other types of ways we are reaching customers that quite frankly we think have a higher payback.

It is likely that that kind of thing you will continue to see in subsequent years, because we are getting a better handle on what the productivity of our spending is.

Gary Balter - Credit Suisse

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

Jennifer Driscoll

Yes, we did.

Jim Muehlbauer

We were 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.

Gary Balter - Credit Suisse

This is my question now, and then I will get off.

Brad Anderson

We appreciate the context of the first four questions.

Gary Balter - Credit Suisse

You see AT&T made an announcement today about being able to converge the PC and the TV, and I think Apple -- I am waiting to see so much -- that Apple has put out something yet on what they are doing. How do you think about how the convergence, and obviously that has been something you had been playing towards for years now, how do you think that is going impact the sales of certain kinds of categories, and how are you positioning yourselves as more and more TV content will be available on PC?

Mike Vitelli

I will try the first one, the TV side. First of all, you are accurate that there is more places for consumers to consume content than ever before. It is a part of what we are 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 is licensed content or personal content. Those options are going to proliferate over the next several years. In the short-term, it probably will not have a major impact other than to get people continually excited about the category and their potential sources for high definition and other content.

Brian Dunn

Lastly, it is also the reason why we are investing so heavily in services that are going to be connecting it, and that is 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.

Brad Anderson

I think an example of that is what you are seeing in the market right now, where we are putting the skill sets we have got together to do “I Pledge”, which we think is a unique value proposition. We are trying to engineer the enterprise. As that computer integration occurs, we will also be able to do that in a unique way that no one else can do.

Brian Dunn

Also, it creates some complexity in the marketplace in the consumer’s view, and we think it underscores the importance of our deepening our relationship with the customer and what we are doing with customer centricity to make sure that we are positioned to help the customer navigate.

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

Jennifer Driscoll

The fourth part of that question was answered by Vitelli, [inaudible], Anderson, and Dunn. Next question, please.

Operator

Thank you. Our next question is coming from Steve [Hirka] with Berman Capital. Please go ahead.

Steve [Hirka] - Berman Capital

Just one question that is not as multi-faceted as Gary’s, but it is on the online sales. That is growing 35%. It is a growing piece of the business. If you can give us some order of magnitude of how big that is, relative to your stores, whether or not it is eating into comp store sales as best you can see, whether or not there is a mix issue, whether or not you are getting as much flat screen TVs sold on that -- things along those lines, whether or not it will have the similar margins as you would have in the store.

John Walden

I might be able to help with that. It is 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 has really been to be part of the customer experience and leave it up to the customers to decide how and when they want to find information, make purchases, et cetera.

It is a very important channel. It is important from a direct sales perspective, but it is not overwhelming in terms of its materiality. It is critical in terms of the information it provides and the impact it has purchases made in the store.

So when you look at the whole experience, yes, it is material. When you look just at the direct sales, you get a smaller picture of what the value of that thing really is.

Steve [Hirka] - Berman Capital

Okay, so it is not necessarily going to change the dynamics or the margin, the SG&A ratios of the overall business?

John Walden

Yes, that is fair, Steve. Maybe context, we have 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 are seeing is that we have positive traffic, no doubt about it, but the consumer is using that online channel and the traffic to that channel, I think it is 60% plus are using that channel to do their research and understanding of products before they show up at our store, so you have to look at them in an integrated way in order to see what is unfolding in terms of both our store performance and our [inaudible].

Steve [Hirka] - Berman Capital

Thanks very much.

Jennifer Driscoll

You are welcome. Next question, please.

Operator

Thank you. Our next question is coming from Colin McGranahan with Bernstein. Please go ahead.

Colin McGranahan - Bernstein

Thank you. Good morning. I wanted to focus on the gross margin in a couple of 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? If so, is there seasonality to that gross margin rate at all?

Brad Anderson

Good job of the math. We think you are off by a tenth.

Colin McGranahan - Bernstein

It is early yet. I have not had all my coffee.

Brad Anderson

That is about right, Colin, and there is publicly available information regarding some of the publicly traded retailers in China. You would see that the business model is just very, very different. The gross margins in that business, I would say you are not far off.

The good news is, as Jim alluded to, is that we see it for this year as a break-even proposition. I do not want to mislead you. We have investing to do in China over the long-term. We see a growth runway in China. You can see that the way the business model is shaping up, it is a lower margin model today, because that is how the marketplace is, but it is also a lower SG&A model as well.

Brian Dunn

Because the vendor suppliers assume more of the cost than they do in North America.

Colin McGranahan - Bernstein

So if I think about just international then, 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.

Brad Anderson

Yes, in part because you are waiting in China. That is correct.

Colin McGranahan - Bernstein

Right, and you did not disaggregate any impact on SG&A, but I am again assuming it is less than the 15 basis point impact on gross margin, because it is less profitable?

Brad Anderson

That is correct.

Colin McGranahan - Bernstein

Okay. Is there, in the gross margin change year over year, is there any change in how you are accounting for vendor funding between gross margin and SG&A? It looks like if you started to disclose that, not all of that is in cost of goods sold, as EITF seem to kind of push towards.

Jim Muehlbauer

No, we have not made any changes in our vendor support accounting year over year. The trends that we have seen in the U.S. business are consistent with what we saw in the second quarter of last year.

Colin McGranahan - Bernstein

So of the 35 basis points gross margin erosion, it was not just in vendor funding shifted to the SG&A line at all?

Jim Muehlbauer

That is correct.

Colin McGranahan - Bernstein

Finally, you did not really comment at all on promotional financing and the overall contribution of the credit card business. Can you comment on that at all?

Jim Muehlbauer

Colin, we use that vehicle along with the other tools in our arsenal around Reward Zone and other promotions. It is a part of our mix in serving customers. We really have not 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 really the mix of that business has not changed materially.

Colin McGranahan - Bernstein

Then finally, Darren, 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?

Darren Jackson

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 trend and understand things like what would China affect the gross margin rate. I mean, 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, and that is principally driven by what we can see in the mix of business, in terms of how the businesses will wait out.

I think we 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. We are seeing little shifts in the mix, and as we look at the balance of the year and we see things coming online from video games and what that will mean in the mix to balancing out what the price points will be in flat panel TVs, our best view, China included, is just estimated as best for the balance, we will see about a 50 basis point erosion the rest of the way.

Colin McGranahan - Bernstein

That is very helpful, and if limited availability on PS3, that would negatively impact comp but maybe do a little bit better on gross?

Darren Jackson

That would be the math.

Colin McGranahan - Bernstein

Thank you.

Jennifer Driscoll

Thank you, and thanks, Darren, for the answer. Next question, please.

Operator

Thank you. Our next question is coming from Bill Sims with Citigroup. Please go ahead.

Bill Sims - Citigroup Investment Research

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 holiday?

Mike Vitelli

The LCD category, as more of the major manufacturers are coming online with their new fabrications, their supply is starting to improve. Last year we went through the cycle where we actually had a lot of shortages. We do not think we are 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 are coming from, but in general, LCD availability is solid and good, particularly in the larger screen sizes which we are most concerned about. We are looking forward to that being really getting exciting from a customer’s point-of-view in the back half.

Bill Sims - Citigroup Investment Research

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

Mike Vitelli

ASPs overall have been dropping by 25% or 30% comparable, but what is 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 -- the next year, the same $2,000 notebook has a lot more features and options in it, but $2,000 was kind of the mindset the customer walks in with. Flat panel is getting to a similar position.

If you walked in last year with $3,000, you would buy 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 is a really dynamic and exciting time. The growth in television is really in that sense just beginning.

Bill Sims - Citigroup Investment Research

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 how are you taking steps to address it? Thank you.

Jim Muehlbauer

I think as we have discussed in our release, 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 we looked into the back half of the year, starting as early as the last quarter.

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

Bill Sims - Citigroup Investment Research

Thank you.

Jennifer Driscoll

Thank you. Next question, please.

Operator

Thank you. Our next question is coming from Danielle Fox with Merrill Lynch. Please go ahead.

Danielle Fox - Merrill Lynch

Thank you. Good morning. Could you talk a little bit about the profitability profile for the services business, and how it is changing? This year, is the services business accretive to operating margins and EPS? 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?

Jim Muehlbauer

I would be happy to talk about that. I think as we have talked before, we are still in the early days of our services business. If it is a nine-inning ball game, we are in the first couple of innings. We continue to see enhanced profitability from a gross profit standpoint on the enterprise, based on the growth in that services business.

We have also talked about our continued desire to invest in the infrastructure to support that business, so the technological improvements that we are providing our agents to serve customers, we continue to see opportunities to invest around those.

Sean has talked before about really focusing on the productivity of our agents. This year, he is 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 the services business.

Brian Dunn

It also should be apparent now with why our current campaign of HD Done Right that we could not begin to make that claim without the investment we are making in the services business.

Danielle Fox - Merrill Lynch

I just have one follow-up question on the promotional environment. Could you just clarify a little bit some of what you said about the changes in the credit offers? We have seen a step up in the length of the deals for home theater, but I think on the call, you mention that the promotional intensity has actually increased in notebooks and DVDs. What exactly is happening in terms of credit offers in TVs? I was not entirely clear on that, whether or not it has become more promotional or not.

Jim Muehlbauer

Let me start that response, and maybe I will have Mike Vitelli kind of 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 moved 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 have 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.

Mike Vitelli

Jim, I think that is right. We use different levers at different times. Right now this week, we are at 36-month financing. Another week, we will be 12. So it will go in and out based upon what we are trying to do that particular week.

Danielle Fox - Merrill Lynch

You are 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, though year over year there would not be any change in the impact?

Darren Jackson

Yes, so maybe the -- 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 are looking for and working with our banking partner, what we can see in the numbers for this quarter for sure is that there was no impact essentially year over year in our gross margin rate related to financing.

Jennifer Driscoll

Those answers came from Jim, Mike, and Darren, respectively. Now, for our last question, please.

Operator

Thank you. Our next question is coming from David Strasser with Banc of America Securities. Please go ahead.

David Strasser - Banc of America

Thank you. 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. If you can, 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?

Jennifer Driscoll

Well, David, you know we do not give product mix percentages, but Mike, would you like to comment?

Mike Vitelli

The second quarter, MP3 players in general as an industry, were flat to down. We experienced modest single-digit increases there from a comp sales point of view. We are hoping that there is going to be some exciting announcements in the marketplace in the next several hours.

David Strasser - Banc of America

Everyone is kind of hoping that. Are you seeing anything change as far as a mix between Microsoft and other MP3 players within your stores? Any traction being gained outside of the iPods?

Mike Vitelli

It is limited, and Microsoft specifically has not introduced their new product yet, but in general, the media player or [plays-for-short] type of devices is still modest as a part of the mix compared to Apple.

David Strasser - Banc of America

Just going into the back half of the year, how are you thinking of this category within the context of your guidance? I do not know if you know what they are 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?

Brad Anderson

David, the way I would say it, as I talked about earlier, and I will have Mike jump in, we are trending the business every 12 months. As Mike said, as we closed out the second quarter, in this space, the space in general is slightly down. We were up. 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 in terms of the trends of the business and how the consumers are reacting to the new launch.

I think in total, honestly, given the strength of this category for the last -- it has to be 18 months -- we feel good about where we are at and what it will contribute for the back half of the year.

Carla Haugen

Thank you, 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 19th. 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, Carla Haugen, at 612-291-6146. Reporters, on the other hand, should contact Sue Busch, Director of Corporate Public Relations, at 612-291-6114. 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.

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Source: Best Buy F2Q07 (Qtr End 08/26/06) Earnings Call Transcript (BBY)
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