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

Q4 2010 Earnings Call Transcript

March 25, 2010 10:00 am ET

Executives

Bill Seymour – VP, IR

Brian Dunn – CEO

Jim Muehlbauer – EVP of Finance and CFO

Mike Vitelli – President, Americas - Enterprise EVP

Shari Ballard – President, Americas - Enterprise EVP

Barry Judge – EVP and Chief Marketing Officer

Analysts

Michael Lasser – Barclays Capital

Matthew Fassler – Goldman Sachs

Dan Wewer – Raymond James

Will Truelove – UBS

David Strasser – Janney Montgomery

Mitch Kaiser – Piper Jaffray

Kate McShane – Citi Investment Research

Peter Keith – JMP Securities

Operator

Good morning, ladies and gentlemen, thank you for standing by. Welcome to the Best Buy fourth quarter earnings conference call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be opened for questions. (Operator instructions) This conference is being recorded today, Thursday, March 25, 2010. I would now like to turn the conference over to Bill Seymour, Vice President of Investor Relations. Please go ahead, sir.

Bill Seymour

Thank you, Brandy. Good morning, everyone, and thank you for participating in our fiscal 2010 fourth quarter earnings conference call. We have two speakers for you today. First, Brian Dunn, our CEO, will share his thoughts on 2010 and give you a quick update on his thoughts about how we are doing across the globe. Second, Jim Muehlbauer, our CFO, will recap the financial performance and then provide you with guidance for 2011.

And finally, after our prepared remarks, I anticipate we will have ample time for your questions. As usual, we have a broad management group here today in the room with me today to answer your questions after we make our formal remarks.

Before I pass the call over to Brian, I’d like to take care of a couple housekeeping items. First, we would like to request that callers limit themselves to a single question during the Q&A portion of the call so that we can get to as many questions as possible during the next hour. Second, I’d like to remind you that comments made by me or by others representing Best Buy may contain forward-looking statements, which are subject to risks and uncertainties.

Our SEC filings contain additional information about factors that could cause actual results to differ from management’s expectations. Third, as usual, the media are participating in this call in a listen-only mode. And lastly, I’d like to remind you that our full year fiscal 2010 results include restructuring charges we recorded during the first quarter, which impacted our full year net earnings by $25 million or $0.05 per diluted share.

The balance of our discussion on this morning’s call will exclude these charges. That means the comparisons we make will be on an adjusted non-GAAP basis. For a comprehensive GAAP to non-GAAP reconciliation of our reported to adjusted results, please refer to the supplemental schedule on pages 11 and 12 of this morning’s news release.

With that, I’d like to turn the call over to Brian Dunn.

Brian Dunn

Thanks, Bill, and welcome aboard. Thank you, everyone, for joining us for our fourth quarter earnings call. I'd like to cover two topics with you today. First, I’ll touch on the results we reported this morning and how we are positioning ourselves for the future. And second, I'd give you a brief overview of our operations around the world. After that, I'll turn it over to Jim to add some more color on our Q4 and full year results and provide you with an update on our financial guidance for 2011.

Now let’s turn to the numbers. This morning we reported adjusted net earnings for fiscal 2010 of $3.15 per diluted share, which I’m pleased to point out was at the very top end of our full year guidance range and substantially better than our original guidance. These results would not be plausible without the exceptional work of our employees around the world. The strategic bet we are making is that as technology continues to march forward, people -- our people will be the key core differentiator for Best Buy.

Our customers want and often need someone they can trust to help them navigate the complexities of our increasingly connected world. This year’s results give me confidence that our people continue to be Best Buy’s key point of differentiation. Calendar 2009 will be one of the most challenging years that world economy has faced. Experts said that rising unemployment with real consumer spending for the year, particularly on high ticket discretionary goods, consumers are going to retrench, increase savings, and reduce their personal debt. Value determined what and from whom consumers would make their purchases. And the experts were right.

Most of these things did happen. But you know what? Other trends emerged that the experts didn’t see. Best Buy experienced significant year-over-year increases in unit volumes in each of the three major screens; notebooks, televisions and mobile phones. In fact, each one of these categories experienced large enough increases in volume to offset price declines for the tune of double-digit comp growth in notebooks and mobile phones, and mid-single digit comps in TVs.

What do all of these trends tell me? For starters, they tell me that staying connected has become a non-negotiable for millions of people and that some of the things we offer no longer fall under the category of discretionary purchases. These solutions have become such (inaudible) elements in people’s lives that they have little or no tolerance for any kind of disruption if things aren’t working the way they should. And each additional mobile phone, notebook computer, and television gives us an opportunity to introduce customers to the world of connectivity.

Second, we learned that while value absolutely played a bigger role this year in determining how consumers made their choices, value means more than just being sharp on price. Value is about price and knowledgeable service and assortment and the ability to have someone who could all-up for you if you need it. Value is about having the confidence that the product you buy will work the way you want it to.

Like our customers, we needed to take a hard look at our budget and plans for the year. We made a concerted effort to be more focused and efficient while retaining the flexibility to deploy our resources against the highest returning opportunities. We made some tough choices on how to best utilize our human and financial capital. We re-engineered our labor model in the spring, creating a more flexible and customer-friendly experience. We scrubbed our advertising plans, making sure our resources were focused not only where our customers are, but also where we know they are going.

Last, we are beginning to identify ways to better collaborate and share ideas across the entire enterprise, work that you will continue to see us flush out in the year to come. We are in the midst of transforming this organization building on what we have been to become something new. It’s an ability we have demonstrated time and time again, and I’d like to give you a few examples that illustrate our current transformation.

First, we are building upon our foundation as a company that primarily sells hardware and accessories, learning to see that hardware is merely the starting point in a relationship with customers, not an end in itself, but the means by which we can connect customers to the people, content and networks they care about. As an enterprise, we plan to sell tens of millions of connectable devices this year. Each one of those devices is an opportunity to create a longer, more profitable relationship with our customers.

Take, for example, the growing and exciting, but potentially intimidating array of entertainment experiences. We can help customers understand which of the various TVs in the market are right for them; plasma, LCD or LED. Very soon, you will have to choose between each of those options and whether or not you wanted to be 3D capable. But the TV itself is only a part of the equation. The experience really comes to life through a connection with the right type of content.

For instance, we can help the customer understand and choose among the various ways to bring movies into his or her home, purchased in a store, rented through the mail, or streamed directly to their PC, TV, Blu-ray player, or mobile phone. And then, in this case, it could be that the right solution means enhancing a high definition satellite or cable TV package or broadband Internet service for an IP-enabled model, with the traditional solutions customers have come to expecting this category; a digital surround receiver, speakers, cables and the universal remote control, a Blu-ray player, a gaming platform, and installation.

It could also mean integrating capabilities once only accessible on your PC with other devices in your home. Now, that same television could become the telecommunications hub in your home. Best Buy will help you choose the right broadband connection so you can Skype with family or check a friend’s status on Facebook, all from your TV.

To be clear, we are still in the early days of this work, but we are moving quickly in the right direction. Best Buy Mobile, for example, is one part of the enterprise where we really do this effectively today. And you will see us leverage the skills and systems we have developed for that business in other parts of the organization.

We are evolving from a US-centric organization to a globally integrated retailer, a place where ideas will be shared, optimized and leveraged regardless of their point of origin. The best ideas about how to serve customers are most likely to come from the people serving them every day. And more and more frequently, we will see new ideas coming from outside the US. For example, our wireless world concept stores in the US are influencing our center of the store work in the States. And the big box stores we are building the UK will undoubtedly have a big impact on how we think about big box stores around the globe.

The point I want to make is that we are developing global capabilities that will enable us to share best practices around the world. We fundamentally believe that the answers to our customers’ technology questions lie somewhere within our 180,000 employees, and we are learning to use technology to solve these technology challenges quickly and accurately by engaging our own employees and our customers together.

Another way we are changing. We are building on our big box retailing foundation to become a truly multi-channel, multi-format operator. As we reported this morning in our news release, online sales grew last year by approximately 20% to approximately $2 billion in revenue. And one of the most exciting pieces of our online channel is that in-store pickup is approaching a 40% total of online sales, which shows the power of being a multi-channel retail company.

We doubled our investment in customer care this year, making it easier for customers to get the health they need if they have an issue. We added more click-to-check capabilities online for select categories and created dedicated phone operators in many stores to better handle car volumes. And we expanded our use of social media tools like Twitter and Facebook to engage with customers in virtual spaces where they already spend a great deal of time. In some, we are using the very same technology we celebrate as a technology retailer to more quickly resolve customer problems. The end result was that customer complaints fell 18% versus fiscal 2009, all while customer interactions, sales and earnings were on the rise.

Now I’m going to shift the topic and update you quickly on our operations around the world. The progress we have made and the opportunity is still ahead of us. We see the various businesses we operate within each region as a portfolio, each with a different role and intent within the broader enterprise. Resources will flow to the project in places where over time we believe we can get the highest returns on our investment.

Our focus for the next several years will be on balancing growth opportunities with improving returns on capital. Our established markets like the US and Canada will look to leverage their strong market share positions to create better solutions and experiences for customers. The result of this focus, we believe, will expand operating margins and improve overall returns. We will also prudently look for new growth opportunities in these markets, whether that means expanding new store formats like Best Buy Mobile, reinvigorating the center of our store, or testing new category not traditionally associated with Best Buy.

In fiscal 2011, we intend to deliver on our investment in Europe while positioning the business for new growth opportunities. We will continue to merge the strength of our Carphone Warehouse brand and the rest of Best Buy. At the same time, we will create our multi-channel experience and look for unmet needs for the European customers. We are confident and excited about our first Best Buy store openings in the UK and look forward to serving customers in this exciting marketplace.

Within our emerging markets, Best Buy China, Mexico and Turkey, we will continue to assess what we have in place, invest prudently in growth opportunities; we will carefully measure the returns and evaluate each concept on its progress. We view these towards as a new venture. And as such, they will progress more slowly.

Looking specifically at our Best Buy China stores, I think our non-commission, non-directional sales model, maybe ahead of consumers by a few years in that market. However, like our big box stores in Europe, we will continue to experiment with the model and will not add a significant number of stores until we believe we have a concept that serves the need of both our customers and our shareholders.

Our Five Star chain in China is a profitable business, one that has grown revenues and operating income at double-digit growth rates since we acquired it. No small feat in any market given the economic environment. This is a business we intend to optimize and grow profitably.

One question I’m often asked by investors is whether or not I think we are spread too thin. My answer is a simple no, I do not. We have a deep intelligent management team in place focused on the challenges and opportunities we know we face. Having talented leaders dedicated in each region as well as for each brand and country will help us stay true to our objective of growing our businesses across the world carefully and profitably. It is designed to bring the right level of focus and support to each business we operate, whether that business is in a mature market like the US or Canada or a new venture like Mexico or Turkey.

I do want to be clear that at this time that we don’t plan any significant deployments of people or capital to meet parts of the world. But I also want to be clear about this. We believe our fundamental value proposition is universal and there will be future potential to bring value propositions to customers around the world where it makes good sense at the right time.

Technology is becoming a bigger part of people’s lives around the world. Everywhere people use technology more every day to be entertained, to be productive, and to be connected. And when it doesn’t work the way it is supposed to, the disruption it causes is also becoming bigger. We believe that we exist to help make technology work for people. We are committed to making the idea of a connected world reality for customers around the world. And you can expect to see us invest in our international growth with discipline and our laser focus on creating great value for customers and shareholders.

I’ve spent much of the past year traveling around the world and I’ve learned so much from our customers who probably understand where we are helping them and where we are falling short; from our vendors and partners, as we play the roles each of us can play in delivering the connected world of customers across the globe; and especially from our employees who helped me understand their unique cultures and shared with me their dreams and their concerns.

With all of that in mind, I’d like to offer a profound thank you to all of our customers who have chosen to shop with us over this past year. I would also like to thank all of our vendor partners for the support and continued innovation, which is critical to the benefits we all derive from a connected world. And finally, I want to give a heartfelt thank you to all the men and women across our entire enterprise who will make the connected world a reality.

And with that, I will turn it over to Jim.

Jim Muehlbauer

Thanks, Brian. And good morning, everyone. First, I’d like to recap the results we reported this morning and then provide some additional color on the fourth quarter and full year performance. Finally, I’ll provide you guidance on our expectations for fiscal 2011.

Starting with the quarter, this morning we reported fourth quarter net earnings of $1.82 per share, which was a 13% improvement versus our adjusted EPS of $1.61 last year, on a very strong 7% gain in comparable store sales. We finished the full year with adjusted EPS of $3.15 on sales of nearly $50 billion. Both revenue and earnings were up over 10% versus last year. The 1.7% comparable store sales gain in our domestic segment, expansion of our gross margin, strong operating income growth in our international segment, and expense management across the enterprise, all contributed positively to our full year results.

Looking back on the past year, while there were many challenging factors that play in the macro environment, I’m extremely pleased that our performance met or exceeded virtually all of the guidance goals we established with you throughout the year. For example, we grew domestic market share by an estimated 240 basis points. This year-over-year gain was a record for the company and we believe it was more than anyone in our industry.

We delivered full year comparable store sales growth and domestic comparable store sales of nearly 2% in an environment where most retailers reported full year declines. We implemented cost reduction initiatives and actively managed expenses that helped drive operating expense leverage at much lower comparable store sales levels than in the past and far below the benchmark 3% that many use when modeling our cost structure.

Our customer satisfaction scores improved 210 basis points to almost 83%. We continue to drive improvements in employee turnover. In fact, during the year, domestic store turnover improved by 8 percentage points to a record low level of 36%. And as I mentioned in my opening comment, we delivered adjusted full year earnings per share of $3.15, which was $0.25 or nearly 9% above the top end of the original guidance range that we established at the beginning of the year.

The strength of these results underscores Best Buy’s relevance and its unique position as one of the largest customer acquisition platforms for technology solutions in the industry. For example, when we peel back the layers in our results, one of the underlying themes is the incredible strength of our computing business, which grew significantly not only during the quarter, but also for the entire year. In fact, this quarter represented the 29th consecutive quarter of double-digit sales growth in the notebook computing category. And we firmly believe that this growth is critical to our transformation into the connected world.

From a customer perspective, the computer and the connection that makes possible at home, at work, and on the road make it a critical device in the daily lives of many individuals. Computing is a category that not long ago was struggling to get one per household. Computers are now a utility in people’s lives and are the center of the connected world.

While this is all very exciting for customers, the question you may ask yourself is what’s in this for Best Buy? It’s no secret that computers buy themselves yield a lower gross profit rate than many of the other products that we sell. It’s also not a secret that for the past several years computing had become a bigger part of our mix, and that trend has put pressure on our overall gross profit rate. What sometime gets lost in the computing story is the overall financial impact computing has in our model. We track and analyze each part of our business and focus on its complete contribution, including the hardware sales, accessories, services, SG&A, and the space and capital required to operate each business.

When we look at the computing business at the operating margin line, it is much closer to the domestic company average, as it runs at a relatively low SG&A rate because of the high sales velocity. Most importantly, on a return on invested capital basis, it actually operates at a higher rate than the overall domestic business. So even though computing has a slightly lower gross profit margin, the business in total generates positive returns because it is so efficient with expense and capital.

So we are thrilled with the growth that we’ve seen in computing, because it not only satisfies a customer need, but it also drives shareholder value and provides further opportunities for more profitable future growth in the connected world. Many of these new growth opportunities are centered on our ability to successfully create solutions for customers, including offerings from our services business, which include warranties, home theater installations, and computing services.

While this category has not grown as fast on a comparable store sales basis over the past several quarters as the core signing hardware categories, the opportunity at hand for us is to find new ways to improve these value propositions and make them even more relevant to our customers. In fiscal 2011, you will see us test and deploy new service, content and connection offerings in order to enhance the customer value proposition in a space that is highly accretive in our business.

With that context, let me spend a moment giving you some additional color on our margin performance this year. We are very pleased that our top-line strength drove in an 11% increase in the gross profit dollars for the year. On a rate basis, our full year gross profit rate of 24.5% increased 10 basis points. I mentioned earlier that we’re pleased to deliver on most of the guidance goalposts we established at the beginning of the year.

The gross margin rate came in below our original expectations due to stronger consumer demand in specific product categories, decisions we made to improve our top-line revenue and share by growing sales in key categories that have lower margins like computing, and through focused initiatives throughout the year to gain share in growth categories such as appliances.

Looking at our enterprise operating cost for the year, SG&A totaled $9.9 billion or 19.9% of revenue, which was a 10 basis point improvement year-over-year. In our domestic segment, the full year SG&A rate of 18.6% was a 60 basis point improvement year-over-year. The SG&A leverage that we delivered was driven by tight cost controls and stronger than expected revenue performance.

I’d also like to point out that in the fourth quarter and for the full year, SG&A rate was limited by the increase in incentive compensation versus last year when we essentially had little incentives earned. We estimate that this incremental pay for higher profit performance impacted the full year domestic SG&A rate by approximately 50 basis points.

So now let me take a few minutes to give you some additional background on our international business. In fiscal 2010, I’m happy to share with you that our international business finished the year strong with both revenue and profitability improving sequentially throughout the year across the globe. As a reminder, this was the first full year in which we reported Best Buy Europe.

At the beginning of the year, we provided you detailed guidance on Best Buy Europe, and I’m pleased to share with you that we deliver on that top and bottom line guidance. For the year, Best Buy Europe revenue totaled $5.6 billion. The operating income rate finished the year at 3.7% before purchase accounting amortization, or 2.1%, including the amortization of those items. As a reminder, these results exclude restructuring charges.

In total, Best Buy portion of the net earnings from the operations of Best Buy Europe was slightly accretive to our overall results. Based on the reporting complexities of this business and questions we receive from shareholders, this morning we posted a new schedule titled Best Buy Europe accounting flowchart to our IR website. We hope you will find this information -- this overview information helpful in assisting you build out your models for the Best Buy Europe business.

So turning back to the full year enterprise P&L, all in all, adjusted operating income increased 14% to $2.3 billion compared to $2.0 billion a year ago. On a rate basis, adjusted operating income increased 10 basis points to 4.6% of revenue for the year. The company’s strong financial performance also improved with cash flow generation.

Free cash flow, which we define as operating cash flow less capital expenditures, increased $1.0 billion to $1.6 billion in fiscal 2010. This was driven by our improved profits and approximately 50% reduction in CapEx spending. As a result, we finished the year with a cash and cash equivalent balance of $1.8 billion, which was an increase of over $1 billion versus the prior year. In total, we are pleased with all the strategic and financial results we delivered in fiscal 2010.

Entering fiscal 2011, we are squarely focused on continuing to profitably grow the business and build on the momentum we have achieved to date. We intend to execute a set of plans focused on the connected world that will provide continued expansion in our operating margins and improve our company’s return on invested capital.

So turning now to fiscal 2011, let me share with you our thoughts on the upcoming year. Our plans call for top-line revenue of $52 billion to $53 billion, which represents a 5% to 7% growth year-over-year. The revenue outlook includes comparable store sales growth between 1% to 3%. Additionally, we intend to continue moderating our square footage growth and leverage our existing footprint.

Prior to the past year, it was not unusual for us to grow square footage by 8% to 10% a year primarily through the opening of 30,000 and 45,000 square foot boxes in our domestic big box business. In fiscal 2010, we moderated this growth to just over 3%. And in fiscal 2011, we anticipate that a majority of our new store openings will come from the expansion of smaller footprint concepts such as Best Buy Mobile Standalone and CPW wireless world stores. As a result, we again expect modest square footage growth in the range of 3% to 5% for fiscal 2011.

From an operating income rate perspective, we expect enterprise margins to expand by 30 to 40 basis points from our adjusted 2010 results to nearly 5%, driven by both gross margin expansion and SG&A rate leverage. While we expect the improvements in both the first half and the second half of fiscal 2011, we anticipate that our operating income rate expansion will be larger in the second half of the year, as we ramp growth initiatives and begin to lap the mixed pressure headwinds we experienced in the back half of fiscal 2010.

In the domestic business, we are planning for operating margin to increase by a rate that is at the top end of this range. Looking at our CapEx next year, we anticipate spending approximately $850 million in fiscal 2011, and we expect to once again increase free cash flow over the prior year. Based on the strength of our fiscal 2010 performance and our expectations for the coming year, we have the capacity to increase CapEx spending and leverage profitable growth opportunities in the connected world.

We also have $2.5 billion of remaining availability under our existing share repurchase authorization approved by the Board of Directors. For those of you that have been following us closely over the past several years, you’d probably recall that we have utilized both of these levers to improve ROIC and invest in our business.

As a matter of fact, over the past five years, we have returned approximately $5.8 billion to shareholders in the form of share repurchase and dividend payments. So while I anticipate that we will return to the market to buy back shares, our earnings and EPS guidance for fiscal 2011 does not reflect the impact of share repurchases.

To conclude the overall P&L outlook for fiscal 2011, we expect a tax rate of 38.0% to 38.5%. Bringing it all together, we are forecasting annual EPS of $3.45 to $3.60 for fiscal 2011, representing an improvement range of 10% to 14% year-over-year versus our fiscal 2010 adjusted earnings.

In summary, we see tremendous opportunities for our investors and our employees in fiscal 2011 and beyond. The entire Best Buy team, more than ever, is aligned to follow and anticipate customer needs resulting from their transformation into the connected digital world. We remain committed on executing and prudently investing in this strategy in order to drive profitable and sustainable growth in returns for our shareholders.

And finally, I’d like to personally welcome Bill to IR team. We are excited to add his background and experience to Best Buy. I am confident you will enjoy working with him and leveraging his knowledge in the mobility and connectable device space.

With that, Brandy, we are ready for questions.

Question-and-Answer Session

Operator

Thank you, sir. We will now begin the question-and-answer session. (Operator instructions) And our first question comes from the line of Michael Lasser with Barclays Capital. Please go ahead.

Michael Lasser – Barclays Capital

Good morning. Thanks a lot for taking my question. I’m sure this will be the only one on the gross margin this morning. But can you talk a little bit about the breakdown in the domestic segment of the mix versus ray [ph] impact in the fourth quarter and then how you see that proceeding through the course of the year? And it would seem like if you’re going to build on some of the relationships that you built with customers this year and improved your profit rate. It would suggest that those folks are going to be less price sensitive this year than last. So maybe you can clarify that as well.

Jim Muehlbauer

Michael, do you promise this will be the only question on gross margins?

Michael Lasser – Barclays Capital

I can’t make that promise.

Jim Muehlbauer

There are other questions from you, right?

Michael Lasser – Barclays Capital

You’re right.

Jim Muehlbauer

So -- happy to give a little context. In the fourth quarter, the domestic margin basically played out exactly where we thought it would play out. We anticipated when we gave guidance for the balance of the year at the end of our Q3 call that we were going to continue to see margin pressure from growth in our computing business, and that’s exactly what we saw. So the margins came in about where we thought. I think the context that we also talked about in this call, about why growth in our computing business is important for the future in the connected world, but also drives return on invested capital in our model today I think is important context as we look at that margin rate not only this year, but the activities that we see in connectable devices, be it TVs, computing, mobile phone and other connectable devices into next year. Mike, do you want to chat a little bit on --?

Mike Vitelli

Two things I can add to that, Michael. One is that when you do the comparisons of one year to the last, there are always things in each of the years that are unique and different about them. So when you look at last year, we were down. Last year had in it some favorable things that didn’t reoccur, which is that we were lean on inventory. So we were lean on promotional goods while we finished the fourth quarter. And that was our explanation for last year, why last year was up. So that comparison is different.

We also were selling profitable once in a lifetime converter boxes last year, which was also favorable. But I think, as Jim said, the biggest opportunity is we had material increases in units in televisions and in computing especially. And the opportunity for us, as you talk about going forward, is being able to create solutions and connections and content and services for those computers that are relevant and present them at a really impactful way and an easy way for our employees to present. And we know that that’s possible. We are working on this with the center of the stores. That’s why we are optimistic as we move into next year.

Michael Lasser – Barclays Capital

Okay. So if I could just clarify, how much of the gross margin expansion in the domestic segment for the upcoming year is going to be driven by things that you already sell in the store versus what you might have to roll out -- new service offerings etc. that you might have to roll out later in the year?

Mike Vitelli

I think they are all in the store. The challenge is they are invisible. The mobile broadband connection is invisible. CinemaNow and Napster are invisible. There is no place to see them. And what the center of the store is about is to put those literally and figuratively [ph] present center for our customers to see the art of the possible and what they are for them when they connect the computers, the phones and the televisions to the Internet via mobile broadband and the wireless broadband in their home. That’s really what it’s about. Most of the services are there. They just not present it in a compelling enough way for -- to be something the consumers say, Gee, I want that. And we want to make sure that that’s where it is. We’re going to make them see it and want that and then we can deliver it.

Brian Dunn

Michael, I would add one -- Michael, this is Brian. I would add one other thing and I think it’s really important to call this out. I mentioned on the call that we had moved to a new operating model in the stores. We are now entering our first full year end-to-end where we will have that model. And I would remind you that our history is really about getting a concept, growing share, and then building out solutions for our customers. And as that engine of our 140,000 or 150,000 store employees really a chance to become more experienced in sharp -- in building solutions for our customers, we tend to gain good momentum quickly in that second year.

Michael Lasser – Barclays Capital

Thanks a lot and good luck this year.

Brian Dunn

Thank you, Michael.

Jim Muehlbauer

Thank you.

Operator

Thank you. And our next question comes from the line of Matthew Fassler with Goldman Sachs. Please go ahead.

Matthew Fassler – Goldman Sachs

Thanks a lot. This might be in essence a follow-up on Michael’s question. But it sounds like you are looking for a material change in direction in margin momentum, particularly gross margin and particularly in the US. It would be very helpful if you could give us some more details about the business model drivers and (inaudible) contribute in 2010.

Brian Dunn

Yes. Good morning. This is Brian. I think that we will call on Mike and Shari, the leaders of that business to give a little commentary there.

Matthew Fassler – Goldman Sachs

Great.

Mike Vitelli

So to amplify a little bit more of what we talked about earlier, connections, content and services are the three drivers -- the three big drivers of the profitability with all of the televisions, computers and cell phones that we sell. And we know and believe that we present those in a compelling way and show people what’s possible now with mobile broadband with Internet connected televisions and with the digital services that are growing every single day, and we will sell more of those and present them more impactfully [ph]. And that’s really where part of our margin plan is for next year.

Matthew Fassler – Goldman Sachs

How much of that has been substantiated by results that you’ve seen to date?

Mike Vitelli

Since we started putting tests into the market presenting simple things like television connections to high-definition cable and satellite services and showing mobile broadband more impactfully in the computer department and in the cell phone. We’ve seen improvements that have been pretty substantial albeit small in the fourth quarter. As we rolled that out more aggressively across the entire chain, that’s where we are confident about the improvement. And it takes a small improvement to create a large impact on margins in those areas. One of the things you might think about, Matt, is the number of televisions we sell each year and they have been traditionally -- that has been a low attachment category for us for connected services. This year, as we grow into as IPTV becomes not just new and exciting, but becomes the norm on models, it creates an opportunity for us to create a much broader array of experiences for people on their televisions and that’s very good space for us.

Matthew Fassler – Goldman Sachs

And then I guess my follow-up question goes to Jim. You spoke about the improvement in operating margins being more heavily weighted to the second half of the year. If you could give us any visibility on trajectory -- any more detailed visibility on trajectory, that would be very helpful.

Brian Dunn

We are taking follow-up questions only from Matt today, Jim.

Matthew Fassler – Goldman Sachs

My apologies.

Jim Muehlbauer

The phase-in certainly over the last two years has been very interesting given the macroeconomic environment, number one, and certainly how we’ve been driving parts of our business, number two. If you look at the operating margin and the pressure that our margin saw in the back half of this year, Matt, given the mix of sales that we’ve seen, we’re just going to be up against some easier compares in the gross margin line in the back half of the year. We’re going to up against more difficult compares in the back half of the year from a sales standpoint. All in, like I said, I expect that our operating margins are going to expand both in the first and second half, but we’re going to see more of that in the back half of the year.

Operator

Thank you. And our next question comes from the line of Dan Wewer with Raymond James. Please go ahead.

Dan Wewer – Raymond James

Thanks. Good morning. You noted that the new selling space composition is going to change, moving away from the big box stores and focusing primarily on the Best Buy mobility center on stores as well as the wireless world stores in Europe. I think it would be important if you could help compare the store economic model between those formats and the blue boxes perhaps by sales per square foot, margins and SG&A.

Jim Muehlbauer

Yes, Dan, it’s Jim. We won’t get into the specific details of each of the concepts for -- I think for obvious proprietary reasons at this point in time. But if I helicopter up and look at where the business had options to grow in the previous five years, really we were limited by what we initially saw in the domestic market by focusing on 45K and 30K boxes. And over time, through the launching of 20K boxes in the domestic business and working with the team over really a period of two, 2.5 years to refine the operating model in those boxes, we’ve gotten to the point within our domestic business where our 20K boxes, 30K boxes and 45K boxes, all delivered very similar returns on invested capital over their life.

So if we look at the smaller footprint boxes going forward, in many respects, we see an opportunity to drive return to much greater than that for a couple of key reasons. Obviously, the cost of those boxes is much less given the square footage, but the devices and the connections that are going to be made within those boxes, especially today in the Best Buy Mobile business and in the wireless world business we have in the UK, they are very margin rich sales that set both in computing connections, mobile phone connections, and where we see the world going from an overall connected world standpoint. So we are confident that we have a model that does a couple of things. A, allows Best Buy’s strength in kind of to frame the different options for the customers (inaudible) for choice, to show up in places where customers are looking for those goods, in malls with high traffic area where that makes sense, and allowing them to get the same experience in the connected world suite of products that they would get within a big box store.

Brian Dunn

And over the course of that year, Dan, this is Brian, I would add that we now have another year of data and we continue to see the same trend that we saw initially as we rolled these and that is that these sales, the vast majority of them, the vast majority of the sales in the connections are incremental. As we put these stores into these malls around the country, they are not having any sort of material cannibalization on the big stores that are adjacent to. We are accessing a new group of customers that were particularly scoring with women -- female customers in those places. And that is very, very encouraging to us.

Dan Wewer – Raymond James

With the higher margin rates in these stores, is it safe to assume that the sales per square foot less than it is in a big box?

Brian Dunn

Sorry, say that again.

Dan Wewer – Raymond James

Will the sales per square foot in the smaller format stores be lower than a blue box that is offset by the higher margin rate?

Brian Dunn

Yes. I think over time we’re going to depend on the content, but we could actually see sales per square foot. And more importantly, what I ask you to focus on as we go forward is really margin per square foot.

Dan Wewer – Raymond James

Okay.

Brian Dunn

Because once again, the profitability of that business is based on the margins that we drive. The margin per square foot will be much higher.

Dan Wewer – Raymond James

Great, thank you.

Jim Muehlbauer

Thanks, Dan.

Operator

Thank you. And our next question comes from the line of Will Truelove with UBS. Please go ahead.

Will Truelove – UBS

Hi, thanks. Can you give us a little more detail about the rollout of the connectivity center as well as is there any more detail you can provide in terms of the amount of connections or the amount of revenue changes once connectivity center is in place for a certain amount of time? Thanks.

Brian Dunn

This is Brian. The question was the status of the connectivity center or the connected world with --

Unidentified Company Speaker

We have -- this actually falls on me. I have talked about this frequently as the center of the store initiative, and it’s really become much broader than that. It’s not just a center of the store, it is essentially we do not believe that our store fully reflects all the things that customers can view today, and we believe that there is a huge opportunity for us to re-engineer that in a way that’s going to be very, very compelling. One of the things we’ve talked to our vendor partners around the world about is how do we build the stage, if you will, to show the very best. Mike Vitelli calls it the invisible what are actually is the connected -- sort of the tissue of the connected world.

And as was mentioned on the call, we have tests in the wireless world in the UK that we are very, very pleased with. We have a test in Vancouver that’s showing us we are learning some interesting things from. And we have a couple of tests right here in the United States. So I think you should also think about the continued evolution of our Best Buy Mobile stores within our big blue box or big stores today, the continued elevation of our digital boats. Those things are all coming together and they are all really important clues to how that’s all going to create this new footprint for us in -- I don’t know if Mike or Shari has any color they would like to add to the work specifically here in the States, but --

Shari Ballard

Yes. I would just underscore that each of the tests is teaching us something different. So there are component parts that we are learning around the physical aspects of the store, which has been a lot of what we talked about here. Also the people aspect of this are, what kind of labor model do you want, what kind of selling model do we want to sell in a connected world? So that’s one of the tests that’s happening in one of the stores. And then we are also looking at the technology infrastructure you need to actually bring this to life not only for customers but in the way employees do their jobs. And I think from a progress standpoint, really pleased on what we are learning in each of the tests, and they are generally on the timeline. And I think -- I know there is a real hunger for concreteness around it and there is us too. And I think as soon as we’ve got something that looks like it’s a winner, we’ll be out loud about it, but we don’t have it yet.

Brian Dunn

And I’d also just call out that we are not sort of sitting in our heels and waiting for these all to come to fruition into this perfect (inaudible) above on it. We are taking what we’re learning, and we’re deploying it every day. And part of what you see in our confidence in our margin expansion plans for this year and our operating income expansion for this year is based on things we’ve learned and are going to be able to deploy around the world.

Will Truelove – UBS

Great. Thanks so much.

Brian Dunn

Thanks, Will.

Operator

Thank you. And our next question comes from the line of David Strasser with Janney Montgomery. Please go ahead.

David Strasser – Janney Montgomery

Thank you. I’m going to just touch on the 3D a little bit. Just two questions. I won’t do a follow-up. I’ll just tee up them together. I guess the first one would be --

Brian Dunn

You know, I appreciate the honesty.

David Strasser – Janney Montgomery

The first one would be just sort of I know you’ve rolled it out. It’s only been a week or two, but anything that’s jumped out of you plus or minus as it -- from consumers or from the store base, anything that surprise you one way or the other, and if any color on how it’s started. And then Mike Vitelli, I know you’ve spoken at some conferences interoperability of the glasses. And I’m just getting -- trying to get a sense from you. Do you think that that trend is going to happen or not, and what you’re hearing from the vendor as you talk about that more publicly?

Brian Dunn

Okay. Great, thanks for the questions. In the first one, what we are seeing is the customers and the employees are excited about what they are seeing. And we think that’s great because it’s going to continue to bring excitement for the store, which is what we try to do for our customers all the time. I think as the momentum builds and the quantity of the units sold, that will bring some confidence and excitement into the content production community. So we feel good about it though it’s in its early stages and anything like this that comes out as its growth curve -- but it is bringing excitement. So we’re pleased with what we see.

Your point about the interoperability of 3D glasses, we feel strongly about that representing the customer’s point of view. We would like a common set of glasses that we could use on TVs. All the manufacturers agree that’s a very good goal and they each have specific points with their individual benefits with the technologies that you’re using. So they will keep pushing at that point as we believe it’s correct and right to the long-term and confident that (inaudible).

Mike Vitelli

Yes. (inaudible) Just a quick comment. I’m going to follow on to your follow-on. I think one of the things that’s very interesting that we are seeing on 3D is the amount of the traffic and the curiosity the people who are coming in and looking at television, and really screams to me that innovation is not dead in TV. We are in the early inning that continues to advance, and that is the appetite for this home theater experience and the sort of Holy Grail, just magnificent home theater experience continues to evolve and the consumer appetite was very, very strong.

Brian Dunn

And then the evidence today is movie theaters, many of them announced increasing prices for 3D -- 3D attendance, which reinforced with the consumer interest in it, which then reinforces the opportunity for the televisions. So I think we are pleased at the moment.

Mike Vitelli

In the strength of Avatar, the strength of Alice [ph] and -- Barry has seen that six times.

David Strasser – Janney Montgomery

Great. Thank you very much. Appreciate it.

Jim Muehlbauer

Thank you.

Operator

Thank you. And our next question comes from the line of Mitch Kaiser with Piper Jaffray. Please go ahead.

Mitch Kaiser – Piper Jaffray

Thanks, guys. Good morning. Nice quarter. Jim, maybe you could talk a little bit about you intimated that you might start tapping into the $2.5 billion. You finished the year with, I think, $1.8 billion in cash at the end of the year and you said that your free cash is going to be greater than $1.6 billion. Can you just give us some parameters on how you might think about that, as we progress over time?

Jim Muehlbauer

Yes. I’d be happy to, Mitch. As we think about that, I provided the historical context on purpose. And that is, we look at the cash flow abilities of the business to both allow us to invest in where we are going to go for the future so to keep the machine moving for the long-term, but also using opportunities to overall improve our return on invested capital. We’ve shown the tendency in the past, obviously do both. Matter of fact, as I mentioned over -- we got over $5 billion in share repurchases alone over the last five years. So as we move on a track forward over the next several years, growing our top line, expanding margins, we know we are going to have cash flow available to enhance returns for shareholders by repurchasing our shares. The timing and the windows of that will be determined in the future specifically. But certainly it’s a great opportunity for us. It’s what we see going ahead to create value for our shareholders.

Mitch Kaiser – Piper Jaffray

Okay. Is there any parameter that we can think about that then, as we progressed?

Jim Muehlbauer

What we purposely have tried to do, Mitch, is I think Matt identified this -- certainly appropriate to his question is, we specifically want not only our shareholders but our employees to focus on what we are doing in our operating model. That is the future of the company and making the transformation with the connected world and growing our operating margins and growing our top-line for the long-term are the most critical points. What we wanted -- what we don’t want to lose focus on is that this is not a won-and-done return to shareholder story and then we move on to a chapter that looks different. We’re going to grow the operating earnings of the business where we are focused on driving ROIC over the long-term. Share repurchase will be a component of that over the long-term. And we are very fortunate that for our shareholders and our business model that we’re going to have the capacity to do both.

Mitch Kaiser – Piper Jaffray

Okay, understood. Thanks, guys, and good luck.

Jim Muehlbauer

Thanks, Mitch.

Operator

Thank you. And our next question comes from the line of Kate McShane with Citi Investment Research. Please go ahead.

Kate McShane – Citi Investment Research

Thank you. Good morning.

Brian Dunn

Good morning.

Kate McShane – Citi Investment Research

Some of the non-traditional retailers as consumer electronics, even in the traditional resource, they are competition, doing more on the service side. What is the risk that some of your competition gets more aggressive on service over the next 12 months while you do, and that it could put pressure on the price of e-charge for the service and its margins. And it has been incorporated in your guidance.

Brian Dunn

I’ll turn it over things to Mike for some context. But first, let me just frame it a little bit and tell you, we etc that there will be competition in that space. We welcome the competition in the space. We think our Geek Squad and the women and men, the 20,000 agents we have across the world are in a position to do more for our consumers and consumers around the world than any other unit. This is hard business. This is heavy lifting to get into, and we have the team that we are very, very proud of. And we think that it actually positively calls attention to the capacity we have as more people stuck into it.

Mike Vitelli

That’s right. There will be competition as it is extremely hard work and the thrill that we have, our own employees doing that work, which is really great (inaudible) whole team that executes it. We have capacity and capability to do it. We are improving our customer satisfaction, the work that we do (inaudible) the home every day. So we are confident -- and to your other point, yes, we were not naïve to what the pressure might do to the margins in Singapore.

Brian Dunn

And as we do in any kind of competitive environment, we will be very knowledgeable about what our competition is doing, but we will be extremely focused on what it is we are doing to deepen our relationship, to deepen our connection with our customers. And we will focus on learning more about our customers and doing more from that [ph].

Unidentified Company Speaker

Also to the -- I think a relevant point that plays into our performance over the last year is being the strong customer acquisition platform for technology allows us an opportunity to be relevant in the mind of consumer, which is not only valuable to our vendor partners that think of our services businesses. People don’t come into our store necessarily asking for a service. They come in looking for an experience. And as part of that experience, if we can marry a service capability in a solution that we have already got built within our model, it becomes part of the entire transaction overall.

So from a competitive standpoint, we know that customers don’t look at services 100% of the time. It’s just the services. They are look at this part of an overall solution. That’s where we’ve excelled in bundling these things over the last year few years. It’s also why it’s important in moments like we had during last year that we use our leverage to build opportunities to continue high traffic flow into our business and give us the ability to take that -- share that we built this year and monetize that going forward.

Kate McShane – Citi Investment Research

Thank you.

Brian Dunn

Thanks, Kate.

Operator

Thank you. And our next question comes from the line of Peter Keith with JMP Securities. Please go ahead.

Peter Keith – JMP Securities

Hi, thanks for taking the question and congratulations on the results. I was hoping you could provide some perspective on how you are thinking about market share gains going forward on an annual basis. I know this past year was a better of an anomaly, but you captured anywhere from 80 to 100 basis points in years past. But now going forward, we no longer have circuit of the share (inaudible) square footage growth is a bit slower. So how are you thinking about that on an annual basis, both on the near and medium term?

Barry Judge

This is Barry Judge. You’re right (inaudible) our history over the last decade has been to grow about 100 basis points -- anywhere between 80 and 120 basis points of market share. And in the past year we gained over 200, as we noted in the release. As we go forward, we think the market -- we will gain again market share for all the reasons we’ve talked about on the call. Great execution, driving people in the stores, bundling services, content connections too are connected devices, but we think that (inaudible) will return closer to our historic level.

When you look at the gains and look at our total market share, we have somewhere between -- somewhere in the mid-20s in terms of market share. So obviously there is a lot of market share if you get. Often we hear a lot about Wal-Mart, and we look at Wal-Mart closely and Amazon etc. When you add up our combined market share, it’s still below 50. So they go out market share to get. And when you look at the last year, much of the market share gains actually came from other channels and competitors (inaudible) just noted. So we look at opportunity to grow and then didn’t call out, but I should call out opportunities against market share in the back time [ph] channel as well, which is where we gained significant market share last year as well.

Peter Keith – JMP Securities

Okay. That’s helpful – helpful color. Appreciate it. And just to clarity, if you see that potentially return to that band of sort of 80 to 100 on an annual basis going forward?

Barry Judge

Yes, we are absolutely doing. I think the other broader opportunity to outline, and it’s certainly imbedded in our strategy going forward is, we define the marketplace and the industry define the marketplace today relatively nearly on the hardware products that we sell. Okay? So in the market share we talk about, mobile phones is inappropriately represented than that. Appliances is not represented in that. Certainly, the connected digital devices, direct TV, cable providers, the things that we are going to use to help the customers light up their experiences are not refined in that world. And we really see in this connected world, in much bigger marketplace --

Brian Dunn

The long and the short of it is, we actually see that we have a much smaller share in a much bigger, broader world. And we are very enthusiastic about that.

Peter Keith – JMP Securities

Okay. Thank you very much.

Operator

Thank you. And at this time, I’d like to turn the call back over to management for any closing comments.

Bill Seymour

Okay. Thank you, Brandy. And thanks to our audience for participating in our fourth quarter earnings conference call. As a reminder, a replay will be available in the US by dialing 800-406-7325 or 303-590-3030 internationally. The personal ID number is 4242094. The replay will be available from 11.30 AM Central Time today through next Thursday, April 1st. You can also hear the replay on our website under For Our Investors. If you have any additional questions, please call Wade Bronson at 612-291-5693, Andrew Lacko at 612-291-6992, or me at 612-291-6122. Reporters should contact Lisa Hawks at 612-291-6150. Thank you for your attention. That concludes our call.

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Source: Best Buy Co., Inc. Q4 2010 Earnings Call Transcript
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