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

F3Q07 Earnings Call

December 12, 2006 10:00 am ET

Executives

Jennifer Driscoll - Vice President of Investor Relations

Bradbury H. Anderson - Vice Chairman of the Board, Chief Executive Officer

Darren R. Jackson - Chief Financial Officer, Executive Vice President - Finance

Tim McGeehan - Executive Vice President, U.S. stores

Brian J. Dunn - President, Chief Operating Officer

Michael Vitelli - Senior Vice President, Best Buy

Sean Scully - Senior Vice President, Services

Barry Judge - Vice President, Consumer and Brand Marketing

Jim Muehlbauer - Senior Vice President, Finance

Robert A. Willett - Chief Executive Officer, Best Buy International

Charles Marentette - Senior Director of Investor Relations

Analysts

Chris Horvers - Bear Stearns

Dan Wewer - Raymond James

David Schick - Stifel Nicolaus

Jack Murphy - William Blair

Alan Rifkin - Lehman Brothers

Michael Baker - Deutsche Bank Securities

Daniel Binder - Buckingham Research

Colin McGranahan - Bernstein

Presentation

Operator

Ladies and gentlemen, thank you for standing by. Welcome to Best Buy’s conference call for the third 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. Please go ahead, Ms. Driscoll.

Jennifer Driscoll

Thank you. Good morning, everyone. We hope you enjoyed the on-hold music from the Beatles new Love CD. We appreciate your participation in our fiscal third quarter conference call. This morning, we have four speakers: Brad Anderson, our CEO, will discuss our quarterly results and his continued optimism about the business; Darren Jackson, our CFO, will provide color on the company’s financial results; Tim McGeehan, Executive Vice President of Best Buy's U.S. stores, will share how we prepared our employees to handle record volumes of customers in stores, online, by phone, and at home; last, Brian Dunn, our President and Chief Operating Officer, will share current customer insights, which give us confidence as we prepare to wrap up a strong fiscal year.

While we have four speakers, we plan to keep our formal remarks fairly brief this quarter so that we have ample time to answer your questions.

We would like to remind you that comments made by me or by others representing Best Buy may contain forward-looking statements, which are subject to risks and uncertainties. Our SEC filings contain further information about factors that could cause actual results to differ from management’s expectations.

Be aware that, as usual, the media are participating in this call in a listen-only mode.

With that, let’s turn the call over to Brad Anderson, Vice Chairman and Chief Executive Officer, who will begin our prepared remarks.

Bradbury H. Anderson

Thank you, Jennifer. This morning, we reported third quarter earnings of $0.31 per diluted share. That is up from $0.28 per share in the prior year’s period. Compared to expectations, we may have slightly outperformed on the top line but due to deterioration of the gross profit rate, we underperformed on the bottom line. While we do not provide quarterly earnings estimates, we understand that earnings that fall short of analysts’ expectations are viewed as a miss. We also know the stock opened down this morning, and we appreciate how our fellow shareholders may be feeling, but we are not disappointed in our performance.

We realize that we may have a [concurrent] point of view, but from our perspective, we are having a powerful year and we are optimistic because of the healthy indicators we see in the business. The primary indicator that has us excited is the customers’ [inaudible].

Certainly the gross profit rate decline was larger than we expected. However, we believe that we made the right choice in this quarter with respect to margin. Darren will discuss the drivers, including the impact of our Five Star acquisition and changes in our revenue mix.

One of the top factors, of course, was promotional activity. We chose to match or beat competitor’s prices on the stake-in-the-ground categories, like name brand flat panel TVs, and honestly, if we could do it all over again, we would make exactly the same decision.

The good news is that our customers responded, and not only did we get traffic but we believe we made significant gains in market share. We are completely comfortable with making a small investment in our gross profit rate in order to grow customer relationships. When we make a positive impression early in the holiday season, it propels us forward into December, which is traditionally a less promotional environment. We have momentum with customers, which is important for today, tomorrow and beyond. Brian will expand on this topic later in this call.

We also improved the customer experience by investing in capabilities that allowed our employees to be better prepared than ever, as Tim will describe.

Thanks to our focus on the customer, we are taking market share and we believe we gained market share in flat panel TVs and laptop computers. As we turn the quarter on the final stretch of the holidays, we have sold a lot of gift cards that we know will be redeemed at close to double the face value.

We also have record numbers of reward zone members who opted to earn points with us.

All of these things bode well for the balance of the holidays, which make up a disproportionate percentage of our annual earnings. Bigger picture -- we are reinventing ourselves as a customer-centric company. We have never expected that results would be [linear] and I hope we have been painfully clear on that account.

We also are cognizant that our transformation is incomplete, and that is no secret to any of you who visit our stores, yet everywhere I look, I see evidence that we are starting to build the capabilities that can differentiate us from our competitors -- capabilities like The Geek Squad, home theater installation, small business, international and our multi-channel experience. These capabilities open up entirely new options for us that can explore next year and beyond.

If we integrate all that we now have, we will do very exciting things for our customers in the future, and we are playing for the long-term and we are playing to win.

Now, I would like to turn it over to Darren Jackson, our Chief Financial Officer.

Darren R. Jackson

Nice job, Brad. Thank you, everyone. We usually save the spellbinding financial update for last. However, we thought it would be helpful to move it up in the call in order to give you the building blocks of our performance for the quarter and the balance of the year.

The punchline is that we remain bullish on the year, despite the speed bump in this past quarter. Let’s start where we left off in September.

Our first week of the quarter started with low double-digit comparable store sales gains. Like many other retailers, we experienced softer sales and growth in October and early November. The quarter finished with a robust, double-digit comparable store sales gain on the Thanksgiving weekend. Our finish to the quarter was impressive, and should bode well for the fourth quarter.

I say that because the double-digit comp sales improvement this Thanksgiving Day weekend came on top of last year’s double-digit comp gain. The sheer volume that the team handled was a record, and our employees deserve a huge thank you.

The strong finish to the quarter allowed us to deliver sales at the high-end of our original guidance. On the other hand, it also contributed to a gross profit rate that was below our plans. Let me talk about each of these line items.

First, our top line. Our employees delivered a 4.8% comparable store sales gain. This performance was led by bestbuy.com, which was up 30%, an impressive 13.7% comp gain in Canada. Year-to-date we are tracking at the upper half of our annual comp sales guidance range. Customer interest remains very healthy and we are purposefully and thoughtfully growing our market share.

Second, and understandably concerning at first blush, was the decline in the gross profit rate of approximately 85 basis points. Let me [point out] the three drivers.

First, we lapped last year’s first time gain of the initial recognition of giftcard breakage. That was worth approximately 30 basis points, or $0.04 a share.

Second, adding the China Five Star business into the portfolio reduced the gross profit rate by 25 basis points.

Third was the remaining 30 basis point portion of the decline, which represents a comparable decline in our core gross profit rate. This rate degradation was more than we expected at the outset of the quarter. It was driven by a few things. One driver was the mix of business, both from a product and a calendar perspective. We generated higher-than-expected revenue gains in notebook computers, which are at lower margins. We also had a greater proportion of the quarter’s revenue come during the gross margin challenge, Thanksgiving Day weekend.

Frankly, the environment was very promotional this quarter in categories like home theater and notebook. Thanksgiving weekend was particularly more intense than the prior year. Consumer electronics is the focus for the holidays, and everyone wants a piece of the pie. Competitively, we felt we had to respond to some very sharp pricing on promotional SKUs because of the name over the door, which is Best Buy.

Historically, these short-term costs have helped us deliver a strong fourth quarter. We believe that will be the case this year as well.

We take a longer view, and we are gaining share and building relationships that will fuel the growth beyond the current quarter and the current year.

Closing the third quarter, our comparable store inventory levels were up only 3%. We are pleased with both the quantity and the improved quality of our inventory position this year. It will allow our employees to serve customers better as we head into the bulk of the holiday shopping season.

That sums up the 85 basis point decline in the gross profit line for the third quarter. Looking for the full year, we now expect our gross profit rate to be down approximately 60 basis points for the year. The modest change from our prior guidance is driven by the third quarter results and the anticipated mix shift to lower margin gaming and MP3 players.

Our assumptions also include a slightly more promotional environment for the fourth quarter versus last year, but importantly, less promotional than the Thanksgiving Day weekend.

The bright spot in this quarter and the year is our SG&A improvements. The 60 basis point improvement for the quarter was in line with what we expected. This may come as a surprise to some of you who expected more. We continue to generate productivity improvements in labor spending and leverage of our overhead costs. The addition of the China Five Star business contributed 25 basis points of the improvement.

Last quarter, we communicated that the SG&A leverage would moderate in Q3 versus the first-half of the year. It did, as we ramped up investments in advance of the holidays. Specifically, we relocated or opened nine more U.S. Best Buy stores than last year. We also added 136 more Magnolia Home Theater locations, and expanded an additional 89 home theater departments inside U.S. Best Buy stores.

Finally, we shifted our advertising spending to line up with the timing of these physical investments, the launch of new gaming platforms, and the WOW holiday advertising plan. These significant investments limited our leverage in the third quarter as expected, but provide an important platform for growth in future periods.

Our SG&A leverage was also constrained by approximately 15 basis points, or $0.02 a share, for additional litigation expense that we did not anticipate. To be fair, you will recall last year’s third quarter, we had a similar sized impact from hurricane related costs and relief efforts, which cost us $0.02 per share last year.

At the bottom line, we grew EPS 11% in the quarter, which puts us at 25% EPS growth for year-to-date results.

Before we leave my commentary on the third quarter, I would be remiss not to highlight the outstanding results of our Canadian team. As I mentioned earlier, comparable store sales were up an impressive 13.7% in the quarter, with both Futureshop and Best Buy brands delivering double-digit gains. Operating income in Canada also increased 200 basis points, driven by strong sales and more efficient promotional strategies and solid retail executions. Congratulations to Kevin and the team for a great performance.

Bringing it all together, we are on track for another outstanding year. From a revenue perspective, our fiscal year-to-date results are strong and early results in Q4 are ahead of our expectations. As such, we now expect comp store sales gains of 4% to 5% for the year.

I already mentioned that we expect our annual gross profit rate to decline 60 basis points. Our SG&A rate improvements will more than offset this decline. We expect operating income rate to improve 30 to 40 basis points. We remain on track to deliver our planned EPS target of approximately 20% for the year.

I will end where I started by sharing with you that we remain bullish on the year and our future. I will say it again that the results are not linear, as we saw in this quarter. However, we are committed to meeting or exceeding our objectives for the year.

With that, I will give you Tim McGeehan, Executive Vice President of U.S. Best Buy Stores, to talk about how we executed in our stores and delivered for our customers.

Tim McGeehan

Thanks, Darren. We can talk about execution and delivering for customers, and it sounds easy. What I would like to accomplish on the call though is to share with you the reason for our success and what really goes into it. The challenge is not small. We knew months ago that we would have stores with thousands of customers lined up outside their doors on Green Friday, and droves of customers online. We knew that day would be by far the biggest day we had ever had as a company. We knew it would stretch us to the limits and test our capacity, and we knew that at the end of the day, our ultimate success would be determined by how the customer felt before, during, and after Thanksgiving weekend.

That Friday and Saturday, we broke through the ceiling of what we expected. We sailed through the largest day in company history, and the primary reason it went well is that we planned well. We also had made smart investments. Namely, we had invested in our people and we had invested in our infrastructure. Of the two, our people and our infrastructure, the people are the more powerful, so that was our primary focus.

Before I get into the investments, let me describe how we planned differently. Last year, we talked about how we expected our teams to execute too many initiatives at one time and were not focused. This year, we listened to our employees and they drove the work. At the core of this is the fact that our playbooks were based on employee and customer input.

On Green Friday, we were ready with clear, compelling offers, an effective ticketing process, store maps, and color coded balloons. Most customers said our queuing systems worked smoothly and that we made camping overnight worth it. We had engaged employees having a good time and that improves the customer experience. Overall, we came through with flying colors. Our results make us very optimistic about our capacity for growth, not only for the balance of the holiday season but for future years as well.

Solid execution as a plan was a result of hard work and meaningful investments, as I mentioned earlier. We invested in some of the traditional ways. A big one was investing more this year in employee training. We took advantage of the best vendors in the world to increase employees’ knowledge of the products and services we offer. We also created new career paths for employees through additional positions in our stores, such as the opportunities in our growing services business.

Last year, we established an incentive program for part-time and full-time employees, which remains in place and is very popular. Retention is up because of the training, incentives, culture and careers we offer, combined with our openness to employees’ ideas for serving our customers better. The result is more engaged, more experienced employees, a combination which enhances every customer interaction.

They say crawl before you walk and walk before you run. The exciting thing is we are only crawling in terms of harnessing the collective power of our 130,000 team members. We are still early in the learning curve on how to turn customer insights into higher returns and how to scale employee innovations across the company. Every day we learn something more and hopefully get better at solving each customer’s needs through our people.

So, I said that our investment in our people is the primary investment we are making. The second type of investment we are making is in our infrastructure, which enables us to deliver on our promises to our customers. Two notable examples are supply chain and multi-channel. We have invested in our supply chain and one of the outcomes was improved customer availability. In fact, we had the best ever customer availability going into Thanksgiving weekend. Our customer availability, or in-stocks, were at 99% for that weekend, and we hit our highest average ever for the month of November. Moreover, our stores recovered quickly with fresh inventory and organized shelves.

We have also invested in our websites. We posted our circulars and holiday offers online and offered designated parking spots for in-store pick-up. In addition, we improved our search engine and research capabilities online, which may have helped our conversion rate. Our site traffic actually quadrupled at times, yet our online sites did not buckle. We stayed open for business and we thrived online, in homes, in our call centers, just like in our stores.

Our investments in our people and our infrastructure are not over, but they are paying off. More important, through the combination of those two investments, we see capacity that exceeds what we formerly thought we had. As head of U.S. stores, I find that very encouraging. I salute our employees for making it happen and we are confident with what they have delivered so far. Our teams are set up to win, and that is exactly what we are going to do.

Now I will turn it over to Brian to talk more about how we are doing with our customers.

Brian J. Dunn

Thanks, Tim, and good morning, everyone. I promise to keep this short because it is important that we have plenty of time for your questions, and what I have to add to the conversation is simple.

Here it is: when we talked last quarter, I said that I was really excited going into the back-half of the year. Today, as we head into the fourth quarter, I am more excited than ever, because I believe, I know, we are listening to our customers and serving them better than ever, and we have only just begun.

I want to tell you a story that I think captures why I feel this way.

I left my house at 4:30 a.m. the Friday after Thanksgiving and headed out to a Best Buy store, with my two teenage sons in tow, believe it or not. It has become a tradition in my family and I swear I do not force them to come. Like me, they like to watch this cultural phenomenon first-hand.

When we got to the store in Eden Prairie, Minnesota, we saw 1500 customers in line, the heartiest of whom had been standing out there for 13 hours. They seemed amazingly happy, considering where they were and what they were doing, and I think that had a lot to do with the fact that they felt Best Buy was taking care of them.

When I got there, Matt Thomas, the general manager at Eden Prairie, and Gina [Gabrielson], the customer experience manager, were walking the line explaining to folks exactly how things would go when the doors opened. This was by no means the first time they had communicated with these people. From the small hours of the morning, the Eden Prairie team had been clearly communicating expectations to folks, handing out tickets that represented access to certain products and services, from front to back, based on the reason the customers had come to Best Buy.

Then, precisely at 5:00 a.m., the doors opened. This incredible crowd of people moved into the store in what seemed like two minutes, and my sons and I followed. I have to admit that as we neared the entrance, I was prepared for absolute pandemonium. As I passed through the doors, I saw exactly the opposite.

By 5:15, there were nearly 2,000 human beings in that store, counting customers and employees, and it just hummed. The execution that Tim described earlier was made real that morning at Eden Prairie. Matt’s and Gina’s team were all over it. The shelves were stocked, the stores looked great, and 100-plus employees interacted with the customers in efficient, energy-filled conversations and got them where they needed to go and what they needed to get.

The checkout line wrapped literally throughout the store, marked clearly with a tape line on the floor, and it moved with amazing speed. People had no idea who I was, thank goodness, and that allowed me to chat with people as they shopped and even as they stood in line. I asked them if they felt the store was taking care of all of their needs and I was being careful not to lead the witness. To a person, they repeated a variation on a theme -- Best Buy is obviously prepared really well for this day and I feel like they care about my needs.

I tell this story because I feel it gets to the essence of why I am so optimistic about our prospects, and not just for the fourth quarter. Eden Prairie is a relatively new store and it reflects many of our most recently developed ideas, including Magnolia Home Theater, Best Buy for Business, and a prominent Geek Squad presence.

As I was walking the floor, I was struck that the store at that hour with that team executing like a clock, was a tangible expression of thousands of ideas, big and little, that have come from thousands of customers and thousands of our own people. It was a microcosm of Best Buy as a whole.

We still have a long way to go as a company. The truth is that this transformational journey will never end, and we need to remind ourselves of that fact every morning when we get up and get after it. But it is also important to recognize the real progress we have made in learning how to really listen to the ideas that come from our customers and from those closest to them, our own people.

A lot of people scratch their heads at this American phenomenon called Green Friday. A lot of people see it as a sort of necessary evil that retailers are forced to deal with and minimize, but that is not how I see it.

Last year on that Friday, 3 million customers shopped at Best Buy. Of that 3 million, half of them were customers who fall in what we call the best or opportunity categories, essentially the two upper core tiles in terms of loyalty and profitability. 270,000 of them were completely brand new to us as customers, and finally 250,000 of them signed up as Reward Zone members for the first time.

Here is how I see the Friday after Thanksgiving. This might be a paradox, but this day that seems to be all about stuff is really a chance for us to reach out to people and show them that Best Buy cares about more than just selling them stuff, that Best Buy is a company that creates experiences, whether that experience is a vibrant home theater, a gaming system that comes to life in that home theater, a wireless network that actually works, or a surprisingly good time at 4:45 a.m. standing just outside the great Eden Prairie Best Buy store. It is a chance to show them what the new generation of Best Buy is all about.

In closing, I would like to circle back to Brad’s comments. We never enjoy missing expectations, but we take great pride in the progress we made on behalf of customers and we are very excited about the momentum we built for the future. At Best Buy, we are all about the future and all about growth. You can and should expect us to make long-term customer growth decisions in favor of a single quarter’s results.

Thanks for your time. We appreciate your support this past year, and we hope you and your families have a happy, healthy, holiday season. With that, we will open the floor to questions.

Question-and-Answer Session

Operator

(Operator Instructions)

The first question comes from Chris Horvers with Bear Stearns. Please go ahead.

Chris Horvers - Bear Stearns

Good morning. You mentioned that you are focused on the longer term prospects for the electronics business. Could you talk about the longer term revenue and gross margin outlook in the light of the increased competitive set in TVs versus growth in the services business? How do you see these two factors playing out?

Bradbury H. Anderson

Mike, do you want to go ahead and --

Michael Vitelli

Looking at it from a point of view of the television business, I think we are on the onset of a tremendous growth opportunity for the industry and for Best Buy in particular. The household penetration for high definition TVs is still rather small. It is probably in the 20s, 25%, which we look at as a 75% opportunity, plus when you start getting into multiple sets in homes, we look at the next several years, and the fourth quarter in particular, as a tremendous opportunity for growth.

Brian J. Dunn

I would also add that we do not just look at it as the TV business. We look at it as the home theater experience business, and we think about audio attachments, we think about all the pieces that come together around the customer to create a home theater experience. That is what the customers are in the market for.

Darren R. Jackson

Brian, to build on that, I think you have to look long-term and think about, we continue to focus our investments in making structural improvements in our margin. We are still early in the services business. We are still early in some of our private label development. We are still early as we look out in terms of Canada and other parts of the business developing their supply chain efficiencies, and the structural things we continue to make those investments in.

Environmentally, we are going to have these moments in time where we are going to have to respond to price competition, but I would also say environmentally, we will see solutions evolve. So our HD advantage, if you think about the TV cycle, is something that we can do uniquely. We can put together, through the power of that idea coming from our blue shirts on the floor, how do you get DirecTV, how do you get a financing offer, how do you get it installed, and how do you get the best advice for what is right for your home?

I think you have to think about our business model going beyond a moment in time against a product and going against a solution and structural advantages we are looking to navigate not just this quarter, but over the foreseeable future.

Chris Horvers - Bear Stearns

Okay, as a follow-up then, could you maybe shed some light on the growth in the services business that you saw, including Geek and perhaps what the attachment rate was with home theater install, both on the top line and in terms of the benefit to gross margin?

Jennifer Driscoll

Sean Scully will take that one.

Sean Scully

First and foremost, even the day after Thanksgiving, which was naturally a big volume day, we saw triple-digit growth on both the in-home Geek Squad and in-home home theater installation. We did see that mix shift to home, but candidly that is actually a competency and a capability that we have built to support that customer.

We are still naturally maximizing our home theater efforts. We really built that in the last year. We are very happy with the quality that we have and we are happy with essentially the revenue that we are driving for, with strong triple digits.

Geek Squad is still a strong double-digit growth for us and we are prepping and preparing not only for this holiday but for Vista.

Chris Horvers - Bear Stearns

Any gross margin color?

Sean Scully

We usually do not tell you that and I do not think we are going to change that today.

Jennifer Driscoll

That was a good try there, Chris. Next question, please.

Operator

The next question comes from Dan Wewer with Raymond James. Please go ahead.

Dan Wewer - Raymond James

Good morning. Last week, Tweeter had indicated they were seeing a lower attachment rate on customers purchasing the lower priced flat panel TVs, and if this is a phenomenon Best Buy is seeing as well.

Michael Vitelli

In looking at it overall, I would say that is not true. I would say it could be true for a couple of days, when that activity reached volumes that were unprecedented. But overall, as Darren mentioned earlier, we have been thrilled with the response that consumers have had to the high definition advantage offer where we are regularly telling them and incenting them to look at the entire experience, which includes high definition television, the source, the installation, and related services.

Bradbury H. Anderson

This is a big part of what our core story is, which is we are not just one product per attachment. There is a whole series of benefits that are connected up to that enhance the use of the product that we sell, ranging from services to sourced accessories, to extended warranties and beyond. We have a more diverse pool than some of our competitors.

Dan Wewer - Raymond James

So you are not seeing any diminishing returns from these late adopter or more value conscious customers in purchasing accessories?

Bradbury H. Anderson

They will buy it differently, as we have seen with computers over the years. There will be a change in what they buy, but I do not think -- I will let you guys comment.

Michael Vitelli

In fact, I think it is actually more related to size than it is to price. The larger the sets are, the higher the attachment of services and installation and high definition source. When you are into 21-inch TVs, generally those are less because you are not installing those. The relationship is more to size than price.

Dan Wewer - Raymond James

As a follow-up question, Darren, at the end of the previous quarter, you had indicated that inventory per store would likely remain up about 10% until the end of the year because of the importance of being in stock in notebooks and flat panel TVs. You noted you are up now about 3% instead of around 10%. Is there a risk that we may not have the product on hand to support your optimistic sales outlook? I shouldn’t say optimistic. Let’s say upbeat.

Darren R. Jackson

Oh, Dan, we are always optimistic, so I would say this, Dan. If I said we expected to be at 10% comparable store inventory levels for the balance of the year, then I misspoke. Candidly, when we talked about the end of the quarter last quarter, we were up 10% for a couple of reasons, the biggest of which I talked about, the 136 new Magnolias and 89 expanded home theater rooms. So we have built inventory in front of rolling out those new additions to our stores in the third quarter.

I have to tell you that the 3%, I think you ask a good question. The 3% comp store inventory level, it is light in relation to the sales plan that you just saw in the fourth quarter. The teams, and I think -- I do not know, Tim highlighted in his comments, what we feel good about is some of the investments that we have been making in supply chain that is getting our customer availability up and so we can have fewer days of supply and replenish more quickly.

I have to tell you, what you cannot see, which is really a good news story is, underneath, the quality of our inventory, our overall at-risk inventory -- and at-risk has come down significantly, it is well over $150 million Q3 to Q3, so that is yet another example again in the merchant teams, the inventory management supply chain, bringing down the at-risk inventories. That is better than 20%, so I feel good about the content, the quality of it, and the levels and our ability to refresh that as we go into the fourth quarter.

Dan Wewer - Raymond James

Great, thanks, Darren. That was helpful.

Jennifer Driscoll

Thank you for your question, Dan, and Brad, Mike, and Darren for your answers. Next question, please.

Operator

The next question comes from David Schick with Stifel Nicolaus. Please go ahead.

David Schick - Stifel Nicolaus

Good morning. You mentioned in the release and briefly in the conversation that you have had, but could you give anymore details on gift cards, the growth and size, or thoughts around the gift card business?

Bradbury H. Anderson

Barry Judge, you want to take that for us?

Barry Judge

Sure. We are seeing strong sales of gift cards this year, as we have in the past. We expect our gift card business to be up double-digit versus prior year, as I think we have said before in the calls, that we see them coming back at about $2 to every $1 that we sell, so it is a very strong business for us right now.

Darren R. Jackson

Maybe to put some quantification around that, I think last year our gift card business went well over $1 billion, and it grew 16% last year on top of the prior year’s 29% growth. As Barry said, we are tracking a double-digit growth this year and it is approaching the same level of growth in the 15% to 16% range that we are seeing and usually historically bodes well for business right after the holidays as well.

David Schick - Stifel Nicolaus

Darren, as you pointed out, the year, would you have expected a year ago that this Christmas would be up 15%, 16% again, or is that better or worse or roughly in line?

Darren R. Jackson

Barry is back here, he would say absolutely in line with our expectations. We do have a business that I think for the past five years, if we looked at it collectively, has been growing on average almost 20%. It slowed a little bit recently, but I think that just goes to the team’s work in terms of the innovative gift cards and our ability to look at other channels to grow that business.

David Schick - Stifel Nicolaus

Great, thanks.

Jennifer Driscoll

Thank you, Barry and Darren. Next question, please.

Operator

Our next question comes from Jack Murphy with William Blair. Please go ahead.

Jack Murphy - William Blair

Good morning. I wonder if you could talk about your view of the average selling price declines in the digital flat panel TV, where they are at roughly through the third quarter and if you are seeing acceleration going into the fourth and into ’07.

Michael Vitelli

The pricing year over year, if you look at where LCD and plasma are now versus a year ago for comparable inches, if you will, because that is how we try to look at it, is inches, LCD is down about 25%. Plasma is about 30%. I would say they were ahead of where we planned them to be, as far as them accelerating based upon the aggressiveness of the manufacturers of getting their product into the marketplace.

I think in many cases, they are set for where they are going to be into the fourth quarter, and as they move into ’07, they are starting to say again that they think that decline will slow. Some of the manufacturers have started saying that. They said that last year as well, but I am still very bullish on the fact of every time we are changing a $225 tube TV, for whether it is a $1600 or $1400 or $1200 flat panel TV, that is a positive thing for us.

As we said earlier, the experience that the customer is looking for in high definition is materially different than the experience when they were buying tube televisions for the last decade. That is giving us an opportunity to explain to customers how to get the experience that they see in our stores and to bring that into their homes, and that is a big shift and a positive one for us as well.

Jack Murphy - William Blair

One quick follow-up. The LCDs that are getting into the larger screen sizes, is that level of competition and the fact that LCD has also a pretty aggressive built-in ASP decline, is that creating more average selling price pressure on larger screen sizes? Is that something that we should expect for ’07?

Michael Vitelli

I think that would be right. I think to your point, as LCD gets into larger screen sizes, that will put plasma and LCD and even projection TV, so to speak, head to head with each other. It will take a little bit of time for LCD to get to the point where it is below plasma, because that is the projections in the industry as that total industry expands over the next five years, but it will get them in parity and then begin to bring prices down for consumers, which is going to be a positive thing for the growth in the industry.

Brian J. Dunn

It is a positive thing. In fact, it is moving it right into the sweet spot into the power zone for middle America, which is something we are extremely excited about here at Best Buy.

Jack Murphy - William Blair

What would be the implication on margins of the phenomenon?

Michael Vitelli

The product costs move down with the manufacturing capacity, and that is what allows for the price decline, so in general, the margins relatively stay the same, if you will, and follow the price down.

Jennifer Driscoll

Thank you. That was Mike Vitelli and Brian Dunn. Next question, please.

Operator

The next question comes from Alan Rifkin with Lehman Brothers. Please go ahead.

Alan Rifkin - Lehman Brothers

Yes, good morning. A couple of questions, if I may. Darren, you mentioned that there was a shift in the advertising spend in the quarter. Could you maybe just quantify that, and what do you foresee the advertising spend in Q4 compared to last year? I do have a follow-up.

Darren R. Jackson

Maybe a little bit of context, Alan. If you go back to Q2, you might ask yourself, at Q2 I think we were running call it 95 basis points of SG&A leverage. What we had shared with the group is where did it come from? We said a third of it is coming from labor productivity, a third of it is coming from overhead, and a third of it is from advertising. We said part of that was a deliberate decision to shift advertising dollars into the third quarter. When you look at our third quarter SG&A leverage, how did we go from 95 basis points down to 60 basis points of leverage, we would say almost two-thirds of that is that we released the advertising spend into the third quarter, absolutely targeted at the things I talked about in my comments.

The other pieces of it is we also made some investments, as we said we would, in all those Magnolia Home Theater rooms and expanded home theater offerings, which slowed some of the leverage that we experienced in the second quarter. Those are the two big differences quarter to quarter.

As we go into the fourth quarter, we would expect to continue to be investing more in advertising as we reach the gaming platform launches and more importantly, Vista and the Vista launch and what that will mean to our home office business and our services business as we go into the fourth quarter.

Alan Rifkin - Lehman Brothers

Then a follow-up for Brad, if I may. Brad, it was mentioned on the call that obviously you had a tremendous post-Thanksgiving weekend, comps were up double-digit, there were 1500 people at the store that Brian was at, there were 1,000 people in line when the store opened at the store that we were at, looking at that weekend, and maybe even the holiday season holistically, and I realize that obviously you have to be competitive with more and more competitors nowadays, but as you look at the holiday season, maybe from 30,000 feet, is it really necessary to be as promotional as you have been in the past, and maybe sacrifice some of the revenues in an effort to drive even greater profitability?

Bradbury H. Anderson

Thanks for the question, because actually when we first started doing customer centricity, we had a hypothesis that this weekend, actually we called it Red Friday. As a standalone, it made no economic sense. So the hypothesis going in was this was a stupid way to put a huge amount of financial investment and take almost no margin out of it, but as we got deeper into customer centricity and a deeper understanding in terms of the customer, and this is what Brian referred to, we discovered that it may be red on the day, but it is not red.

I think you have seen some other retailers lose, consistently lose the Thanksgiving weekend. There is an elongated impact of that loss that is not smart. That is kind of what we were trying to go back and say look, we expected probably higher margins than we got on the Thanksgiving weekend, because you can never tell and when you compress business into that tight a framework exactly what people are going to buy. But we are very bullish about seeing that so many customers responded, because it is those customers over time are highly valuable to us.

Alan Rifkin - Lehman Brothers

Thank you very much and best of luck.

Jennifer Driscoll

Thanks, Brad. Next question, please.

Operator

Our next question comes from Michael Baker with Deutsche Bank. Please go ahead.

Michael Baker - Deutsche Bank Securities

Thanks. I do want to focus on the gross margin a little bit, and maybe two questions. One, so on the fourth quarter, I think if you do your annual guidance, you back into the fourth quarter down about that same 80 basis points, but it sounds like you expect the fourth quarter to be less promotional. You do not have Black Friday, you do not have the gift card breakage, so either my math is wrong, you are being conservative, or there is something else in there. Gross margin, not -- I would expect to be down less than 80 basis points.

Jim Muehlbauer

Michael, this is Jim Muehlbauer talking. If we look at margins in the fourth quarter, we also recognize, consistent with Darren’s comments, that we are going to be mixing into some lower margin categories, based on the growth cycles of those businesses. Namely, we expect the gaming platform to be bigger in our mix of sales in the fourth quarter. We also know that we will be mixing heavier into MP3 hardware, which carries lower margin rates. Those are two of the things that we will actually see a little bit of degradation, once again just due to the mix change in our business, not in the individual rates of those product line performances.

Michael Baker - Deutsche Bank Securities

Okay, so it is the mix. I guess the follow-up is, I assume that around Black Friday, and I think Mike Vitelli, you alluded to that the attachment rates are lower on TVs, and probably on video games as well, as people are just coming in for the box and getting out as quickly as they possibly can. Is that the case, and if so, can you talk about how much Black Friday hurts the gross margin?

Darren R. Jackson

Why don’t I have Tim qualitatively answer the question. Quantitatively, I will give you the -- I can just say, we did not, when you look at part of the basis point decline in that 30 basis point core decline that we had in the quarter, I would roughly estimate that about a third of that decline came from the mix of more business falling on Black Friday than our original forecast.

So as we said, the good news is we absolutely got the volume. The reality of just the challenge of trying to attach on those days and the mix of the promotional items was probably a third of that cost on that day for the quarter.

Tim McGeehan

Darren, I will just add a little color. The first part of the data, the first few hours, as you know, is just taking care of customers and moving the velocity out of the store. The rest of the day, we do not see that degradation at the rate that we do the first few hours of our doorbusters, or what you will see in our insert and our flyer, either online or in the flyer at a seven-hour special. But that is really a three- or four-hour window, just heavy velocity that we do not see actually even the rest of Friday maintaining at that rate for the rest of the day.

Michael Baker - Deutsche Bank Securities

Okay, thanks for the color, appreciate it.

Jennifer Driscoll

Next question, please.

Operator

Our next question comes from Daniel Binder with Buckingham Research. Please go ahead.

Daniel Binder - Buckingham Research

Good morning. An expense related question. On the litigation expense, I was just wondering if you could address what that is for. Is it one-time in nature or is there sort of a permanent lift in litigation expense accruals going forward?

Then, it sounds like advertising and home theater reset expense was more or less in line with what you were thinking. I am just thinking, as we look forward, is there a lot more money that needs to be thrown at the home theater resets, whether it is -- probably not Q4, but sort of post Q4, into next year? Does that spending in China also pick up next year?

Bradbury H. Anderson

Why don’t I take a swing at litigation? The $0.02 charge, or 15 basis points in the quarter, I think the key takeaway was we did not anticipate it. So in relation to the quarter and the year, it is not something that -- we do not look out and -- we believe any dollars going into this type of litigation matter are wasted dollars. The reality of the size of our company is that I would love to call it a one-time event. At the size of our company, we are going to have other litigation matters of this size, I just don’t know when. So we wanted to highlight it for the group in terms of transparency, but we also want to be candid that we wish they are one-time, but the reality of the size of our company, we are going to have other of these matters. I do not think it is things that we necessarily want to plan for, but they are going to occur.

Jennifer Driscoll

The second question had to do with home theater spending.

Bradbury H. Anderson

Yes, since we have obviously more stores we haven’t done than stores we have done.

Michael Vitelli

Yes, so we have Magnolia Home Theater in just over 300 stores, and probably two-thirds of those we have transformed the home theater department outside and we have done that in over another 100 stores, so there are probably 500 stores left that we can do some action in as we look at next year.

From a Magnolia Home Theater point of view, we are probably close to done and covered in that space, if you look at individual markets where you are going to put that assortment and that level of investment in, but the home theater transformation, which is fundamentally creating a space where you can experience the flat panels in an environment where you can actually see them and step back from them, but more importantly, go through the experience of what high definition source and installation is all about, we will be looking at how much of that we need to do and how many stores next year as we plan out the year.

That is something that will likely have to happen because the consuming public has yet to grasp the need for high definition. They certainly have the need for flat panel television. That experience is very clear, but the understanding and the need for high definition and the experience difference that it gives you is still very, very low on the consumer awareness scale. We think we have an opportunity to explain that to tens of millions of customers.

Bradbury H. Anderson

Mike, if I could just add a couple of notes. One is we are going to continue to evolve what our home theater solution looks like for the customer. As the customer learns more about not just flat panel but exactly what HD source means, what picture quality, what sourcing looks like, not just from picture but also in terms of sound. We are going to continue to work that home theater department. You may go in and see what we call our heat proposition, where we have remodeled the whole flat panel wall. We are going to continue to work on that across America so that solution matches up to fulfill the customers’ needs that we are trying to sell for.

Bob, did you want to just briefly about China?

Robert A. Willett

In terms of China, the level of spend is absolutely consistent next year with our plans. In fact, the mix will change somewhat. We will open probably in the region of 20 to 22 Five Star stores. We open our first Best Buy store in Shanghai in approximately 10 days time. That will be followed by one or two other Best Buy stores in the subsequent 12 to 18 months, subject to how we learn from the first one. It is absolutely consistent with the plan.

Daniel Binder - Buckingham Research

Just a follow-up to that, given that the SG&A was basically in line with your expectations, even though the street was maybe a little bit ahead of that, does this give you any reason to give greater clarity? I know you are not providing quarterly earnings, but at least in the last several quarters, we have had a lot of bumpiness in SG&A. Is there any desire to maybe provide a little bit more color where we have bumpiness so the street does not get too far ahead of you?

Jennifer Driscoll

Darren Jackson is going to take that one.

Darren R. Jackson

What a great question. You know, we bumped through the first-half of the year with 100 basis points of SG&A leverage. I hope to bump the rest of the way through the year at the level.

I think part of it is -- I think it is good feedback. At the end of the second quarter, honestly we tried to signal that we were shifting some SG&A investments into the third quarter, both in terms of advertising, the number of Magnolia Home Theaters. Clearly that did not come through, so I think that is good feedback for us to go back and ask ourselves are we doing a good enough job in terms of making it transparent?

Litigation, as I said, was different than what we thought. I think different from what outside followers had thought as well, but I think when you step back and holistically look at the year, our SG&A guidance for the year continues to be very, very gratifying in terms of seeing overall SG&A leverage come in. I do not think it has come in this well for a couple of years, so it should approach, as we said in the math, it should approach 90 to 100 basis points.

Bradbury H. Anderson

There is also one other perspective, which is, to be honest with you, over the years, I appreciate spending. If you look at the benefit we have gotten as we kept our strategy fresh, and as we have constantly evolved to a very transient industry. If you look at this industry, it is always in some degree of pretty substantial flux, and this company has consistently done a good job of gaining market share and adapting to that change. We have done it by constantly revising and refreshing what our stores are.

I think you are starting to see a pattern that a lot of that occurs in the third quarter. From a timing standpoint, it seems to me that makes a great deal of sense for us. We will not be spending money on a linear basis, I hope, going forward but I also think from a shareholders point of view, I like seeing us spend. Especially, you can pretty quickly see whether or not it gives us leverage in our results.

Daniel Binder - Buckingham Research

Great, thanks. Just one last thing I wanted to touch on. Just a comment you made earlier about the promotional activity in December versus November. In the last few years, we have also seen the promotional activity abate somewhat post-holiday. Is there any reason you would think that would change as maybe some of the marginal players pull back from the category this year?

Bradbury H. Anderson

Well, we’ll ask our merchants here. Mike or Dave.

Michael Vitelli

I think, to your point, the traditional comeback after holiday is consistent with what we are seeing right now and what our feeling is and plans are for the rest of the year. There will always be somebody that could be out there that will do something desperate at a particular point in time, but I think overall, I do not think that is a concern.

Brian J. Dunn

This is Brian. I have a follow-up. I am going to turn the tables. I have a follow-up for you. I just want to call out that I do not think we have been bumpy on our guidance, on our EPS guidance for the year. It is exactly why we have gone to annual guidance here.

Daniel Binder - Buckingham Research

I guess the point I was making is that if you look over the fiscal ’06 period, you had some big quarters where you had some investment spending that rose greater than expected. Then this year, we had the benefit in fiscal ’07 of not having some of that. I guess my point was is that in some quarters, there is just greater-than-normal levels of investment spending, so when we lap that, just having better clarity on what you think will come back to you versus what you plan to re-spend, just might be a little bit more helpful.

Brian J. Dunn

I appreciate that comment. I think there is a huge difference. One of the things that we are trying to signal with the call, last year we also had a problem with this quarter versus expectations, and we were doing quarterly at that point. What we were saying was that we were saying we had made an investment and the investment was not working. Because what we expected, anticipated we saw the investment wasn’t what didn’t give us the outcome.

This year, our lens is very different. We have also made investment here, and this year we are very confident that the investment is working, in spite of the fact that the quarter isn’t linear in terms of its earnings improvement.

One of the things you will see is us, sometimes we will make mistakes and you will see us signal, as we did last year, that we are retrenching from a strategy that was not paying off for us. Right now, we are probably doubling down into a strategy we believe in.

Jennifer Driscoll

With that, could we move on to another caller?

Operator

Our next question comes from Mark Rowen with Prudential. Please go ahead.

Mark Rowen - Prudential

Thanks, good morning. A few questions on the competitive environment in TVs. I know a lot of people have already asked about this, but a couple of things. It looked to us like your advertised pricing in your circulars, you did not really lower prices very much. How much of the margin pressure in TVs came from people coming in where you had to match ads on the floor?

Second, Wal-Mart has talked about their TV business, flat panels growing triple digit. You have said that now you are up strong double-digits, previously, and triple digit. Are you seeing people more interested in price in those as opposed to the whole experience, and are they willing just to deal on price and basically walk out of the store if you do not match prices?

Michael Vitelli

Okay, so two questions. You said that our advertised prices, are you talking about on Black Friday were not low?

Mark Rowen - Prudential

No, no, no -- I am talking about just in general throughout the quarter. It did not look to us like you had lowered prices that much compared to some of the competitors in your circulars and online and things like that in your stores.

Michael Vitelli

Well, we do a number of things. We do have the insert that is there all the time. But I would say the promotion that we have had running for this quarter that has been a good part of our success is the high definition advantage, and that is where you have an opportunity to save up to $400 on a TV, depending upon the various high definition services and installation packages that you might be able to use.

We have, if you will, the everyday price that we are promoting in the circular and online, and an additional up to $400 opportunity. You put those together and we are very aggressive.

In fact, when you talk about matching, it is more often than not that is part of the matching conversation, because when you actually listen to people and what they want in their homes, they want what they are seeing in the store. They want to see that picture. They want to have it hanging on the wall. They want the sound that blows them away, and the high definition advantage gets them that experience at a price that can meet or beat our competition, and that is something that they cannot do.

Mark Rowen - Prudential

But Mike, you were primarily -- you were offering that all through the season, so that was not really unexpected, that special promotion. What I am trying to understand is what changed from the beginning of the quarter through the quarter, and was it the fact that the competition had lower prices and you had to lower prices to match? Or was it that when people came into the store, they came in with ads from competitors and you had to match at that point?

Michael Vitelli

The high definition advantage started in the quarter and worked its way through. The phenomenon of the two days of November and the both offensive and defensive actions of that day are certainly a big part of what happened, of a piece of the margin for TV. But if you look at it in total of looking at our quarters as they progress, if you look at the third quarter without those two days, if you look at our projections through the fourth quarter and beyond, the TV business in total, when you put together the basket of products that go along with it, has been very positive.

Mark Rowen - Prudential

Okay, and then related to that, you have talked about your attach rate of all of the other things that you sell with the TVs as not having gone down, but it seems to me that given the strong double-digit growth and previously the triple digit growth in these big ticket items, that your warranty attach rate should have gone up, which should have helped margins. Why is that not happening? Is the attach rate on flat panels, the big screens, becoming less important to people?

Sean Scully

I think there are two answers there, but naturally, some of these products are gifts, candidly, right? And then the way that they get our installation and our service, or our PSPs, are going to be through that attachment process after the fact.

We are not seeing dramatic changes but we are seeing some shifts naturally in the price point of the product, which is how we price the warranties then to fit with that solution for the customer. But we are not seeing a significant change in that business.

Mark Rowen - Prudential

Okay, thanks.

Jennifer Driscoll

Now, for our final question, please.

Operator

Our final question comes from Colin McGranahan with Bernstein. Please go ahead.

Colin McGranahan - Bernstein

I will have a final two, if that’s okay. Magnolia, if we could focus on that first, could you talk about the performance of the converted stores to the in-store Magnolia shops versus your expectations and versus the rest of the chain that did not have that Magnolia? Then, also comment maybe on the standalone Magnolia comp of negative 10%.

Darren R. Jackson

The Magnolia standalone stores, which there are 20 of them, their comps were down 10%. I think part of the story there is as we look to last year, that business was up closer to 20%. As a matter of fact, when you get into the fourth quarter, their business was up 30%. I think as a practical matter, they are also experiencing and lapping some of the price compression that we are seeing in the marketplace. We are not ultimately alarmed, but we are realistic that that business needs to continue to evolve in terms of its offer beyond TVs and source and sound in order to protect the profit formula going forward for the standalone businesses.

Again, I would remind you part of what Magnolia brings to us in the standalone space is that what we are learning and what we are experiencing which led to the conversion into our own stores, so I think -- I want to make sure we keep it in perspective, understand why it is that way but also understand Magnolia is an enormous source for us to understand the front end of trends in terms of the marketplace, so we can use that information to make adjustments in the Best Buy store and benefit from those. I think Mike will take you through what we are seeing in the in-store Magnolia stores.

Michael Vitelli

The intent of the Magnolia stores within the stores is to change the home theater experience within those stores. Last year, the 120 or so that we opened were literally a standalone Magnolia in the home theater department, and that home theater department did not change.

The 180 that we added this year, that we just completed that as we moved through the quarter, in those stores, we have also changed the experience outside of the Magnolia Home Theater department. So when we look at it, we actually do not focus our attention on is it Magnolia Home Theater or is it outside Magnolia Home Theater. We are changing the experience in the department.

We are very pleased. We consciously picked the stores that we are going into to put that experience in and we are thrilled with the response that our customers are having and the business that we are doing in the stores that we change, and that is why Tim mentioned earlier we are looking at next year how to change the experience in the remaining stores, regardless of whether we put a Magnolia Home Theater in there or not. The home theater experience, that Magnolia was a big part of in getting us going, is what we are going to continue to do.

Colin McGranahan - Bernstein

Okay, and then just a very quick follow-up. Darren, what was the giftcard breakage in the third quarter this year?

Darren R. Jackson

It probably wasn’t even a penny, Colin. Net for the quarter was probably $0.03 against us. We had the initial breakage last year in the third quarter of $0.04. I think roughly we take in almost a penny a quarter, as we did this year.

Colin McGranahan - Bernstein

Thank you very much.

Charles Marentette

Thank you, Darren. Thank you, Mike, Colin for your last question. Thank you, Eric, and thanks to our audience for participating in our third quarter earnings conference call. As a reminder, a replay will be available by dialing in the U.S. 1-800-405-2236, or internationally, 303-590-3000. No personal identification number is required. The replay will be available from about 12:00 Eastern today until 1:00 a.m. Eastern on Wednesday, December 20. You can also hear the replay on our website. Just click on For Our Investors.

Finally, if you have any additional questions, please call Jennifer Driscoll at 612-291-6110; Carla Haugen at 612-291-6146; or you can call me, Charles Marentette, at 612-291-6184. As always, reporters can contact Sue Busch, our Director of Corporate Public Relations, on 612-291-6114. I think that concludes all of the numbers that I am going to give you, and please end the call. Thank you all.

Operator

Ladies and gentlemen, as an update, you will require a passcode for the replay. The passcode is 11078191. Once again, the passcode is 11078191. This does conclude the Best Buy conference for the third quarter of fiscal 2007. You may now disconnect and thank you for using AT&T teleconferencing.

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