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

F1Q08 Earnings Call

June 19, 2007 10:00 am ET

Executives

Jennifer Driscoll - Vice President, Investor Relations

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

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

Robert A. Willett - Chief Executive Officer Best Buy International

Brian J. Dunn - President, Chief Operating Officer

Mike Vitelli - Senior Vice President, Consumer Electronics

David Morrish - Senior Vice President, Computer Merchandising

James L. Muehlbauer - Senior Vice President and Chief Financial Officer, Best Buy U.S.

Jill Hamburger - Vice President, Entertainment

Sean Skelley - Vice President, Services Business Group

Charles Marentette - Senior Director, Investor Relations

Analysts

David Schick - Stifel Nicolaus

Evan Rosta - The Boston Company

Bill Sims - Citigroup

Steve Kernkraut - Berman Capital

David Strasser - Banc of America

Eric Mace - Basso Capital

Michael Baker - Deutsche Bank

Vivian Ma - CIBC

Colin McGranahan - Bernstein

Chris Horvers - Bear Stearns

Presentation

Operator

Ladies and gentlemen, thank you for standing by. Welcome to Best Buy's conference call for the first quarter of fiscal 2008. (Operator Instructions) I would now like to turn the conference over to Jennifer Driscoll, Vice President of Investor Relations. Please go ahead.

Jennifer Driscoll

Thank you, Eric. Good morning, everyone. Thank you for participating in our fiscal first quarter conference call. We have four speakers for you today. First up, Brad Anderson, our CEO, will give you his perspective on the quarter and how we interpret it. Then Darren Jackson, Executive Vice President of Finance and CFO, will take you through the financial overview, including the quarter and our annual guidance. Third is Bob Willett, CEO of International and CIO, participating by phone from China. Bob will briefly characterize our results outside the United States where our top line growth really stood out. And last, Brian Dunn will take a deeper look at the customer and employee data which give us confidence in our overall strategy.

As usual, we have a broad management group here with me to answer your questions following our formal remarks. We’d like to request that callers limit themselves to a single one-part question so that we can include more people in our Q&A session. Consistent with our approach on prior calls, we will move to the end of the queue those who asked a question on last quarter’s call.

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.

As usual, the media are participating in this call in a listen-only mode. Also, the call is available for replay in case you miss a portion of the call. Let me give you the reply instructions. Simply dial 800-405-2236 and then enter the personal identification number 11091337. International callers use the same PIN but dial us at 303-590-3000. The replay will be available from approximately 1:00 p.m. Central Time today until midnight on Tuesday, June 26th.

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

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Bradbury H. Anderson

Thank you, Jennifer and good morning. Thanks, everyone, for joining us on our quarterly conference call. We are proud of our track record of earnings growth over the last 10 years, so missing as we’ve done in this quarter is not taken lightly by this organization. In the past when we’ve missed earnings in a quarter, we’ve expressed a clear point of view to our employees, our shareholders describing a plan of action in response.

The quarters in which we have missed earnings have come in one of two scenarios and most of them fit into scenario one. Scenario one is we missed the quarter because we believe we made poor strategic choices or our initiatives didn’t deliver the expected outcome and/or we overspent in the quarter. In this case, we usually decide to change the strategy or revamp the initiatives to deliver a better outcome. It’s a simple message to land and it’s easy for analysts to tell whether we’re making progress. Moreover, we’ve had a solid track record of making the necessary changes. That’s our scenario one.

Scenario two is far rarer. It’s as follows; we missed the quarter but we believe our strategy is actually consistent with the long-term results we want to drive. This situation is tougher because we see evidence our strategy is working in the marketplace. When we look at this last quarter, we’re looking at market share gains, gains in customer loyalty and our strong international sales results, all of which would normally correlate with good earnings outcomes in the quarter.

Also, the strategic choices we made in the first quarter, such as opening more stores early in the year and our international expansion, are ones we would do again even if we had 20/20 hindsight. In other words, our financial results aren’t consistent with our strategic results. It’s a much harder message to land and it’s more difficult for observers to tell whether we’re right in our interpretation of the facts.

Historically, if we’re correct about scenario two, it can be followed by strong financial results and we saw that last year in the third quarter, though sometimes that takes longer. Today we see our situation as scenario two. As we look at the quarter’s performance, we see our earnings were below our expectations yet our results appear to be better than others in our space. But that’s only one number and we believe it’s misleading and arguably dangerous to look at a single metric.

Over the years, we’ve observed that EPS doesn’t always correlate with the core health of the business and as we look at our business today, we see strong indicators that our overall strategy is indeed successful.

Brian Dunn will elaborate in a moment on these indicators. In addition, we will share with you the trends in our customer satisfaction index which points to real improvement with the customer experience and the employee experience. At the same time, we’re nowhere close to the end of our story on improving our business model and the customer experience.

So we’re confident in our strategy and we’re investing in the long-term success of the company. We continue to grow both the number and the value of our customer relationships through our new stores, our international growth, services, Best Buy Mobile, private label, financial service and brand deployment and new brand deployment, to name just a few areas. In fact, in several places we want to grow faster.

So that’s my lens on the quarter and if I leave you with one point, it’s this; we’re never satisfied with missing earnings. However, we know it does not reflect the core health of our business, the strength of our strategy, or our ability to execute through our people, or our optimism about the future. In addition, we remain very focused on driving long-term success through building and strengthening our customer relationships.

With that, I’d like to turn it over to Darren for a financial overview.

Darren R. Jackson

Thank you, Brad. Good morning, everyone. We’re certainly off to a different start this year than we were in the last two years, when we grew earnings 38% and 85% respectively. The financial results in the first quarter were clearly below our expectations as a soft retail environment coupled with a significant mix change in our business reduced earnings. Today I plan to highlight the performance drivers in the quarter, update you on our capital structure progress, and discuss our outlook for the remainder of the year.

First, total revenue of $7.9 billion was generally in line with our expectations. However, more of the revenue growth was driven by our international business than we had planned. Canada delivered strong comparable store sales with a gain of 12.8%. Five Star and Best Buy China also delivered better-than-expected top line growth. Our international revenue results stood out against our domestic comparable store sales growth, which was 1.7%.

Our U.S. quarterly comp was lower than we had anticipated, given our strong fourth quarter performance of a 5% comparable store sales gain in the U.S. Growth in the television industry slowed dramatically in the quarter due to softer consumer demand in the aftermath of strong Super Bowl sales. We think that some consumers may have opted to make purchases in the fourth quarter leading to a subsequent industry pause.

While sales gains were modest in the first quarter, we are very pleased with our growing TV market share and the fact that the overall household penetration rate for flat panel TV is no more than 20%. We still have millions of customers to delight with our full flat HD experience.

The gaming business, while growing rapidly, was also slower than anticipated this quarter as pricing and availability hampered the take-up of new gaming platforms.

Sales of notebook computers continued to be very strong, fueled by consumers’ interest in Vista. More important, we firmly believe that the differentiator, which is our blue shirt associates and our Geek Squad agents, enabled our strong growth in this category. Our online business continued its strong 20%-plus comparable store sales growth in the quarter.

Now, the story for the quarter is the gross profit rate, which declined 150 basis points this year. The composition of the revenue was the primary driver. The decline can be put into three buckets. First, which was expected, the inclusion of our international business at a significantly lower gross margin rate accounted for 60 basis points of the decline. We have one more quarter to go before we fully anniversary China in our margin structure.

The second bucket is the mix of business in Best Buy U.S., where the sales skewed more heavily toward lower margin categories, specifically gaming hardware and notebook computers grew in the mix year over year, both of which are headwinds on the rate. Collectively, mix accounted for about half, or 45 basis points of the domestic gross profit rate decline. To be honest, we expect this trend of mix to continue through the back to school shopping season.

Finally, rate issues accounted for the balance of the U.S. gross profit rate decline. This was primarily related to television product transitions, the promotional environment plus lower profitability of computing transactions. We believe we navigated the TV transition very well and feel very comfortable with our inventory levels.

Now on to SG&A; our company-wide SG&A rate was flat year over year after getting 110 basis points of leverage in the first quarter of last year. First, our international business provided 40 basis points of leverage, which is due to the operating structure in China and the strong revenue growth in Canada. On the other hand, our SG&A rate rose 40 basis points domestically.

The increase in the U.S. expense rate was driven by several factors. First, lower revenue gains make it difficult to obtain SG&A leverage. Second, investments in initiatives to support customers, such as store operating model, call centers and service facilities were higher than they were in last year’s first quarter. We are feeling the rollover effect of the prior investments we made in the form of capital and labor models in home theater, which are geared to higher volume levels.

Additionally, the number of new stores in operation during the first quarter was more than it had been historically. We opened 30 stores compared with 11 last year in the first quarter.

Finally, we concluded certain legal issues which added expense in the quarter versus last year. These increases were partially offset by the restructuring and severance costs of $26 million or $0.03 a share last year.

When it was all said and done, our level of spending was essentially in line with our plan and wasn’t the driver of the shortfall in the quarter.

Net, it all adds up to roughly a 150 basis point decline in operating income rate. All in all, while we feel like we performed very well where the consumer was ready to buy, we had expected a better profit picture in the quarter.

What you don’t see in the first quarter financial results is that we continue improving key customer metrics and market share in a difficult environment. Those trends give us our confidence in our business strategy. Brian will discuss this in a minute. We are growing our market share and improving our customer satisfaction scores. In short, we are executing on our strategy. These are the things that are in our control and we are pleased with how the customer is responding.

In addition, we feel that the changing retail landscape offers us further opportunities for growth. No doubt that there will be fewer retail storefronts in the home office and consumer electronic space as we enter the second-half of the year. We believe our even stronger position with customers will pay dividends as we look out over the balance of the year and beyond.

Next, I want to pick up where we last left off regarding our capital allocation. As you’ll recall, we told you that we have an opportunity to ratchet up investments in our core business through more stores, acquisitions and share buy-backs. We’ve made good progress on all three fronts in the first quarter. For example, we opened 34 new stores globally and remain on track to open a record 135 stores this year.

Additionally, our 20,000 square foot stores’ productivity jumped 10% to $825 of annual sales per foot. These types of results, coupled with changes in the competitive landscape, provide us with increased opportunity for new store growth. We look forward to updating you on this relatively soon.

Second, we completed the acquisition of Speakeasy for approximately $100 million that allows us to build our capabilities for serving small businesses.

And third, we increased the share repurchases to $412 million in the quarter, nearly double last year’s pace. We anticipate continuing to demonstrate strong repurchase behavior compared to prior year levels over the balance of the year.

That brings me to my final point, which is our outlook for the year. It is still early in the year but we do see evidence that suggests that the consumer spending will be more difficult to read, particularly down to the product level. The current environment indicates more potential variability in consumer spending, leading us to see a wider range of outcomes for the year. We remain confident that flat panel TVs, notebook computers and gaming will remain very appealing to our customers.

As we look forward to the remainder of the year, we see relief in the gross profit rate as we lap the intense promotional environment of the third and fourth quarters of last year, and as we work to increase the profitability of each transaction. In addition, we are taking actions to both edit our expenses while investing to fuel growth and efficiency to meet our customers’ expectations.

We continue to believe that our earnings growth for the year will come in the back-half of the year. The first half will be tougher based on the industry trends and our first quarter results. Therefore, we are moderating our profit expectations for the year.

Revenue is expected to be in line with our original plan of $39 billion. We now expect our operating income rate to improve nominally versus the 30 basis points of improvement that we originally expected. We expect the gross profit rate to have more pressure than we first told you because of mix.

We believe that we can still generate significant SG&A leverage on the year, slightly better than our original guidance. Most important, we are confident in our strategy and plan to stay the course investing for the future. Based on everything that we can currently see, we anticipate diluted earnings per share of $2.95 to $3.15 for the year.

This change in the earnings range is not indicative of our longer term. Rather, it is a prudent assessment of what the business is likely to produce in the current spending environment.

I’d like to reiterate that we see positive momentum in our key customer data and in our competitive position. We believe we have all the right elements in place to capitalize in a choppy environment and accelerate when there is momentum change with the consumer.

With that, I want to turn it over to Bob to talk about our international growth and performance in the quarter.

Robert A. Willett

Thank you, Darren and good morning to everybody. Our international results exceeded our expectations across the board. We would be remiss if we didn’t take a moment to thank the employees who drove this performance.

In Canada, both of our brands reported a double-digit comparable store sales gain for the first quarter, or 12.8% in aggregate. That’s on top of a comparable store sales gain of 7.1% in the prior year’s first quarter. We believe we are starting to reap the benefits of more distinct separation of our two brands.

We saw particular strength in notebook computers and gaming. Moreover, we didn’t have to be aggressive on price to garner these results. In fact, our gross profit rate in Canada rose modestly for the quarter.

In addition, we achieved significant improvement in our SG&A rates in Canada on top of material gains in the prior year’s period. The expense rate improvement reflected revenue gains, leverage of fixed costs, and more effective advertising.

We said on a prior conference call that the story in Canada has two chapters. One was about establishing the footprint and the other two, or chapter two is about improving the operating model, which has now begun. Our customer centricity strategy in Canada is modeled on our approach from the states, using the same customer lens for looking at our business. As a result, good things are starting to happen.

I’d like to publicly thank all of our Canadian employees in both FutureShop and Best Buy, as well as their families for yet another strong quarter.

We are also making good progress in China. Our first Best Buy store in China is projected to finish the year with revenue that ranks it amongst our top stores globally. That’s a pretty good start for a first year of business.

Our Five Star stores are above plan in revenue. We’ve seen some pressure on the gross profit rate yet strong growth in the top line and in gross profit dollars. Unlike our competitors, we are not putting all our focus on adding real estate. Rather, we are focusing on growing both comparable store sales and operating profits at our Five Star stores through the lens of customer centricity.

We are also having some initial success in evolving the margin structure. Secondarily, we continue to pursue a realistic number of new store openings as a part of a controlled growth strategy, which is intentionally measured.

We believe that this pace of growth is prudent, disciplined and sustainable. Moreover, we remain confident that we can boost the profitability of this business over time as we are doing in Canada.

All together, our international segment’s operating income declined modestly for the quarter, due entirely to the investment we’re making, strong revenue results, and expenses. Improvements in Canada were offset by infrastructure investments in China, the build-out of our international support team, start-up infrastructure costs associated with launching Geek Squad in London, and preparations for greenfielding stores in Mexico and Turkey, as previously discussed.

In periods such as this, we see the benefits of an international expansion more clearly. As our international business grows over time, it will help diversify Best Buy's revenue streams. Soft results in one country may be offset by strong results in another. In addition, we can share best practices on a global basis which over time will accelerate our goal of using our network of assets to solve more customer problems.

To enable our success on a global basis and in the U.S., we will continue to invest in our supply chain and IT infrastructure. These investments can be leveraged in any country we enter. This year, three of the major initiatives we are starting to implement are active space management, clearance price optimization and the continued rollout of collaborative planning forecasting and replenishment, or CPFR as it’s commonly known. All three are separately aimed at improving both the customer experience and the bottom line. We’ll keep you informed of the progress of these as we move forward.

With that, I’d like to hand you over to my friend and colleague, Brian Dunn, who will wrap up our formal remarks.

Brian J. Dunn

Thanks, Bob. While we’re obviously disappointed with our financial results for this quarter, I’d like to take just a few minutes to paint a larger, deeper picture for you. It’s a picture colored by an optimism grounded in reality and an unshakeable confidence in our future.

For many people, the consumer electronics industry is the industry most closely associated with how human beings live their lives now and in the future. The solutions we provide are right at the center of how people work, play and live. As a result, the industry has grown steadily and sometimes dramatically for years. In fact, going back to spring of 2001, the industry has seen positive growth every single quarter until the first quarter of this fiscal year.

Does this mean that people are changing their minds, turning away from technology and entertainment products and solutions? We don’t think so. They simply hit the pause button. We believe it’s a timing issue -- natural ebbs and flows of different aspects of our industry. Moreover, in the fourth quarter of last year, we may have fast-forwarded some of the business with terrific promotions.

But to be honest, we believe that what we are seeing also has a lot to do with macro economic factors like housing, interest rates, no relief at the price of gas, and in many other factors that give our customers cause for real concern right now. It’s a humbling reminder that no matter how tight a ship you run and no matter how confident you are of the course you are sailing, external conditions completely outside your control can still rock your boat.

And yet, despite what we believe to be the first industry-wide interruption in six years, we have never been more optimistic about our future growth opportunities. We’re very excited about the investments we’re making, for example, in financial services and Best Buy Mobile, and we continue to move full speed ahead to provide the services our customers need to make all the stuff we sell work together and make their lives richer.

And most important of all, we see signs that we’re making great strides regarding the two people whose relationship matters most -- our customer and our employee. We believe that when times are tough, great companies get sharper, better and closer to their customers. To be blunt, when the market is soft, that’s when great companies, that’s when leaders win market share to be in even a better position when things pick back up.

And that’s what we did in the first quarter. Our overall share of the market increased by 150 basis points and that increase is more than twice the rate of our closest competitor. We gained share in many areas across the store, particularly in computing, home theater, mobile audio and imaging. Our market share is at an all-time high -- all at a time when the market itself has never been more competitive.

Even more encouraging is the fact that the Best Buy brand is especially strong with our best customers. Our customer satisfaction scores are also at an all-time high and our number of reward zone members -- that’s our customer loyalty program -- recently topped 20 million. Reward zone members are especially important to Best Buy because they demonstrate a willingness to engage in a relationship with us which allows us to serve them better. They are more loyal to our brand and they are 2.5 times more profitable than our other customers. Plus, it’s early and we’re just beginning to identify how to serve our reward zone customers and to further evolve our relationship with them.

I offer these pieces of information not to distract you or sugarcoat soft financial news this quarter but instead to provide a lens for a longer term view. When you look through this lens, I believe you see evidence of an amazing performance in an extremely challenging environment. And this performance is a direct testament to our people. We know that our success and our future depend on one thing -- our ability to connect with customers to form real relationships with them, however they choose to interact with the Best Buy brand. Our ability to make good on that strategy depends entirely on our people, their commitment to the strategy and their commitment to Best Buy and we have some extremely encouraging news on that front as well.

Our U.S. retail turnover, which was about 100% in fiscal 2001, has now fallen to 67%. Even more encouraging, our retail management turnover is now approximately 20%. We’re proud of this progress with the people in our company closest to the customer, the men and women who are the Best Buy brand and I would like to thank them for their dedication, especially now in the midst of a tough environment.

We are never happy when we fail to meet the financial targets we set for ourselves. I believe this management team works for and represents three people; the customer, the employee and the shareholder. And during the first 90 days of this fiscal year, there’s no doubt that our performance on behalf of the shareholder was disappointing. But because of the work by our employees on behalf of our customers, we believe the next several years hold the promise of great things to come for everyone in the Best Buy family.

With that, we’ll open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from David Schick with Stifel Nicolaus. Please go ahead.

David Schick - Stifel Nicolaus

Hello? Was that me? I couldn’t tell. Thanks. Good morning. I guess the question is on May 2nd when your K was out, you said obviously the front-half of the year would be somewhat lower on operating margin and it came in worse and it is six weeks later. Can you isolate May and how that worked? And if that was the factor that was worse, what gives you the confidence if that was indeed the shape of the quarter from a profitability standpoint?

Darren R. Jackson

One thing I can confirm is we’re not clairvoyant and that’s what that proves. But I’d say here’s a way to think about it, is that part of the reason we went to annual guidance, and if I use last year’s results as an example, I think we started the year with a view that margins would be flat to down 10 basis points and maybe 30 basis points of SG&A, and maybe we’d finish in a range of $2.65 to $2.80. But I think when the year played out, that’s exactly what occurred except it happened very differently. Our margins were much different in terms of what we thought. They were down over 50 basis points and our SG&A improved by almost 100.

So you would expect that every month we’re looking at the results but we’re looking at them in the context of how do we see the balance of the year playing out and what actions will we take if the results are a little different than what we see in order to shore up the overall annual guidance of the business.

I’d tell you we internally, we had a number of debates going back and forth because it’s early. It’s early in the year but I think where we settled out on is that we just have some evidence and some trends and some variability and volatility that our best judgment was to change the range at this point in time.

Within the context of just looking back six weeks ago, I think it would be imprudent and just misleading to say that the business fell off the cliff in the last six weeks, because it hasn’t.

What we’ve been doing practically is looking out over the balance of the year and asking ourselves, given what we’ve learned, what adjustments do we need to make in order to make sure one, we remain on track strategically in terms of where we’re going, as Brian talked about, and two, where can we make the edits where we need to make the edits in terms of SG&A while protecting and investing in things that we know are adding to the long-term value of our enterprise.

David Schick - Stifel Nicolaus

Okay, to sort of some it up or reiterate, in May, as you said that in early May, it wasn’t a different equation as you thought about the year than it is today. It was just where you set it at that point, so it is not May that is causing the change.

Darren R. Jackson

No, it’s not.

David Schick - Stifel Nicolaus

Okay, great. Thanks.

Operator

Your next question comes from the line of Evan [Rosta] with The Boston Company. Please go ahead.

Evan Rosta - The Boston Company

Thanks for the question. I was wondering if you could explain if it was the change in mix in the last six weeks or around Memorial Day that was the issue on margin, or was mix an issue throughout the quarter?

Bradbury H. Anderson

Mix was an issue throughout the quarter. As Darren was just alluding to, we were trying to look at -- we’re trying to figure out when you are looking at something that’s happened for a few weeks, what does it tell you about what’s the sustaining trend? Because if you go back to the finish of the fourth quarter or of the previous year, we were seeing very different messages in terms of what was happening with the business. So it started to change at the beginning of the fiscal year and that’s historically oftentimes has changed very rapidly. So you might see a month in which you see a shift and change.

What became clear as we went through the quarter is that this shift was not going to dissipate, it wasn’t going to change. And that’s really what changed our guidance and changed the look we had at the balance of the year. Because if the trend was just a blip, which we’ve seen often, then we were looking at a different set of data and this told us that this was much more sustaining than we thought it was initially.

Darren R. Jackson

That’s why we haven’t changed our revenue guidance. Our revenue guidance absolutely hasn’t changed in terms of where we’re going as a company but what’s changed is the content of where we think the revenue gains are going to come. I think it follows that we are following the customer today and so what you should have heard from us on the call is we’ve got a little work to do in terms of figuring out, given this change in the mix, just as we’ve done historically, what do we have to do to support those transactions that work for the customer that will change the profit picture going forward.

Evan Rosta - The Boston Company

And you also had talked in the past about how Geek and software sales were going to mitigate some of the gross profit falling off. Has that not picked up how you had expected?

Bradbury H. Anderson

I think one of the things you look at here and I think it will be apparent in relationship to some of what you see in the industry number, is that those are exactly the things which give us a strong revenue number in the quarter, that even in a time in which the industry shrunk a bit, we’ve been able to grow in other areas because of the competitive strength of our overall offering which very much is impacted by what’s differentiated about it, Geek being a big part of that.

Jennifer Driscoll

That was Brad and Darren Jackson. Next question, please.

Operator

Our next question comes from Bill Sims with Citigroup. Please go ahead.

Bill Sims - Citigroup

Thank you. Good morning. As the industry transitions from 720P technology to 1080P technology, have you seen one, any evidence of manufacturers trying to stuff the channel during the transition? And two, is the marketing of 1080P technology choking off demand for 720P technology in the near term? Thank you.

Jennifer Driscoll

Mike Vitelli will answer that.

Mike Vitelli

In the two-part question, the first part is no, we haven’t seen any evidence of manufacturers dumping 720P. Both technologies have a place. There’s a technology difference and a price point difference. A lot of the entry level LCD products and Plasma products are 720P and then there are appropriate steps to satisfy different customer needs as you move through it.

We were pleased that we were able to move through our transitional inventory at the beginning of the year as the manufacturers were changing relatively quickly, much quicker than we did last year where it took us close to six months given how manufacturers came in at different points in time. We were able to do that in less than three so we felt we are at a great position now that we have the latest and greatest technology on our floor to offer our customers.

Bradbury H. Anderson

Mike, I wonder if we should explain the underpinning of what I think the question is about how manufacturers are coming to market with 720 and 1080P, for the benefit of the rest of the callers.

Mike Vitelli

720P, 1080P -- really just two different flavors of high definition television. Both of them are outstanding. What most manufacturers are doing and what we tell our customers as well is if you are looking at this as a long-term investment 1080P, which is more expensive today, is certainly something that’s going to protect you in future, as you go forward. A lot of the manufacturers are trying to mix to that level and there are certain manufacturers that are focusing almost exclusively on the lower end of 720P. We have a very good balance in our store, in our assortment between the different kinds.

Bradbury H. Anderson

Thanks, Mike.

Jennifer Driscoll

Thank you, Mike and Brad. Next question, please.

Operator

Our next question comes from Steve Kernkraut with Berman Capital. Please go ahead.

Steve Kernkraut - Berman Capital

I just wanted to get some better clarification. You had a 3% comp store sales gain and had no SG&A leverage this quarter, but yet you’re assuming that you are going to have SG&A leverage the rest of the year with a 3% to 5% comp. Is that because of the China influence? What’s going to give you leverage in the back-half of the year that you couldn’t get in the first quarter?

Darren R. Jackson

Steve, that’s just context is that -- if you’ve been listening to our calls, historically we’ve said 3% is our break even in terms of SG&A leverage. As we look to the balance of the year, implicit in our comments, particularly Q3 and Q4, we certainly see a pick-up in the comps coming in Q3 and Q4. I’d say that there are four primary drivers as we look out to the balance of the year in terms of SG&A leverage.

One, we see continued leverage of our -- if I broke it into buckets, a third of that leverage is going to come here in the headquarters, in part because of actions we took last year in terms of making adjustments to our overall infrastructure and headcount here in the headquarters.

Two, we continue to see benefits in places where we’ve done some outsourcing that we’ve talked about before in terms of some leverage in IT and now in GNFR as we look to the back-half of the year, and we’ve continued to adjust areas, and we talked about this as we learn more about advertising and where we are placing some of those advertising bets in terms of the back-half of the year.

I’d say just overall, we continue to make the refinements to our store operating model as an organization, and those buckets collectively are where we see some of the larger SG&A leverage points in the back-half of the year. Maybe one last thing might be more timing where we’ve loaded in the first quarter of this year more stores historically that have landed in our third quarter. We should ride that increased opening schedule into more SG&A leverage in the back-half of the year as well.

Brian J. Dunn

Just because we swallowed it earlier, but the other thing just to be a littler clearer, one of the things, the labor expense in the store is you are looking for trends that happen by product because you try to marry what’s going on with the labor, so when we saw the turn down in television sales, there’s a delay between when you see that and when you realize it’s a sustaining trend and adjust your expense. So we have a different picture of what we’ll see in terms of television that’s more conservative than what we started with.

Steve Kernkraut - Berman Capital

When you talk about an expanded product assortment benefiting you in the back-half of the year, what kinds of products do you really see benefiting you in the back-half of the year?

David Morrish

I can take that one. I think there’s a number of changes that we have coming up but the most significant one would be the expansion of our Apple stores within a store that you will see rolling out across the country over the next several months. We anticipate that we’ll have just under 300 Apple store within a store set-ups by the time we hit our holiday period.

Brian J. Dunn

We’re also extremely enthusiastic about Best Buy Mobile and what we’re learning there and the implications we think that has for our base stores, and you are going to continue to see us expand our assortment and go to places that matter to our customers.

Steve Kernkraut - Berman Capital

Thanks very much.

Jennifer Driscoll

That was Darren Jackson, Dave Morrish and Brian Dunn. Next question, please.

Operator

Our next question comes from David Strasser with Banc of America Securities. Please go ahead.

David Strasser - Banc of America

Thank you very much. I just was trying to get some clarification on the inventory side. On a macro basis, it was up just a little bit more than sales. If you took out China and you kind of looked at it on a U.S. basis, can you break out the comp inventory relative to comp store sales?

Jennifer Driscoll

Jim Muehlbauer, would you like to comment?

James L. Muehlbauer

On the U.S. business, our inventory was essentially in line with our square footage growth in the quarter. The mix of our inventory though obviously is changing. We are skewing more into notebook computers and flat panel televisions that you would expect, but our overall inventory growth in the U.S. was consistent with our square footage growth in the quarter.

David Strasser - Banc of America

Is there any part of it within the mix that might be a little high that we can see an incremental discounting going forward?

James L. Muehlbauer

At this point of the year, no. Mike Vitelli spoke earlier about the great work the store teams and our retail teams did in transitioning through the product inventory in the home theater space and that’s the only technology that we actually transitioned materially in the quarter, so we feel very good about our position at quarter end.

David Strasser - Banc of America

So the transition has occurred in TVs for the most part?

James L. Muehlbauer

That is correct.

Darren R. Jackson

As a matter of fact, our distressed inventory levels year over year are down 200 basis points despite all of our growth in terms of new stores, in terms of absolute dollars, they are down 5%. So that’s a way to think about what is the content of our aged inventory, so we feel good about what’s sitting in inventory right now.

Brian J. Dunn

In a quarter, we had to navigate a very large, one of the largest ever television transitions, if not the largest we navigated.

David Strasser - Banc of America

I’m sorry, just a last follow-up, but what was it that made this one so significant? Is it that shift to 1080P?

Mike Vitelli

It was just the timing of the way the manufacturers all were trying to move through their SKUs and get the new SKUs into the market and as soon as possible. There are less factories where the products are coming from so when four manufacturers transition at relatively the same time, that’s 80 SKUs that are moving all within several weeks. We were able to do that effectively and get that done and behind us so that we are moving into the new product lines sooner than we did last year.

Jennifer Driscoll

The answers were from Jim Muehlbauer, Darren Jackson, then Brian and Mike Vitelli. Next question, please.

Operator

Our next question comes from Eric Mace with Basso Capital. Please go ahead.

Eric Mace - Basso Capital

Darren, there’s been obviously lots of discussion about capital allocations since the last call and you guys touched on it a little bit today but could you update us within the confines of your guidance what kind of share count you are looking at, and has that changed since you initially gave us guidance?

Darren R. Jackson

Eric, here’s the frame, is that without -- historically, we’ve not given out our specific targets in share repurchase but let me talk about behaviorally. What you saw in the first quarter is nearly a double-up of last year’s pace. We have about $800 million still left in our current authorization. Historically, we revisit that authorization generally -- last year I’ll use as an example, during our annual shareholders’ meeting. So what I don’t want to get into is actually predicting, forecasting the future in terms of where that’s going to come out. But what I would tell you is that it’s the same story that we talked about at the end of Q4. It’s implicit -- it’s explicit in our earnings release, explicit in our script that we see a behavior of more aggressive, opportunistic share repurchases just being part of this year and that is, candidly, helping in terms of bottom line EPS that we see for the balance of the year within what we can see in our current authorization.

Eric Mace - Basso Capital

That’s what I was trying to figure out, is as you look at giving guidance ahead of a board meeting and annual meeting, you guys might be in a tough spot of trying to have to base it on some kind of share count when -- I don’t know whether you’ve built something else in there or not and how much flux there is.

Bradbury H. Anderson

Well said.

Eric Mace - Basso Capital

So the answer is maybe.

Bradbury H. Anderson

Watch this space is probably -- we’ll see.

Darren R. Jackson

I think a way to look at is we’re giving you our best view based on the facts in terms of what we can see right now. If that changes, you would expect us, and our historical pattern of behavior has been to update you when material things change.

Eric Mace - Basso Capital

Okay, so nothing else built in. Great, thanks.

Jennifer Driscoll

Thank you, Eric, Darren and Brad. Next question, please.

Operator

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

Michael Baker - Deutsche Bank

Thanks. Darren, it sounded like you guys expect comps to get better from here. The environment is still tough. I’m wondering what specifically leads you to believe comps will get better. Is it that you expect a pick-up in 1080P even though it is higher price point and is a tough economy? Or are there other factors? Is it just the Apple store? And then, related to that, how much did the product transition away from 720P help the comp this first quarter?

Brian J. Dunn

I’ll give a little framing and then I’ll ask Dave and Mike to jump in and give a little detail underneath it. Short and simple, we expect home theater to start to get materially better as the teams hit training camps and the pigskins start to fly in the fall. That has been an historical pattern that we don’t see changing here. We are enormously pleased with how the customer is choosing through this Vista transition, how the customer is systemically selecting us and Best Buy for the differentiated experience it can provide.

I think I’ll ask Dave and Mike to comment on why we are optimistic about the back-half.

David Morrish

I’ll start with the computing space. I think the biggest thing we’re seeing is the engagement of our employees with our customers in terms of explaining the advantages of Vista. You can look out in the press and you can see things. Whenever you introduce a new operating system, some people are going to see it as bad, some people are going to see it as good. And really, our job with our blue shirts and our Geek Squad is to explain to customers exactly all the great benefits of what they can get with the Vista operating system.

I think this has led to some tremendous market share growth for us in the PC segment, but more importantly we’re getting tremendous growth in all of the other associated categories, such as accessories and hard drives, networking, software, and other related categories as well, such as digital imaging.

Another category I want to touch on is also what’s happening in the GPS area inside of our stores. We’re at a point with this industry where there’s less than 10% penetration and it seems to be a new digital product that is just sparking the customers’ imagination. As well, we’re getting the associated accessory sales and also service sales that go along with that very unique category and it should spark some tremendous growth for us in the back-half.

The last thing I want to comment on is that we’re seeing some tremendous strides in terms of growth with our Geek Squad services that are associated with our PCs. The agents are doing an absolutely spectacular job. They are assuring the customers in terms of the fact that we can guide them in terms of their purchases and what they need to complete the digital experience that they want to purchase from Best Buy.

So all in all, I’m very confident about the back-half in the PC category.

Brian J. Dunn

We’re going to go to Mike in home theater and then we’ll hear from Jill on games.

Mike Vitelli

Just one point I wanted to make, Michael, we haven’t completely transitioned that 720P. The industry and Best Buy has both flavors of high-definition in our stores. There is no question that we probably have one of the highest mixes of 1080P because of our Magnolia Home Theater, which is -- that’s pretty much what we keep in that section of the store for the high-end customer. We’re still seeing a lot of customer satisfaction there because that’s where we’re seeing almost a huge, a tremendous percentage of our products get installed where we saw very, very high double-digit growth in our home theater installation. We see that continuing.

I think Brian’s point about the football season is not lost on anyone. That is a big part of what goes on in television. It’s one of the biggest parts of the year. January, which was right before the Super Bowl, was one of the largest television months ever, if not the largest, and that indeed caused a little bit of a hiatus over the last couple of months.

So we are growing. We are growing faster than the industry and the issue is we weren’t growing as fast as we thought we were going to be in that little period of time but we think that’s going to come back.

The other one I wanted to mention also is appliances. The appliance industry is having an incredibly tough time. It’s down a lot in double digits and we’re actually growing in that space. There’s going to be continuing shifts of appliance market share in the hundreds of millions of dollars, maybe close to $1 billion, changing hands between players in the industry. We think the foundation that we’ve put in with our employees, with our ACE specialized people in that department are thrilling customers because there isn’t an experience that customers really like in the appliance industry. We think we actually have something there.

Michael Baker - Deutsche Bank

Thanks, that’s helpful. One more follow-up; what is pricing like on TVs right now? Are you seeing margins firm there at all?

Mike Vitelli

Pricing actually has been great. If you look at it year over year, first quarter to second quarter, you see the traditional down 25% versus the first quarter of last year but frankly, that all happened in the fourth quarter. If you look at our first quarter versus the fourth quarter, pricing is -- cost per inch and pricing is virtually flat, which has been very good to see.

Michael Baker - Deutsche Bank

Thanks, appreciate it.

Brian J. Dunn

I actually am going to jump in and add on to the answer, instead of an add-on to the question. I wanted Jill to give us a little bit of context on gaming, which I think is important for people on the call.

Jill Hamburger

We see really four areas for the back-half from a gaming perspective that will really drive hardware. Number one will be increased availability on some of the allocated systems, be it DS Lite or Wii, that will be drivers for hardware as well as accessories, some of the new accessories that are going to be coming out and some of the mega software releases. These will drive hardware and they also will showcase the capabilities of some of the platforms and also broaden the audience for gaming, and it really plays to the strength of Best Buy in terms of our ability to customize gaming solutions to our customers’ unique needs, in terms of what is the gaming experience that they would like.

So we think these four factors will add to the strength of the back-half.

Jennifer Driscoll

Thank you. That was Jill Hamburger, Vice President. Next question, please.

Operator

Our next question comes from Vivian Ma with CIBC. Please go ahead.

Vivian Ma - CIBC

Good morning. Just a couple of questions; you mentioned that in the third quarter, you are going to be lapping the China acquisition and that should alleviate some of the pressures in the gross margin. I’m just wondering about the gross margin trends within China itself. Has it been stable? Has it been declining? What are some of the factors there?

Jennifer Driscoll

Bob, are you still on the call?

Robert A. Willett

Yes, I am.

Jennifer Driscoll

We’ll have Bob answer that one first.

Robert A. Willett

We’re seeing first of all an improvement in the operating model. I do want to point out though that it’s definitively slow because you are moving from a situation where the vendor controls the staff, the space and basically the retailer is a landlord. In our Best Buy store in Shanghai, we’ve changed that model completely but in Five Star, we’re doing it very slowly. We’re also adding our product ranges from our global sourcing office in China, so we’re starting to see improvements. In fact, the whole purpose of being here for the next few days is to actually look at what we’re doing around that area.

But it’s pretty stable. It’s pretty steady but it is moving and it’s moving in the right direction. But we’re now at a point where we do have to make some fundamental changes in the operating model.

Vivian Ma - CIBC

I have one more follow-up question. For the TV business, I’ve been hearing about the coming availability of wireless TVs and I’m just wondering what is your outlook on that and how does it affect your business, given you have a rather large installation crew? Presumably, the more TVs go wireless the less there would be a need for installation.

Jennifer Driscoll

We’ll have Mike Vitelli answer that one.

Mike Vitelli

Wireless technology is something that’s been talked about in a lot of different areas for a very long period of time. The ability to move the bandwidth of high definition via wireless, it is certainly something that is being demonstrated in the science lab level at this point, so that we can prove that it’s doable over time. But even today, the houses that have high-speed broadband that actually couldn’t move high-definition TV at all, before we get to the point that we’re in a space where you are actually moving high-definition wirelessly, we’ve got quite a ways to go.

Vivian Ma - CIBC

Thank you very much.

Jennifer Driscoll

Thank you, Vivian and Mike. Next question, please.

Operator

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

Colin McGranahan - Bernstein

Good morning. You mentioned as one of the gross margin pressures the lower profitability of PC transactions. I was hoping you could expand on that a little bit and just talk about what you mean there.

And then as an addition, the 10-K for the first time you did disclose warranties. Is that part of the issue, that warranties are falling? Is that in the PC category alone or also you are seeing a lower attach or lower price of warranties in the TV category as well?

Jennifer Driscoll

We’ll start with Dave Morrish and then Jim Muehlbauer.

David Morrish

I’ll start off with the margins that we are experiencing in the PC industry are not any lower than where they have been over the last period of time. As Darren discussed, it’s more of a mix rate issue. On top of that, I think the biggest thing that we are experiencing is significant growth in terms of the other categories that people buy associated with those particular products.

So we’re expecting as we go through the year some upside because our customers are becoming excited about the opportunity of interacting with our Geek Squad agents and really understanding what they can provide from a service perspective so we can offer the complete experience to the customer.

I guess the biggest answer to all of that is that I consider our performance in the PC area actually very, very good and something that we can look forward to in the future. But as Darren and Jim indicated, it’s just a mix rate perspective in terms of where we sit overall.

Colin McGranahan - Bernstein

I’m not sure I understand that. You said in the release lower profitability of computer transactions. So you are selling, within the PC category, you’re mixing negatively?

James L. Muehlbauer

Versus last year, the overall profitability of the PC transaction, the basket, is lower than last year and we’re excluding the Geek Squad experience from that. I think that’s the point Dave was mentioning, is that when you bundle the Geek Squad attached to the PC transaction, we are making progress.

Probably more importantly in our business model as we look forward, given the continued interest in the notebook space with Vista, we’re even discovering more opportunities to meet customer needs by attaching better solutions.

And it’s actually part of it, and you brought the question up around the warranty business, it’s actually using that vehicle to meet customer needs in a way that we haven’t reinvented in a number of years. So clearly with the advent of Geek Squad, it provides us the opportunity to provide a level of service that’s different.

We’ve got to find a better way going forward to make that experience work for the consumer in conjunction with the warranty we offer on that package.

Colin McGranahan - Bernstein

Okay, so when you add in Geek Squad on a year-over-year basis, it could be a more profitable transaction but excluding Geek Squad, it’s less profitable than it was a year ago and the main driver of that lower profitability, excluding Geek Squad, is less warranty attach? Is that correct?

James L. Muehlbauer

It’s slightly less profitable than a year ago and as Dave said, it’s more of a mix issue, desktops and notebooks this year versus last year.

Darren R. Jackson

Colin, you shouldn’t over-blow that. That’s a de minimis part of the change, so I don’t want you to run away thinking boy, that’s half of the issue. It’s de minimis in relation. When you add in Geek, it actually goes the other way.

Colin McGranahan - Bernstein

Thanks, Darren. I was just curious, you didn’t mention Geek as an offset in the release. Could you expand on it at all and just tell us what Geek did in terms of the positive up-tick in gross margins?

Sean Skelley

I would say first and foremost, we were very focused on making Vista the best transition we could make it and we saw very positive, very limited returns and exchange issues. Although we did see a blip when it did get released in customer satisfaction, we were able to regain the customer satisfaction that we had before Vista, which was our main focus.

Candidly, we received a high percentage of calls with customer questions which we took, answered and supported those customers. We saw a solid double-digit growth in Geek and we saw a triple-digit growth in home theater install, so we see both of our services infrastructure actually supporting our business growth. I would say that it’s been a comparable opportunity for us to actually change our expectations around inventory. So when Mike Vitelli was talking about our smooth transition relatively through home theater, a big part of that was because when we install, we see a 25% to 35% less returns and exchanges and Geek Squad rates are about 40% less returns and exchanges when an agent is involved with the transaction.

Colin McGranahan - Bernstein

By my math, solid double-digit growth in Geek would translate to maybe as much as 30 basis points of offset to gross margin. Does that sound realistic?

Darren R. Jackson

Colin, that would be high. We’ve talked about it being an impact for the year that is favorable. We met our expectations in Q1, given the mix of that business, but that estimate would be high.

Jennifer Driscoll

Thank you. That was Dave, Jim, and Sean Skelley, Senior VP of Services. Now we are going to take our last question, given that it’s been one hour.

Operator

Our final question comes from Chris Horvers with Bear Stearns. Please go ahead.

Chris Horvers - Bear Stearns

I made it to the finish line.

Jennifer Driscoll

Congratulations.

Chris Horvers - Bear Stearns

I was a little worried there, and since I’m last, a couple of quick follow-ups here. First on Colin’s question on the services side, I think a key piece of the Best Buy story is the customer-centric service model. I think looking at the profit contribution, can you talk about qualitatively where we are in the profit cycle of the Geek and the Magnolia install business and when we might see more callout as to improved profit contribution?

Sean Skelley

I’ll tell you where we’re at in the transaction. Jim, if you want to help me on any of the financial points that I can or cannot -- I would say on the transition, clearly from home theater, we actually just built that competency, so last year at this time we were building it in respect for the growth that we had in home theater. So we are just about ready to lap that from an anniversary standpoint. We did get operating profit faster from that business than we thought and we are continually in a positive operating profit in that business. Again, triple-digit growth over top of last year’s triple-digit growth.

On Geek Squad, as I think we told you last year, we also put a big infrastructure in place, which was Geek Squad City, serving about 3,000 PCs a day. That was an infrastructure spend. That was to support our customers and expense for it. We don’t anniversary that until about September of this year, so that is an impact essentially on the Geek Squad business. We are seeing strong double-digit growth and our agent count is roughly 10,000, so we’re seeing that mainly in productivity match the year over year.

I think to your point, the complexity of our story is it’s helping our returns and exchanges. It’s clearly strongly helping our customer SAT, where we are seeing strong CSI scores, particularly in home theater and in computing, and we believe that we have a brand that is going to highly differentiate us as the integration of these products continue to grow and challenge the consumer for getting the best expectations they can from the product service.

Lastly, when a leading consumer magazine rates you as the best service provider, I think you can’t ask for better publicity. We candidly are making sure that we can continue to live up to that expectation.

Chris Horvers - Bear Stearns

So is it fair to say that on the Geek side, that the spending up until you get there in September, anniversarying Geek City, you are still spending more money year over year? Any qualitative comments on how much of a ramp on profitability it is as we lap through on both the Magnolia and Geek?

Darren R. Jackson

Here’s the frame I would give you. The spending is going to continue but I think it would be misleading to say and then it stops. I think part of our future in terms of how Best Buy is going to differentiate and win in the marketplace is ultimately, we’ve got to touch the customer where they live. So we’ve got to solve problems in their home. I think this has been a journey for us that last year took the form of a technical asset called Geek Squad City.

In terms of other investments we need to make in order to continue that migration in terms of the relationship with our customer, I think we are going to be on the call next time, the next time, the next time, the next time talking about how we are driving this balance to build this organization that at the heart of it is connected to relationship and in that relationship is this service experience.

So we would be -- I think about it, it is a four quarter gain in terms of where we’re going. I can’t see the second quarter now.

Sean Skelley

We’re just building the trust and making this crap work right now. Candidly, the consumer wants their life better and the fact that we’re making it work is going to get them to access us to make their life better. We were talking about wireless TVs -- I can’t wait. That’s where the opportunities really come for us to help that consumer where they want it, which is clearly going to be their car, in their businesses and in their home.

Bradbury H. Anderson

But there is also a core underlying point in understanding the environment at Best Buy, and part of the reason we say we’re in an opportunity rich environment is the amount of change we’re swallowing in any given period of time is increasing. Moore’s law has gone from 18 months to 10 months. That means what’s coming into our consumer marketplace in terms of capacity is staggering increases in capability and along with that staggering increase in capability comes staggering increases in confusion.

What we are doing with our combination of our capability in store, our international capability, and our service capability is solving for that. But it won’t be linear because the change doesn’t come in to the consumer at a linear pace.

So some of -- if we’re learning -- you had mentioned that our customer SAT rates deteriorated with the launch of Vista and we had to recover from that. Those are the kinds of learning experiences that we are going to constantly be ingesting and they don’t look like a linear transition for the future.

Robert A. Willett

The other thing to say, Sean paid for scheduling, routing, dispatch in Geek City but actually Magnolia will benefit from it and multiple other businesses that we’re developing will benefit from it, as will Canada, et cetera. So unfortunately, the first part of the business that requires something funds it, but afterwards we know that this is going to go across the two or three other key platforms of growth that we are developing that will really maximize this investment.

Charles Marentette

Thank you to Sean, Darren, Brad and from China, Bob for answering that final question, and thank you to our audience for participating in our first 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, and entering the PIN number 11091337. The replay will be available from 12:00 p.m. Eastern Time today until 1:00 a.m. Eastern Time next Tuesday, June 26th.

As always, you can hear the replay on www.bestbuy.com. Just click on “For Our Investors”. For additional questions, please call Jennifer Driscoll, Carla Haugen or me, Charles Marentette. Reporters, you can contact Sue Busch, Director of Corporate Public Relations.

With that, I’d like to conclude the call. Thank you very much.

Operator

Ladies and gentlemen, this does conclude Best Buy's conference call for the first quarter of fiscal 2008. You may now disconnect and we thank you for using AT&T teleconferencing.

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