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

F2Q09 Earnings Call

September 16, 2008 10:00 am ET

Executives

Jennifer Driscoll - Vice President of Investor Relations

Brian J. Dunn – President, Chief Operating Officer

James L. Muehlbauer – Executive Vice President – Finance, Chief Financial Officer

Michael A. Vitelli – Executive Vice President – Customer Operating Groups

John E. Pershing – Executive Vice President – Human Capital

Bradbury H. Anderson – Chief Executive Officer

Shari L. Ballard – Executive Vice President – Retail Channel Management

Robert A. Willett – Chief Executive Officer – Best Buy International, Chief Information Officer

John Noble – Senior Vice President and Chief Financial Officer – Best Buy International

Sean Scalli

Analysts

David Strasser – Banc of America

Gary Balter – Credit Suisse

Michael Baker – Deutsche Bank Securities

Dan Binder – Jefferies & Co.

Christopher Horvers – J. P. Morgan

Michael Lasser – Lehman Brothers

[Alan Rifkin] – Merrill Lynch

Vivian Ma – Oppenheimer & Company, Inc.

Mitchell Kaiser – Piper Jaffray and Co.

Dan Wewer – Raymond James

Scot Ciccarelli – RBC Capital Markets

Joe Feldman – Telsey Advisory Group

Operator

Welcome to the Best Buy conference call for the second quarter of fiscal 2009. (Operator Instructions) I would now like to turn the conference over to Jennifer Driscoll, Vice President of Investor Relations.

Jennifer Driscoll

We have two speakers for you today. First, Brian Dunn, our President and Chief Operating Officer, will give our highlights for the quarter and our comments on the second half. Second, Jim Muehlbauer, Executive Vice President of Finance and CFO of our company, will give the financial recap and add color on our guidance, including the impact of Best Buy Europe.

We do have fewer speakers this quarter in response to investor requests that we allow more time on our calls for Q&A. We plan to have more than a half hour for your questions today.

Speaking of add as usual, we also have a broad management group here with me, including our CEO, to answer your questions following our formal remarks. We’d like to request that our callers limit themselves to a single question so that we may include more people in our Q&A session. Consistent with our approach on prior calls, we’ll move to the end of the cue those who asked a question on last quarter’s conference call.

We’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 our actual results to differ from management’s expectations.

May we also remind you that, as usual, the media are participating in this call in a listen-only mode.

With that, let’s turn the call over to Brian Dunn, who will begin our prepared remarks.

Brian J. Dunn

I’ll focus my comments on the successes of the second quarter, the pieces that didn’t work as well as we expected, and the plan we have in place to deliver our earnings guidance for the fiscal year.

First, I want to thank our employees for another quarter of outstanding effort. In the chief of a tough market they continue to create better and better experiences for our customers and our customers are responding by choosing Best Buy over the competition at a convincing rate, something I’ll talk about in a minute.

I also want to specifically thank the Best Buy employees who helped our Gulf Coast stores and communities prepare for the onslaught of Hurricane Ike. We can only imagine how you’d feel now as you return to your homes and deal with the devastation that Ike wrought. Our thoughts were especially with those in the Gulf Coast community whose lives were disrupted, whose homes were destroyed, and whose family members lost their lives.

This quarter’s earnings were below our expectations, something we’re never happy about. But we issue annual guidance because we know that a given quarter will present unique challenges. We’re in the process of making some changes, primarily on the expense side. More importantly, we remain both optimistic and committed to our strategy.

Why are we optimistic? First of all, from a top-line perspective, we are growing our business. Difficult times have historically brought out the best in Best Buy. In a challenging environment that finds many of our competitors retrenching, we are opening more new stores. We believe that it’s smart for strong companies to work on distancing themselves from their competitors in tough times and we believe that when the world’s most resilient economy improves we will be well positioned to benefit from it.

As we’ve said all along, we’re keeping our eye on a few key strategic indicators and they are extremely encouraging. Let me take a minute or two to detail a few specific winds that support what I’m saying.

First, our internal measures of customer satisfaction rose to a new high, over 81%. Likewise, market share gains accelerated on top of what were already all-time highs. We added share in TVs, computing, mobile phones, and gaming – in fact, all of our major categories in the past 90 days. Specifically, we estimate that our domestic market share at the end of the calendar quarter was nearly 21%, up 1.6 percentage points versus the prior year’s period.

And most importantly to us, employee retention is at an all-time high. We’ve never had turnover below 50% before and our 12-month rolling rate for turnover sits today at 49%. We believe that’s because the people who drive customer satisfaction in market share gains are committed to writing this growth story and committed to writing themselves into it.

Second, as I said before, we continue to grow our business – faster than just about anybody in our space. Our 4.2% comparable store gain, 5.3% here in the US, was at the high end of most retailers in the past quarter. That tells us that customers continue to respond positively to what we offer. We believe customers need someone they can trust to provide perspective on our fast-moving, exciting, but often confusing industry. Someone who will work with them to make technology work for them. And we believe that our performance in every category this past quarter supports that belief.

Finally, our strategic investments in growth are beginning to have a noticeable and positive impact on our business. This impact was most apparent in our Best Buy Mobile experience, which we accelerated to all US stores months ahead of schedule. Today more than 5,000 Best Buy employees are trained and dedicated to improve the experience of buying a mobile phone for our customers. In a business where most US customers surveyed said they would rather visit the dentist than upgrade to a new phone we have improved customer satisfaction scores dramatically. In fact, our customer satisfaction scores in this business are now some of the highest in our company.

We moved aggressively with Best Buy Mobile because the mobile business delivers above-average profit rates, but also because we believe that mobile technology will play a larger and larger role in what we call the connected world. It’s yet another reason why we see opportunities in the back half of the year.

Speaking of that, let me now turn to our plan for the final two quarters of fiscal 2009. At the beginning of the year we said that we plan to invest into the teeth of this difficult macroeconomic environment using our resources as a competitive advantage while many of our competitors scale back their plans, cut back on customer service, or even close stores. We’ve stuck to that plan and we’ve made many of those investments. Invest by mobile, in international, and in several critical store projects.

Of course we’ve made some investments that have not generated the kinds of returns we expected. We are looking carefully at our investment portfolio. In the second half we will decelerate or stop some of these projects to focus on our priorities, including those that are garnering the best returns.

We’ve already identified cost savings in the back half, yet we will not stop investing in selected growth projects, nor will we make any moves that erode the customer experience. This mid-year inflection point allows us to exercise what has always been our guiding principle when it comes to disciplined spending. We will ensure that our investments are customer driven or they will be driven out.

The second area we’ll focus on during the back half is our promotional strategy. We were generally pleased with our gross profit rate. At the same time, we see an opportunity to improve the effectiveness of our promotions a bit when we view them collectively through the eyes of the consumer. We’ll continue to fine tune our strategy in the second half, leveraging our knowledge of our customers to ensure each offer is connecting with its intended target. While we go after that opportunity we will not stop using promotions as a powerful means to deepen our relationship with our best customers, especially members in our Reward Zone loyalty program, which now includes more than 31 million US memberships.

I’ll wrap up my comments now, but before I turn it over to Jim I want to reiterate that we are and will remain 100% focused on driving value for the long term and not just a season. And although we’re never satisfied with earnings below expectations in any quarter, we think it does not reflect the long-term health of our company or the soundness of our strategy.

With that, I’ll turn it over to Jim Muehlbauer who will offer some additional color on our second quarter results and the outlook for the balance of the year. Jim?

James L. Muehlbauer

Thanks, Brian, and good morning, everyone. I’d like to take you through our fiscal second quarter results and how they compared with our plans for the period. Secondly, I’ll update you on our earnings guidance for fiscal 2009, including what will be different in the second half due to changes we are making in the business and the impact of adding Best Buy Europe.

When we compare our second quarter results to our forecast, clearly our bottom line finished below our expectations due in part to our discretionary spending activities that exceeded our original plans.

Revenue for the second quarter met our expectations and probably was ahead of what many of you may have expected.

Our comparable store sales results for the domestic segment again showed strong improvement from the previous quarter, advancing 5.3%. These results were driven by continued strength in notebook computers and gaming, strong results in flat-panel televisions, and acceleration in Best Buy Mobile. In fact, our quarterly comparable store sales gains at stores open for six to 10 years were positive. On average, their comps were 3 to 4 percentage points better than we expected based on the normal store maturation curve.

Normally comparable store sales peak after six or seven years and can go negative after that, unless of course we remodel or relocate the store. The performance of these older stores in the last two quarters have stood out, so that is exciting. Roughly 470 of our domestic stores opened more than six years ago and when our teams rejuvenate those stores results on a sustained basis we see that as very promising for our company and our shareholders.

On the other hand, as I look at our portfolio our international comps were slightly weaker than we planned. Canada had comparable store sales gain of 1% against a gain of 16% in last year’s second quarter. China’s second quarter, which includes results from April through June, have a 7% comparable store sales decline reflecting general economic conditions, including the aftermath of the earthquake.

Bigger picture, our top line held up well considering the macro-environment. We believe the drivers of these results were our US stores strong execution, their efforts to grow their business through a local lens, our improved product assortments, as well as benefits from the fiscal stimulus cheques. Candidly, it’s hard to precisely quantify the relative contribution of each.

Our gross profit rate declined by 10 basis points, which was almost identical to what we experienced for the first quarter. The growth in notebooks and gaming has been applying pressure on our gross profit rate for two years and these categories continue to have growth rates well above the chain’s average.

As planned, the growth in our Best Buy Mobile experience accelerated this quarter and the strength in our mobility area was nearly able to offset that mix impact from notebooks and gaming. We expect this trend to continue into the second half.

Our original SG&A guidance includes deleverage for the fiscal year of 30 to 40 basis points to fund initiatives that would drive our long-term growth. Embedded in that assumption was an expectation that our second quarter would be the high-water mark for the deleverage in the year, or approximately 70 basis points. We knew we would be undertaking a number of strategic and tactical projects, including the roll out and operation of Best Buy Mobile, remodelling and resetting our GPS selling space, and investing in infrastructure to expand our platform for international growth.

We also planned for year-over-year increase in our investment and store labour. We accomplished those objectives reasonably in line with our spending expectations.

In addition, our second quarter SG&A rate reflected subsequent decisions to invest slightly more labour in pursuit of an even greater top-line outcome during the back-to-school shopping season. We partially accomplished that objective.

We also spent more than we had expected on travel and related activities, and incurred some one-time expenses that we had not planned. These expenses collectively cost us the additional 20 to 30 basis points of deleverage that we hadn’t originally expected. As I will discuss later, we’ve addressed these items and we can tell you with full confidence that for the year we will be back on track for our full-year SG&A spend.

Our second quarter also included $0.02 of dilution in net interest expense resulting from the financing of Best Buy Europe without the benefit of any of its earnings. We are reporting the operating results of Best Buy Europe on a two-month lag basis while the cost of financing this acquisition is included on a real-time basis.

If you helicopter up and compare the quarter’s results with our expectations, revenue and gross profits were in line and SG&A was above. Fortunately, SG&A is the most controllable of the three elements.

That brings me to our annual guidance. To provide clarity, I will break down the guidance for you into three pieces and then give you an enterprise outlook. First, I’ll talk about our guidance for the base business, which is our existing Best Buy business. Second, I’ll walk through our expectations for Best Buy Europe. And third, I’ll explain the impact of the previously disclosed change in our share repurchase assumption. The combination of those three pieces will give you our annual guidance for the total company.

Let’s start with the most familiar piece, our base business. At the outset of the year we laid out expectations for a comparable store sales gain for Best Buy of 1% to 3% for the fiscal year. Our strong first half performance in comparable store sales was approximately 4%. In the back half we have based our planning assumptions on modestly softer consumer spending.

We’re excited about the digital TV transition, our expanded assortments in computers, lower prices in gamings, the completed roll out of Best Buy Mobile, and our access to the iPods. Yet we recognize that there will be many factors in play during the second half, which makes overall consumer spending difficult to predict.

We currently expect to finish in the top half of our annual range for comparable store sales. This implies a second half comparable store sales gain of approximately 1% or 2%. After adding the impact of new stores, but still excluding our European business, we are estimating an annual revenue for the base business of just north of $44 billion, an increase of 10%.

Our initial guidance for the year also assumed a flat gross profit rate. Our gross profit rate for the first half declined by 15 basis points. We expect to improve that trend modestly in the back half thanks to stability in our revenue mix and plans to increase the efficiency of our promotions. As a result, our guidance for the base business now assumes an annual gross profit rate that will be down slightly to last year.

Next, let me give you some more color on the SG&A for the second half. We planned fiscal 2009 to be an investment year for the business, so our initial guidance assumed SG&A deleverage of 30 to 40 basis points. For the first half of the year it was up approximately 55 basis points. Again, we had planned that the second quarter would bring our peak spending in SG&A in terms of dollar increase year over year.

As Brian mentioned, we are making portfolio changes in our second half spending plans. We’ll reduce or defer non-essential in-store and corporate projects and lower our non-customer facing overhead costs. We’ll also adjust our advertising spend to closely align with expected business conditions. Through these reductions, plus the impact of coming off that planned peak, we anticipate that our SG&A rate will slow and meet the original target for annual deleverage of 30 to 40 basis points.

Bringing these assumptions together we still contemplate a 5% operating income rate for the year, down approximately 40 basis points from last year. That gives us guidance for annual EPS contribution from the base business of $3.25 to $3.40, an average increase of 7%. It’s unchanged from what we gave you before.

To be clear, our previous guidance included the benefits from an expected $800 million in share repurchases or roughly $0.05 per share which we later announced will not be taking place this year. From this point forward those share repurchase benefits are not included in our guidance.

Now I’d like to walk you through the earnings impact of our European business. We estimate that Best Buy Europe, which is primarily comprised of 2,400 Carphone stores will be accretive to the enterprise by $0.03 per diluted share for fiscal 2009, inclusive of the cost of financing the $2.1 billion acquisition. We anticipate that it will generate revenue of approximately $3.2 billion for July to December based on current foreign exchange rates.

As you saw on our news release this morning, Best Buy Europe will raise both our gross profit rate and our SG&A rate. We expect that the operating income rate will be approximately 4% for the back half.

The inclusion of Best Buy Europe will modestly lower our average effective income tax rate as well since its current expected tax rate is approximately 25%. Keep in mind that while we’ll report the full income statement of Best Buy Europe starting in Q3 only 50% of the after-tax earnings makes it to our bottom line. So the operating results of our 50% stake in Best Buy Europe would bring us approximately $50 million in earnings after tax but before financing costs. Included in this amount are purchase accounting adjustments, such as amortization of intangible assets.

We have lowered our estimates for Best Buy Europe since the updated guidance we gave you in June. The retail business in Europe is proceeding as expected, so that wasn’t the impetus for the change. Rather, the company has now completed the phasing of the operating plans for Best Buy Europe and updated its estimates for purchase accounting related to the amortization of intangible assets. Additionally, recent strength of the US dollar is expected to slightly lower the results of Best Buy Europe as consolidated in Best Buy’s financials.

So we started with guidance of $3.25 to $3.40 for the base business. The second step was adding accretion of $0.03 for Best Buy Europe. That brings us to the third step. Now we subtract $0.05 for dilution for the fiscal year, reflecting our decision last may to suspend $800 million in planned share repurchases following the acquisition of Best Buy Europe. Rather than lower our earnings guidance by a couple of pennies, we are maintaining our original guidance range. As the business plays out in the second half, we are comfortable that we can offset those pennies in other parts of our business.

To close, we are satisfied with our top-line performance in the second quarter and with our margins. We were a little disappointed with our SG&A rate, so we are taking actions and have some work to do there.

We plan to have most of the year’s earnings growth in the second half, putting together our better-than-expected performance in the first quarter with the results in the second quarter, we are only slightly behind our original expectations for the first half with roughly 70% of the year’s earnings still ahead of us. So we are pleased, but not satisfied, with where we stand entering the back half of the year.

Our focus is fully on serving customers and delivering on the financial expectations for the year. We have great confidence in our people and in our strategy of customer and employee centricity.

With that, I’d like to open up the call to questions from our audience.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Gary Balter – Credit Suisse.

Gary Balter – Credit Suisse

You have bullish second half guidance. Could you incorporate in that the worries that people seem to have about panel price and the flat panel or flat televisions pricing dropping significantly? How much the stimulus package helped and whether you see that and the impact of credit availability on Christmas? How do you look at the Christmas season?

Michael A. Vitelli

Let’s talk about flat panels first because I know that’s going to come up a lot. From an industry and an inventory point of view, for the most part the inventory’s relatively solid. As many of you have been reading and writing, the factories have been making adjustments in their production and as they see the change in world supply. We think that’s good. We think them reacting to world-wide demand in different categories where they supply panels for and making those adjustments are positive because they need to make money and they’re not overbuilding based upon what they see in forecasting.

Price declines have been following the pattern they’ve followed for the last several years. The first quarter and the second quarter of this year, for us, they were in the 13% and 14% range in average ASPs. The good news is net flow is as it’s been in previous quarters and we’ve built in the projections in the second half that reflect that and the growth accordingly.

To talk about the availability of credit, that’s a good point for us that we’ve aggressively gone out and put together a program to offer financing to our customers. We think that was a big part of what we saw in the first quarter and the second quarter of customers coming to us, in some cases when they needed financing and in other cases where they didn’t and they thought it was a good promotional offer. So our ability to offer credit to customers has been a positive for us.

Gary Balter – Credit Suisse

And how do you measure the impact of the stimulus package in that as you look towards your second half and your 1% to 2% comp guidance.

James L. Muehlbauer

Clearly as we look at the back half of the year, as I’ve said in my comments, we’re not expecting the same level of consumer spending in the back half, which is why we’re not forecasting a repeat of a 4% comp in the back half. The thing that gets difficult to predict is that while we know the stimulus cheques had an impact on our business, given the multitude of things that we did around improving our assortment, especially in the computing space, adding products like Best Buy Mobile, where essentially customers come in and purchase products that basically have a recurring bill versus a payment on the front end, we know those type of purchases historically aren’t stimulus cheque driven. So we have parts of our business that we know are performing well absent stimulus activity. We have other parts of our business that we know that the customer has benefited by having that extra spending capability.

So our back half plans really reflect what we see in the marketplace at this point in time, both from a competitive standpoint and we both have been able to build share in the first two quarters and we anticipate that’s going to continue in the back half of the year as well.

Bradbury H. Anderson

That’s part of the reason we shared the data about the older stores is that the only variable we can see moving the older stores up from a comp store result is that the work we’re doing at a store basis is actually driving that improvement.

Operator

Your next question comes from Chris Horvers – J. P. Morgan.

Christopher Horvers – J. P. Morgan

On the wireless business, I’m checking my math, maybe the mobile business aided domestic comps 250, 300 basis points. If you could comment on that. And also, it seems like Best Buy Mobile, it certainly helped drive sales, it certainly helped drive gross margin. How much of the labour side in the operating model is diminishing the returns in the business and where are the returns now versus what you expected and what the tweaks to the model would result in?

John E. Pershing

Chris, that’s certainly the encouraging part of Best Buy Mobile. So you’re right, the comp sales performance in Best Buy Mobile almost comping up triple digits was something that was a great tailwind for our comps in the quarter and we expect to see that in the back half of the year, as well, although not at quite the same rate because we’ll be laughing the launch of the Best Buy Mobile stores of last year. But as we think about the impact both on margins and SG&A, great margin lift in the business.

The SG&A leverage we’re actually just getting started on. We know purposely that that model that we’re investing in for customer’s experience in the mobile space is more expensive to run. We want our employees to spend more time with those customers getting them the solutions that they need and we’ll actually spend more labour in that space than some of the other parts of our business. We have not yet begun to try to find opportunities to maturely leverage that labour. We want those teams to learn how to serve customer needs and grow the top line of the business before we start finding opportunities that the teams will identify themselves to get more efficient in that labour spend. So we see opportunities going forward to get more efficient in that piece, but honestly, that’s not the part of the model that we’re focused on right now.

Christopher Horvers – J. P. Morgan

So right now you’re still in the investment phase and you expect the returns to increase as you tweak the model.

Operator

Your next question comes from David Strasser – Banc of America.

David Strasser – Banc of America

Can you talk a little bit about inventory to follow up on some of Gary’s questions? You know, in the US where are your inventories on a comp store basis relative to where the comp was and what areas you’re investing heaviest in? Where your relative comfort is on the end categories.

James L. Muehlbauer

Our enterprise inventory, if I take out the impact of including the Best Buy Europe venture which is also included in our balance sheet this quarter, was up about 20% year over year. While our comp inventory in the US business was up roughly 10%. That number’s a little deceiving in that last year as we looked at our inventory levels we know we were a little lighter in some categories than we wanted to be in Q2 of last year heading into the holiday season. So if we look at the comp inventory levels year over year we were up roughly 10%. Part of that was driven by just inventory positions that were too low last year. Plus the investments that we’re making for this year purposely in the areas that we expect the greatest levels of growth in the back half of the year. Continued growth in our computing business. Continued growth in Best Buy Mobile. And growth in our flat-panel TV business for the back half of the year. That is where our inventory investments have been made.

Michael A. Vitelli

The other thing to add to what Jim said is we’re also pleased with the quality of our inventory. Looking at how we measure our at-risk and the products that are selling well and doing well, it’s actually better than last year. So our quality is better as well.

Operator

Your next question comes from Mike Baker – Deutsche Bank Securities.

Michael Baker – Deutsche Bank Securities

Can you discuss the margins on flat-panel TV, both just on the TV itself and then including installation and warranty? How are the year-over-year trends in the margins in that business? Thanks.

Michael A. Vitelli

The good news is that we see an improvement, and we have seen a significant improvement in the second quarter and the first half in our attachment rates of home theatre installation and warranty services and protection for home theatre. The promotional sense in the first half of the second quarter were a little more aggressive in the marketplace, so in total we saw our home theatre margin rates slightly down. Part of that was the use of financing, part of that was the increased use of Reward Zone. Collectively they are right where we want them to be and we’re pleased with the continued detachment that we’re seeing in the home theatre installation space.

Michael Baker – Deutsche Bank Securities

And so, have you lowered the prices on your warranties and on the home theatre to help drive that attachment? Does the comments on taxes being up, is that sort of units or is that dollars or both?

Sean Scalli

Yes, to expand, this is Sean Scalli [sic], to expand on Mike’s point. We actually saw growth in the attachment rate on our extended warranties, which now have moved to black tie warranty protection. With the drop in price we still saw growth in that category.

On the installations specifically we were less promotional this year than we were last year. Last year we essentially included some installation offers. This year we weren’t. We saw good growth, particularly on the 37-plus side of our TV business.

Operator

Your next question comes from Mitch Kaiser – Piper Jaffray.

Mitchell Kaiser – Piper Jaffray and Co.

I know the iPhone’s been out for just over a week. Could you maybe talk a little bit about the results that you’ve seen thus far and then maybe what your expectations are for the iPhone and what’s embedded into the guidance for the back half?

James L. Muehlbauer

We don’t talk about specific results of individual products within our portfolio. I know the team would be happy to comment on what they’re seeing from a customer standpoint and what it means strategically to have that product in our store.

Michael A. Vitelli

The one thing that we are seeing is that, as we said, I think Jim mentioned earlier, part of what the iPhone is doing is bringing people into our stores and the investment that we’re making in the experience in that department is producing some of the highest customer satisfaction rates coming into Best Buy. That’s probably the most important thing that it’s doing for us. It’s bringing people in and letting them see the experience that we can provide that’s completely different than the rest of the industry. We think that experience today is going to help us every day after that for the rest of the year. The category in general is really positive for us and the investment in the experience that we think is going to pay off well beyond the Best Buy Mobile department in the store.

Operator

Your next question comes from Dan Wewer – Raymond James.

Dan Wewer – Raymond James

Brian, most of your specialty store competitors are struggling at a faster rate. Could you talk about what you’re seeing those type of competitors doing to generate traffic and if it’s creating any type of an irrational competitive behaviour in the carpet?

Brian J. Dunn

I think the simple answer is no. We have not seen irrational behaviour in the marketplace. We’re very pleased with the market share gains that we’re seeing. What we’re doing is what we always do is we’re focusing on our experience for our customers in our stores. We think that is the most important strategic competitive posture we can take.

Dan Wewer – Raymond James

Jim, could you clarify one of your answers a few minutes ago? You talked about comp inventories up 10%, I believe, in the US. Was that 10% at the store level or for the total enterprise?

James L. Muehlbauer

That was 10% for the total domestic business.

Dan Wewer – Raymond James

So if you were to look at that in comparable stores you’re up, what, 1% or 2%?

James L. Muehlbauer

No, it would be higher than that, Dan. If you think about it, our square footage was up roughly 10% year over year. Our total US inventory was up 19% or 20%. So I’m saying our comp inventory was up roughly 10%. In pulling that apart you have to look at where we stood in our inventory positions of Q2 last year. We were light in inventories, especially in flat-panel TVs. So we had that inappropriate comparison the last year. And we’ve made some purposeful investments this year in parts of our business that are growing for the back half, namely computing, TVs, gaming, and mobile phones.

Dan Wewer – Raymond James

But if we’re looking for same-store sales to increase 1% to 3% why should we not be concerned about comparable inventories being up 10%?

James L. Muehlbauer

Yes, well, the 10% is not an apples-to-apples number. That’s what I’m trying to dissect for you. The other thing to remember, given where we’re at in the year, we’ve got six months of sales in front of us. So over the next two and a half to three months all of the inventory that we have in the pipe in those categories is out and sold to customers and we’re reordering. Certainly, as we always do, we have the opportunity to purchase more from our vendors or scale back as customer demands dictate.

Dan Wewer – Raymond James

What would you estimate the year-end comparable inventories will be?

James L. Muehlbauer

I’ll have a better idea of that when I know what the year-end, quarter-end comparable store sales will be.

Dan Wewer – Raymond James

Well, I was just thinking if you made your plans.

James L. Muehlbauer

I’m not providing an estimate on that at this point in time. Certainly we would not expect it to be up 10% at the end of the year, Dan.

Operator

Your next question is from [Alan Rifkin] - Merrill Lynch.

[Alan Rifkin] – Merrill Lynch

With the tightening of credit in the marketplace can you maybe just shed a little bit more color on the use of financing, particularly around the holiday period? Whether you think it will be more intense than that of last year?

James L. Muehlbauer

As typical, we’re not going to comment on promotional strategies and expectations for the back half of the year for obvious reasons. But I would like to build on something that Mike Vitelli talked about earlier. When we put our financial services strategy into place firmly about a year and a half ago we knew that we’d be building competitive advantages for customers on multiple fronts. One is, really, the ability to offer a variety of financing packages that meets their unique needs. One of the things that we’ve certainly learned in the first half of the year is the opportunity to simplify our financing message with customers. Historically we’ve focused our financing activities on individual product lines with different types of financing periods. So you could get ‘X’ type of financing if you bought a computer, you could get ‘Y’ type of financing if you bought a certain brand of television. The traction that we’re getting both from customers and our store employees around simplifying that message, around offering 24-month financing for purchases no matter where they take place in the store, under whatever brand the customer is looking for above $999, has really helped improve our attachment rates in financing. So that’s positive for customers because many of those customers are Reward Zone members. They’re getting access to credits, but they’re also getting Reward Zone points. That’s positive for the Best Buy model because as we put those transactions on our branded card vehicles we don’t incur the same type of tender cost that we would have to pay the banks under other types of forms of payment. So there really is multiple wins across the business model for both us and for our customers.

What we’re most encouraged by is that when the employees in the stores feel more comfortable in helping the customers meet their needs by allowing more breadth in what the customers can include in that financing package it makes the transaction simpler for everybody and the customers actually walk out getting what they needed at the price they wanted with the type of financing that fits their lifestyle.

[Alan Rifkin] – Merrill Lynch

Brad, with your stock price significantly lower today than where it was at the beginning of the year when you suspended your share buyback program, and with estimates for Europe coming down, is there any sort of reconsideration with respect to buying back stock as potentially near term that may provide a greater return on invested capital than the investment in all of these countries out there?

Bradbury H. Anderson

Well, near term I think that’s clearly the case. I think part of what we’re trying to say as an organization is core to the values here is we just don’t make decisions for near-term variables as much as we possibly can. It’s part of what you see in the way we’ve handled this year. We think this year is an extraordinary opportunity for the company to position itself in an incredibly strong way for the long term because we’re going into the sort of short-term difficulties with enormous strength. We have financial strength, we have strength in terms of market position, we have strength in terms of strategic options for the enterprise for the future. What we’ve decided to do with this fiscal year is lever that strength at a point in time in which we think all of our investments will be much more efficient than they would be if we were trying to make exactly the same investments in a very strong economic climate. We would expect, based on what I’ve seen historically from the firm’s history, when the economic climate improves you actually get the benefit from those investments like a wave. They’re easier to make in this kind of climate, they get higher productivity because of some of the stress in the organization, and when we see that they don’t pay – as you’ll see us do in the balance of the year – it’s much easier to move off those investments than it would be in an environment in which you’re sort of swimming in very, very good results.

So I would definitely pursue the strategy we’ve got over again. To be honest with you, even when it comes to the expenses we engaged in the second quarter I wouldn’t make the same expenses with hindsight, but I would start with the same premise we started with.

[Alan Rifkin] – Merrill Lynch

Brad, what would be the strategic disadvantage if you held off the international spending for just six or 12 months until you see what the global environment looks like? And instead more so focus on greater cost control?

Bradbury H. Anderson

Well, the huge strategic advantage is anything we would have done would have cost us a lot more to do or may not be possible to do. You got options that open up to an organization when there’s more stress on the economic climate that’s literally closed. So I’m pretty sure that a lot of the things that you see us doing today, if we were in a stronger climate, at a minimum would cost us a great deal more and in some cases I think flat out wouldn’t be available.

The other thing is, as you look at sort of the way we’re building unique strategic skill sets we want to make sure that we can capitalize those. One of the things about Best Buy is it’s in an always changing ecosystem. Because the products we sell are always in transition. So you have time intervals you get when you get a strategic advantage. So if you lost that interval in terms of time it has a huge strategic impact in terms of what you’ll ultimately be able to capitalize out of your advantage.

Operator

Your next question comes from Dan Binder – Jefferies & Co.

Dan Binder – Jefferies & Co.

I was wondering if you could give us an idea of how business trended through the quarter and then, more specifically, if you were to look at the TV business how that has trended versus recent quarters. In other words, it’s still double digits. Is that pace slowing at all or is it fairly steady.

James L. Muehlbauer

Dan, why don’t I take the trend in business in the quarter and I’ll let Mike follow up on the trend of the TV business. As I look at our domestic business during the quarter, the trend of business was actually for the most part fairly consistent. Certainly we saw a little higher results earlier in the quarter than the end of the quarter, but it was not a tale of two cities. There was not a dramatic difference in the comparable store sales results in the US business between the first month of the quarter and the last month of the quarter.

Michael A. Vitelli

And looking at the TV business, looking at the second quarter and the then the first quarter, both quarters were better than the second half growth of last year. So actually, the TV business in total for us has actually turned around and started moving in a more positive direction versus the second half. If you look at the months within the year, within the quarter, they were relatively the same, as Jim said, overall because it reflected our overall business.

Dan Binder – Jefferies & Co.

And then just as a follow up, you mentioned earlier the roughly 13% or so decline of average selling prices in the first half of the year. Can you give us a sense of what you’re anticipating for the back half?

Michael A. Vitelli

No. And let me explain why, because this has come up before. The minute that we say we think and we plan that prices go down this much then somebody else says, gee, we have to do better than that. It becomes a self-fulfilling prophecy in the industry. In fact, I would encourage a lot of people to not talk about what they think is going to happen with prices because it gets into speculation. But the model of price decline has been consistent with what we’ve seen in past years and what we expected and planned for this year.

James L. Muehlbauer

If only that commentary worked both ways, we could just say TV prices are going up.

Dan Binder – Jefferies & Co.

Well, since you can’t answer that question, just a follow up on somebody’s prior question about the pricing on warranty and services. Can you give us an idea of how that pricing has trended?

Sean Scalli

Yes, as we mentioned before our attachment rate is, well, we were actually 6% for the quarter and we saw growth in TVs. We saw stronger growth in top-line revenue. We saw a little bit of drop naturally because of ASP drops, but it was still positive. So we’re excited about what we’ve done there and we’re probably more excited about how we’re pushing that advantage further. We’re going to have that continual product essentially covering the basic needs that you want, but now we’ve pushed into a premium black tie protection, which will actually do even more for the customers. We’re only two days into it, but we expect that to help us continue differentiation and continue to offer great choices to our customers for the third and fourth quarter.

Operator

Your next question comes from Michael Lasser – Lehman Brothers.

Michael Lasser – Lehman Brothers

I’m just curious about the legacy stores. You commented how they were comping quite well, those stores that are older than six year. Can you talk a little bit more about their performance? Was the driver there the same things that drove the overall results for the quarter or was there something more unique?

Shari L. Ballard

Some of the drivers were similar, so we saw RPT growth in those stores as well, but one of the things that was stand-out different was we saw close-rate growth that was higher than the average close-rate growth for the company. I think that has us excited in a lot of ways. We’ve got the teams in those stores, as Jim mentioned earlier, there’s a particular trajectory that we normally see in terms of the age of stores and the declining of comps, so for us to prove in this model with the number of older stores we’ve got that those older stores still know their communities well enough it can find local needs well enough that we can actually grow the comps in those stores, that is really good news for our model. Some of what we saw there was similar to other stores and there was also some standout in terms of close rate.

Michael Lasser – Lehman Brothers

On the extension of financing, can you talk about, how, maybe quantify the penetration. I know in the last call you said that you weren’t as aggressive with financing in the third and fourth quarter of last year such that you can be more, use that as a tool in the back half of the year. Maybe you can offer some quantification so we know what sort of impact that can have on a business over the next couple of quarters.

James L. Muehlbauer

Yes. So our financing activities have benefited, as I said, from increased penetration year over year. We’re also, as you’ve seen in the marketplace, we’re using a simplified financing message that I talked about earlier. In light of all that, our financing activities continue to be accretive to our overall gross margins and we planned that for similar outcomes for the back two quarters of the year as well.

Operator

Your next question comes from Joe Feldman – Telsey Advisory Group.

Joe Feldman – Telsey Advisory Group

I was wondering, you talked about on the call and in release about increasing the labour and customer facing labour in the stores. We were just wondering, how much of that will be sustained throughout the back half of the year and going forward versus paring that back as you’ve talked about some ways to cut some costs? I’m also thinking about the Best Buy Mobile, because you specifically called that out.

James L. Muehlbauer

Yes, there will actually be, we’ll make labour changes as a result of putting new value propositions into the store like Best Buy Mobile. As I mentioned earlier purposely, that model has got more labour associated with it, but it also drives the bigger outcome for the store and we have gross profit. So as we looked at our model year over year, serving customers in areas that are high-touch in our stores within the mobile space, within the computing space given the significant growth of our business. Mike Vitelli talked about how the business in home theatre has been improving. High-touch spaces in our stores where we know our employees make the difference in making that transaction and that solution work for our customers. That’s a very differentiated experience than our competitors utilize. So we’re very happy to invest labour in those spaces to give the customers what they’re looking for.

We’re also at this point in the journey, we’re not asking our store teams to optimize the labour that they’re deploying in those areas at the expense of meeting those customer needs and growing our overall business. I think Brad said it well, at this point in time in this season we see a significant opportunity to build share in the business and we see an opportunity to do it in a way that’s actually fairly profitable for us. So that’s kind of the investment lens we’re looking through.

Maybe, Shari, you want to comment on how that actually translates into the stores local plans as they think about their customer facing spends.

Shari L. Ballard

I think the stores at this point are half way through the year with their local growth plans and identifying where they’ve got unmet needs for the customers and trying to find better ways to serve them. So they are through, like I said, half way through the year and through the process of prioritizing what they actually see relative to those opportunities where they believe that they’ve got value propositions that when they invest in them the customers respond to. So they’re actually paying off in places where they’ve tried value propositions where the customers are not responding and deciding what that means. So it will either mean they’re investing something to get at a customer need, that’s working, they’ll keep doing it. They’ve invested something to get at a customer need, it’s not working right now, they’ll have one of two decisions to make: they’ll either adjust the value proposition to make the customer, help the customer respond or they’ll stop investing in it. So they’ve got a view now of their full suite of local needs. They’ve prioritized them and they’re going into the back half with a prioritized view of the spend.

Joe Feldman – Telsey Advisory Group

Yes. And then I guess just a follow up on this whole kind of labour and then into the cost discussion. You’ve mentioned a few times in the call that you’ve identified some areas to cut costs and I guess I’m still a little fuzzy on what those are. I was hoping you could clarify that again.

James L. Muehlbauer

So what I mentioned in my comments is that as we look at the number of projects that have both going on in the stores, to Shari’s point, and the things that we’ve had going on within the corporate enterprise, we’ve invested in some things and now have got some feedback on what’s working and what’s not working in some areas. So like we do every year, we have an opportunity to both prune some of those investments and accelerate others. I would tell you the magnitude of the expense reductions that we’re looking for aren’t inconsistent with what we’ve done in the past of the business. We’re not alarmed by the level of reductions that would be entailed and, as Brian mentioned, we are purposely not going to scale back on the growth investments that we see for the future. So as we look at kind of delaying, deferring some store and headquarters projects we’re going to look at some of our overhead spending, some of our advertising spend in the back half of the year. Can we see opportunities to be a little sharper in those areas based on some of our learnings from the first half.

Bradbury H. Anderson

Jim, I’d like to comment on the longer-term implication to what we’re seeing. One of the things that we are seeing now is that we’re able to move market share with different tool sets. So what you’ve got in the organization is a lot of legacy tool sets that we’ve used over the course of the years. I think less so the second half of this year, but much more so as you look into next year and beyond. There will be places we will be able to disinvest which are getting deteriorating returns, which I think happens almost in any, it’s a little bit like we talked in older stores. It happens in any sort of mature retailer. You start to see reductions in efficiency in legacy investments. What we will be doing over the course of the next several years is cutting back significantly on some of those legacy differentiators because we have the option of seeing new things work at a much higher related productivity. And that’s part of what we’ve been doing with the first half of the year is essentially flooding the zone with new options so we have a much better frame with which to edit as we look into the future.

Operator

Your next question comes from Scot Ciccarelli – RBC Capital Markets.

Scot Ciccarelli – RBC Capital Markets

Can you guys give any examples of what Jim classified as kind of one-time-ish expenditures that aren’t expected to be repeated in the second half?

James L. Muehlbauer

Yes, Scot, we had a few things. We had some legal expenditures related to things that we’ve had in the system for a while that we do not expect to occur in the back half of the year. As we appropriately looked at our selling space in kind of mobile electronics GPS we wrote off some assets that we had in place, some fixtures that were not quite at the end of their useful life for accounting purposes, but we saw a better value proposition capability that we could deploy for the back half of the year. So those were one-time expenses that we also put through the P&L in the second quarter that will not recur in the back half of the year.

Brian J. Dunn

We also have sort of a whole laundry list of things we’ve looked at. There’s some travel expenses we won’t be making in the second half that we made in the first half. There’s some project costs that we won’t be incurring around resets that we might have rolled forward with. None of these things we believe has a material effect on what we want to do.

I also want to go back and build a bridge to Brad’s comments just a moment ago. I think it’s really important that you understand that these aren’t just sort of knee-jerk, back half reactions. These are building blocks to retiring some of the legacy pieces that Brad referred to that will pay, we will build on this work for next year and the years beyond.

Scot Ciccarelli – RBC Capital Markets

It sounds like you guys are pretty solid up with the historical pattern that you’ve had when you roll out various initiatives where you throw a lot of labour at a project and then try and fine tune it later on. Is it fair to assume we saw quite a bit of that this quarter, particularly on the Best Buy Mobile side?

Brian J. Dunn

That’s exactly what we do. I mean, our history is we find a value proposition that works. We move to scale and we move to scale without thinking about efficiency. Once we see if we can move that and move that share, as Brad referred to earlier, then we get to the business of refining and making the value proposition more efficient.

Scot Ciccarelli – RBC Capital Markets

And how quickly does that happen, Brian? Is it a quarter? Is it a year? What’s the time frame before you start to try and fine tune the labour model?

Brian J. Dunn

I would love to tell you, Scot, and you know this as well as I do, one side doesn’t fit all their [inaudible], but we certainly think as we get into next year we’ll understand materially more about Best Buy Mobile and the elements of the value proposition that are precious and we’ll be able to make some.

Bradbury H. Anderson

It’s partially directly connected to how sophisticated the program is.

Brian J. Dunn

Precisely.

Bradbury H. Anderson

So what you’re seeing with the roll out of the mobile strategy, that’s several years in duration. Because we tried it ourselves a number of times and failed. We then had to find a partner that we could work with effectively. We then had to test whether we could work, whether that partner’s innovations would work in the US. And then we rolled it as fast as we possibly could once we had the evidence that the test was going to work. It looks like a mass roll out in the first half of this year, which is what it was, but it’s several years old in duration.

So when we’re looking at overall strategy for the company, and this goes back to the question from earlier about why we’re doing major investment right now, is these things that we put into the pipeline, not all of which work, but so far I think if you look at the evidence over the last several years for the organization, a very high percentage of them tend to work. They’ll have different levels of duration. We find it, and we’re seeing a fair amount of this right now, you find it you can use it right now to something that will take us three or four years to get the full benefit of what we’re searching for.

Robert A. Willett

We’re also taking those lessons that we’ve learned from the US and we’re not scaling Best Buy Mobile in Canada. We just got our first standard on stores and we got our first (inaudible) stores.

Coming back to your original question about cost that Jim answered, one of the big costs we’ve had this year that we won’t have to any significant degree next year is PCI compliance. Now, that’s huge in the US and minimal in Canada, and it will be minimal in Canada next year, but very small here in the US. That’s a very significant number.

Jennifer Driscoll

It’s related to customer privacy of their data.

Operator

Your next question comes from Vivian Ma – Oppenheimer & Company.

Vivian Ma – Oppenheimer & Company, Inc.

I just want to get a little bit more color on the international business, specifically on China. Looking at the cost decline in the quarter, what are you expecting for the rest of the year for comps in China? And then, too, it looks like some improvement in the gross margin, but offset by the SG&A. I’m wondering of the 150 basis point increase in the international segment, how much of that is related to the China part of the business?

John Noble

In terms of comps, obviously we had some big impacts in Q2 in China. What we have seen so far is a bit of a rebound, not a full rebound, in our comps in China. And we have modest expectations for the balance of this year from a China comp perspective. We obviously have some investments, particularly on our Best Buy China business in anticipation of additional store openings this year. That contributed, I would estimate, around 50 basis points to our SG&A rate in international.

Jennifer Driscoll

Thanks to our audience for participating in our second quarter earnings conference call.

As a reminder, a replay will be available in the US by dialling 800-405-2236 or internationally by dialling 303-590-3000. The personal identification number is 11119134. The replay will be available from approximately 11:00 Central until Noon Central time next Tuesday, which is September 23rd. You can also hear the replay on our website under bestbuy.com for our investors.

If you have additional questions please call Wade Branson, Director of IR, at 612-291-5693, or me, Jennifer Driscoll, at 612-291-6110. Reporters, on the other hand, please contact Sue Bush at 612-291-6114. And that concludes our call.

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Source: Best Buy Co., Inc. F2Q09 (Qtr End 08/30/08) Earnings Call Transcript
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