Highlights From BBY's Q3 Conference Call: TV Sales Turning Positive; Strong Black Friday and Online, But Margins, Movies & Games Stall

This morning, Best Buy (NYSE: BBY) reported Q3 EPS of $0.47, $0.04 worse than the analyst estimate of $0.51. Revenue for the quarter came in at $12.1 billion versus the consensus estimate of $12.14 billion. Shares are selling off heavily, currently down over 15%.

Highlights From BBY's Q3 Conference Call:

• Same-store sales rose 0.3 percent. Domestic comps were up almost 1 percent.
  
• (Brian J. Dunn) For me, the key takeaways of the quarter were we took decisive actions to drive our business, specifically in revenue and market share both in-store and aggressively online. These actions, while negatively impacting gross margin, significantly resonated with the customers and resulted in improved traffic and comp sales including a significant increase in our online growth.
  
• We still have most of the holiday season in front of us and we are on track to deliver both our revenue and earnings guidance for the year as adjusted.
  
• We are at the early stage of the holiday season, but we have all observed so far retail has been very promotional and consumers have been value conscious.
  
• In terms of our Domestic sales performance, our Domestic comp was up 1% for the quarter and was strengthened by November's performance.
  
• Our in-store comps on Black Friday were strong helping us to deliver an overall comp of 7% for the day.
  
• During Black Friday we delivered a number of records in our Domestic business: the number of people in line outside the stores as well as overall traffic, sales and transactions. According to third-party customer surveys, Best Buy was the number one place to shop in CE and technology, and for all of retail Best Buy ranked number two in initial shopping destination. In addition, BestBuy.com was the third most-visited U.S. retail Web site on Black Friday, up from fourth last year.
  
• Our domestic-online comp was up 20% for the quarter compared to online growth of 13% for the first half of the year. For November, our online business was up over 30%, which was double the online growth of the overall industry according to comScore.
  
• We delivered a meaningful increase in our online conversion rate on top of higher customer traffic. We offered free shipping for all items during the holiday season and were early to the market with this powerful value message, and we continue to enhance our own online assortments. We've more than doubled our online-only SKU count to approximately 50,000 products since last year.
  
• It is also important to note that more than 1.4 million customers chose to pick up their online orders at the store location this quarter, representing approximately 40% growth versus the prior year, a testament to the importance of our multi-channel approach.
  
• Best Buy Mobile posted positive comp growth in the quarter following the introduction of the iPhone 4S in mid-October. And we continue to expand our points of presence by adding more than 100 of our profitable mobile stand-alone stores across the country year-to-date, bringing our total to more than 280 stores. Tablets have been very popular so far this holiday with continued triple-digit growth in the category resulting in significant share gains for us.
  
• This growth is coming from the continued strength of iPads (Nasdaq: AAPL) coupled with the increasing popularity of Android-based models. We believe our tablet-central strategy has positioned us to capitalize on the momentum this new product is bringing the industry. Importantly we anticipate that tablets will be one of the first areas where we leverage our
  expanded-connection strategy as we grow profitable connections revenue beyond just mobile phones.
  
• E-readers are seeing similar trends as tablets and are proving to be very popular gift items this season. We've been leveraging the introduction of the new Kindle Fire (Nasdaq: AMZN) and the Nook (NYSE: BKS) to drive triple-digit growth, new customers and share gains in e-readers.
  
• Appliances continued its strong momentum with the fourth consecutive quarter of positive comps and continued share gains.
  
• As we discussed last quarter, we expected the gaming industry would improve with more new titles in the second half, however, industry sales have been weaker than we anticipated so far in the second half. While we're pleased with the strong demand we saw for Black Friday weekend, we'll have to see how the rest of the year plays out.
  
• As you recall, we've had conservative assumptions for TVs for this year based on consumer demand. The good news is that TVs did pick up compared to expectations. Our total TV units grew over 10% in the quarter delivering a TV comp that was down slightly. Growth was stronger in large screen sizes. Units in this segment were up more than 15% and comps were in the positive mid-single digits.
  
• We've also stabilized TV share and have actually driven share gains through October. Connections are a key component to our growth strategy and overall connections grew 8% in the quarter driven by Best Buy Mobile. As an example of the potential for expanding connections beyond phones, mobile postpaid broadband cards grew 50% in Q3 and 60% during Black Friday weekend.
  
• Our International business delivered strong gross margin improvement and operating income growth of over 80%. The highlight was a very strong margin performance from our business in Canada. Our International performance also reflects the benefit of restructuring in Turkey and China from earlier this year and we expect to see continued positive impact in our International segment as a result of our strategic actions announced November 7.
  
• Five Star had flat comps for the quarter, driven largely by industry appliance sales. Five Star continues to be an important part of our international strategy and we continue to build our footprint of stores in China. Through the first three quarters of the fiscal year, we generated $2 billion in free cash flow on track to meeting our adjusted free cash flow objectives of $2 to $2.5 billion for the end of the year.
  
• We are on target to purchase approximately $1.5 billion of our stock for the fiscal year 2012.
  
• (Jim L. Muehlbauer) Domestic business delivered both positive store traffic and comparable store sales growth. This was the first period that we've seen positive Domestic comps since the first quarter of fiscal 2011 and store traffic is growing for the first time since Q3 FY'10.
  
• We were pleased with our top-line results and the improvements in our traffic metrics during the quarter. The investments we made to improve sales and market share coupled with customer purchases that were more heavily weighted towards value and promotional items resulted in a lower gross profit rate in the quarter.
  
• The biggest positive sales drivers in the Q3 Domestic comp included tablets, appliances, E-readers, mobile phones and movies. Total mobile computing had very strong comparable store sales growth of 16% in the quarter. Within this performance, notebook comp sales trends improved for the third straight quarter delivering a mid, single-digit decline that was slightly ahead of our plan for the quarter. Appliances continued its momentum with comparable-store sales growth of 14%
  
• E-reader products delivered triple-digit comps that once again had a meaningful impact on the total Domestic segment revenue growth. Consistent with our commentary on the second quarter call, the mobile phone business benefited from the launch of the new iPhone 4S halfway through our third quarter as well as other new devices introduced during the period.
  
• The Movies category also delivered comparable-store sales growth as we drove strong promotional activity in this area to improve traffic. Movie sales also benefited from a stronger lineup of new releases that occurred during the quarter.
  
• The 20% increase in Q3 online sales was led by double-digit growth across nearly all key product categories with tablets, televisions and laptops having the biggest impact.
  
• Television comparable-store sales trends improved significantly down low single digits versus the double-digit declines in previous quarters. This was above our plan and represents an important improvement in one of our largest businesses.
  
• Notable areas of Domestic segment comparable-store sales decline during the quarter included digital imaging and gaming. Digital imaging's revenue decline was due to continued overall industry softness and the decline in gaming was driven by industry weakness primarily on Gaming hardware.
  
• Total Gaming comparable-store sales did show meaningful improvement from the prior quarter led by high single-digit growth in Gaming software driven by strength in both new and pre-owned titles.
  
• Sales in our International segments increased 1% with favorable impact of foreign currency and net new store growth offset by a 1.7% comparable-store sales decline.
  
• Our Five Star business in China delivered flat comparable store sales which including a strong golden week performance. Best Buy Europe experienced mid, single-digit comp declines similar to the trend experienced in Q2.
  
• And Canada comp sales were flat, reflecting a strong sequential improvement from the prior quarter when comps were down high single digits. Key improvements versus the prior quarter came in areas like gaming, software, computing and televisions.
  
• Turning now to gross profit performance in the quarter, total gross profit of $2.9 billion was down 1%. Domestic gross profit dollars declined 3% as the rate declined 130 basis points after being up approximately 90 basis point in the previous year.
  
• We also saw strong consumer demand in Mobile Computing products, which have lower gross-margin rates on average. And finally, similar to last quarter, our successful tech-support service offering had a negative impact on our year-over-year gross profit rate.
  
• Why was the decline larger than was anticipated at the beginning of the quarter?
  
• First, during the quarter were made incremental decisions to invest in additional promotional activity. We focus these actions on areas with competitive opportunities like Computing, Television and Movies and were satisfied with the strong response we saw from consumers.
  
• Second, consistent with my earlier comments, consumer purchases mixed more heavily into promotional and value items. Consumers' response was strongest in lower-margin computing and promoted televisions and movies. And lastly, a higher mix of our sales during the quarter took place in the month of November and especially Black Friday, which is more promotional by nature.
  
• Within the International segment, gross profit dollars increased 4%. This dollar growth was the result of foreign-currency exchange rates and a rate increase of 80 basis points. We're also benefiting from the actions we've taken in our international portfolio to exit the lower-margin big-box test stores in China and Turkey.
  
• We continue to generate significant cash. Free cash flow through the third quarter was very strong at $2 billion. FY '12 cash flow has benefited from the reversal of year-end timing items that we have previously discussed and from proactive management of our inventory.
  
• In fact, our domestic comparable-store inventories finished down 11% in the third quarter.
  
• As Brian said, we are currently on track to deliver our adjusted free cash flow target for the year of $2 billion to $2.5 billion.
  
• Before we move onto our outlook I also wanted to call your attention to a couple of other items included in our Q3 results. During the quarter we incurred a total of $150 million of pre-tax restructuring costs that were largely associated with the planned closure of the 11 big-box pilot stores in the U.K. These charges were consistent with our previous announcement on this matter.
  
• Also within the quarter, we sold our investments in the shares of TalkTalk Group PLC and Carphone Warehouse Group PLC. The $55 million pre-tax in associated with these transactions were $0.13 of EPS has been excluded from our adjusted diluted earnings per share of $0.47 for the third quarter.
  
• We continue to expect adjusted annual diluted EPS in the range of $3.35 to $3.65, consistent with the previous guidance when excluding the items outlined in today's release and bi-billed [ph] at the outset of this call. (Consensus is $3.44)
  
• Summarizing the key elements of our updated outlook, our revenue range has remained unchanged for the entire year at $51 to $52 billion, representing full-year comp sales to flat to down 3%. (Consensus is $51.81 bln)
  
• Based in our year-to-date sales and our expectations for Q4, we currently expect to finish around the midpoint of this range.
  
• We now expect the full-year gross profit rate to decline approximately 50 basis points. This includes a fourth quarter gross profit rate that is a modest decline compared to the prior year and better than the rate decline Q3.
  
• Also in computing, we have reduced inventory transition costs due to lower levels of inventory this year and the impact of tech support is expected to be less of a drag given the timing recognition of deferred revenue on this program. Also within domestic, we anticipate a lower mix of gaming sales and reduced year-over-year promotions in movies both of which should improve the rates relative to Q3.
  
• We now expect full-year SG&A dollar growth to be approximately 2%. Excluding the impact of the 50 third week in FY '12 and FX, SG&A is now expected plan to be slightly down for the full year. So rolling it all up, our expectations on total operating income dollars remains within our prior range, which was a 5% decline to 2% growth. Our adjusted diluted EPS guidance range of $3.35 to $3.65 represents a range of down 2% to up 6%.
  
• (Q&A) If I'm going to ask one question, I guess is going to be how you longer-term view the balance between driving traffic and gross profit rate including not long-term - but in the fourth quarter? At some point, I think we need to see sales and margins get better, gross profit margin that is. How do you drive that combination? Thanks. (A) Mike, that is the age-old question in retail and what our focus really is. Our focus is to grow our business, our top line, grow our customer base and to grow op income as we do so. You heard us talk about how important services are to us and it's our intent to grow that business. You also - on November 7th, we talked about our transaction with our partners at Carphone Warehouse. That is entirely designed to take what we've learned in smartphones and spread those connections across fast-growing categories like tablets, to bring back connections capability to places where the customer is interested. And SG&A is a critical component as well. We believe that there's - there continues to be room for us to improve our efficiency and you will see us aggressively pursue those things and the bottom line here is we are absolutely confident we can grow our top line and our operating income and do so in a capital-efficient manner. Thank you.
  
• If I were to ask a follow up, it would be operating profit down 25% year-to-date. So when we think that starts to get better? That's domestic operating profit. (A) Yeah, Mike, it's Jim. It is, and just recall that we had planned for operating profit to be down year to date through Q3, and certainly given the weighting of our earnings in Q4 we had planned operating profit to be up in Q4. We still expected it to be up in Q4, but I think the core point of your first question is, where do we see the opportunities in the business to grow both the top line and to grow the gross margin dollars in the business? And consistent with Brian's response, Michael, we are investing into higher margin spaces around connections and services, and actually we saw some comparable-store sales growth in Q3. The key for us is to make sure that our relevance stays high with consumers and we get the opportunity to grow those businesses given the footsteps we both have both in-store and online. So we've got to bring that mix to the right level of top line growth and margin growth, but one thing is for certain, we're not going to be able to execute our strategies in growing connections and services without the strong foot traffic and brand relevance that comes along with it. And secondly, in order to grow operating income we've got to sell a more profitable mix of products, and we're seeing progress in that space to Brian's point around what's happening in mobility and services. We also have significant opportunities to continue to work on our cost structure which you've also seen great progress on this year. It's going to take a combination of all those factors, but we're certainly encouraged by where we're starting to see some of our biggest businesses play. As we mentioned up front, we had very conservative assumptions for what the notebook category was going to do this year and the television category, and year to date we're exceeding our expectations on both of those two very big businesses. So in light of the macro headwinds and what we see in that CE industry, we're using this time to make sure that we remain relevant with customers from a traffic standpoint while focusing on the profitable growth opportunities that will actually grow op income going forward. Probably a way longer answer than you were looking for, Michael, but I appreciate the question around finding that balance and making sure we drive op income going forward.
  
• My question was just tied to some of the sourcing issues the computer makers might have with the hard drives and the Thailand issues, if that's going to or you're expecting to have an impact on you in the fourth quarter. (A) We are going to have moderate impact with hard drives in the fourth quarter. The manufacturers are doing the best they can to get that into the best products for them and for us which means it'll have less of an impact on the higher-end SKUs and probably more impact on some of the really entry-level value SKUs as they put the hard drives in the best return product that there are for the industry.

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