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Best Buy (NYSE: BBY ) reported fiscal third-quarter 2010 results Tuesday. And what a quarter it was. The consumer electronics retailer saw earnings rocket 337%, trumping analysts' expectations. Revenue rose 4.6% and the Richfield, Minn.-based company raised its full-year earnings and revenue outlook. Online revenue rose more than 20% in the quarter, and comparable-store sales surged 8.4% in November.
However, shares sold off more than 8% on the company's report, after investors learned that gross margins were weak and would continue to be weaker than expected. The retailer saw higher sales volume on lower-margin versions of items such as notebook computers and flat-screen televisions.
Margin results fueled concerns that Best Buy will suffer from intensified price competition from the likes of Amazon (Nasdaq: AMZN ) , Wal-Mart Stores (NYSE: WMT ) , Sears Holdings (Nasdaq: SHLD ) , and Target (NYSE: TGT ) .
To gain some inside perspective on Best Buy, I spoke with the company's CEO, Brian Dunn. Here's an edited transcript of our conversation:
Jennifer Schonberger: You reported increased profit, but gross margins were lower due to what you called the sales mix. Do you expect that trend to continue through calendar year 2010?
Brian Dunn: We haven't given new guidance on that yet. I do think that we're going to continue to see this trend move into the connective devices. The strength of our computing category and the rate of growth there, I do see that continuing. So I think we'll see [this continue] certainly through the balance of the fiscal year as we talked about on the call, but we haven't finished the calculations for next calendar year yet.
Schonberger: Do you expect to continue to pursue your current pricing strategy going forward?
Dunn: Yes. It says Best Buy above the door, and we're certainly going to be right there on pricing where we need to be. Also, for us, pricing is just table stakes. If you take the correct market price, marry that with a dominant selection and the greatest help in the world -- our blue shirts and our Geek Squad -- we think all of those things together create a compelling offering for our customers ...
... But I also want to be really clear with you. If people are going to move on pricing, we're going to be there ...
Schonberger: It's your first holiday season without having to battle Circuit City. You had a strong Black Friday, but there is still a balance left in the holiday shopping season, how do you expect the holiday season to finish?
Dunn: I think the holiday shopping season is going to finish up and follow the same trend line over the last few years. I think it will [occur] later. I think it will be fast and furious, and that actually bodes very well for Best Buy because I think that we push enormous volumes through our stores ... As we get into that last week in December and right into January with the gift cards we have moving through our system and all the accessories ... Then the NFL playoffs kick in and that is a strong driver for our home entertainment business. So Christmas really runs until mid-January for us.
Schonberger: You said on your earnings call that you think the growth you're seeing now is more than just easy year-over-year comparisons and that you think that strength is sustainable. What makes you confident that the growth you're generating now is sustainable?
Dunn: This is our 16th consecutive quarter of positive [market] share gains. We have a long history of not just catching and releasing share. We tend to own our share, keep it with us and build on top of it. We see the pattern in what we call the connective categories -- computing, smartphones, flat-screen televisions, digital cameras, and now e-books -- continuing and in fact strengthening. We see that we are best positioned to do more and do the best for customers in that space.
Schonberger: Is the retail recession over, as far as you're concerned?
Dunn: I don't know. I think that the consumer is coming back out. The consumer over the course of the year has demonstrated a willingness to spend in categories that they view as utilities to their lives. Again our computing, smartphones, home theater business, and digital camera business all reflect that.
So I think what's happening is the consumer is emerging with sort of a "new normal." We as Americans have this wonderful capacity to adapt and adjust, and I think we're seeing that. I think it's showing up in the customer coming out now and being very focused on, am I getting a great value? Am I operating with a brand that I trust will be here next year and a brand that cares about what I want to do? Finally, [will this] company help me get the most out of my purchase?
Schonberger: Where is the growth going to come from for the remainder of fiscal 2010 and into fiscal 2011 (basically calendar year 2010)?
Dunn: I think you'll continue to see the strength and growth in computing and in smartphones and in home theater. You're really going to see the growth around these connectable devices -- devices that allow people to be connected to the things they care about, to things they want to do. And we really see great evidence around that.
Schonberger: In terms of domestic versus international growth, do you expect domestic sales to continue to dominate the sales pie going forward?
Dunn: Yes, I certainly do for the next five to 10 years. I believe our U.S. business will be our largest business, but our international portfolio of business has grown materially over the last few years; we now have a multibillion-dollar international business. Over the midterm I see our business in Europe being an important growth engine and certainly over the longer term I see China being a very important growth engine.
Schonberger: China has been a bright spot for many American companies. I know you recently made an acquisition there; any plans to expand even more, or is that very, very long term?
Dunn: I just got back from China last week. The acquisition you're referring to is our Five Star Brand in China, which has 167 stores. That business is accretive, so we're in a positive position with that business today. I have reviewed some of their growth plans, and we're not going to be able to be public about that today, as it's part of our planning for next year, but I'm very encouraged by what I'm seeing from our Five Star team.
It's an example of our core international hypothesis: get engaged, committed local leadership, marry that with our big-box expertise and our worldwide global vendor connections, and really help power the back end as the local teams make the strategic decisions around their customers. It's really starting to take root in Five Star and I'm very pleased with that.
In China we also have our Best Buy stores in Shanghai, which I would describe as more of a test, as we learn our way as to what model to launch there. Most of the labor in stores in China is known as vendor deployed. The vendors pay for the labor and they deploy the labor. Our Best Buy stores in Shanghai are an outlier to that. We're testing five stores in the format of Best Buy paying for the labor and deploying as it sees fit. I think we're just a little ahead of the customer there. Again, this is just a test we're working through.
Schonberger: I know you've spoken to computing as an area of growth for you. But what other areas of innovation is Best Buy looking toward for future investment?
Dunn: I think there are a number of places this technology readily lends itself to -- home management, power consumption, and all those sorts of things that go around home monitoring. I think Best Buy has a role to play there because if you think about all the enablers for that -- digital technology -- we're really in a strong position to help our customers with that [by] combining it with our Geek Squad capability.
The digital connected services -- whether it's connecting people to phone services for their smartphones, connecting people to digital cable or satellites, or new over-the-air HD technology -- [are another] example of the types of spaces we can move into. This is a huge business in this country alone that we are participating in only a small portion of.
A couple of other areas -- musical instruments continues to be a very nice growth story for us, and we intend to continue to grow that. Then there's our Club Beats Headphone DJ Lifestyle. We're seeing interesting traffic there, too.
You're going to see us test the elasticity of our brand and go to all the places our customers want us to go. We're testing electric bikes out West ... if you think of this digital technology it touches almost every aspect of our lives and we want to be in a position to help our customers and our shareholders with that.
Schonberger: Are you taking concrete steps toward investing in these areas whether it's through acquisitions or otherwise?
Dunn: We've done some joint venture work. We have our Best Buy investment fund where we invest in some of these start-up technologies. I don't think this is so much about acquisitions, but if the right opportunity presents itself, we'd certainly look at it. But I don't think it's through acquisition as much as it's through our connections with our vendor partners and the work they're doing coupled with what we know uniquely about our customers.
Schonberger: Best Buy differentiates itself on service. What does the advent of consumer shopping online mean for Best Buy in that it becomes more difficult to offer service online than in-store? How do you differentiate yourself, or maintain a competitive advantage against the likes of Wal-Mart, eBay (Nasdaq: EBAY ) , or Costco (Nasdaq: COST ) ?
Dunn: … It means a couple things. It presents a great opportunity for us with our BestBuy.com business. We were very pleased with the growth we saw in that channel [in the third quarter].
I also think it presents a great opportunity to leverage online with our brick presence. I think having our online presence as a companion to our bricks is a wonderful way for customers to be able to shop us 24/7 ... [yet] I think it's still very important for customers to have a place where they can go to touch it, feel it, see what it will do and have someone there who can help them connect it. A lot of these technologies don't readily jump out of the box and work easily together.
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