Best Buy's earnings rise, but falling prices trim profit margins

best-buys-earnings-rise-but-falling-prices-trim-profit-marginsFalling prices for electronics kept taking a chunk out of Best Buy (BBY) profits, but company executives said more sales and traffic helped it achieve third-quarter earnings that easily beat analysts' estimates. And expecting more of the same for the rest of the year, they upped their guidance to investors.

The electronics chain posted net income of $227 million, or 53 cents per share, a dime better than the 43 cents Wall Street had expected. That's 51% above the same period a year ago, after factoring out a one-time accounting charge that hit earnings in 2008.
Revenue grew 5% to $12 billion in the third quarter, and comparable sales were up 1.7%. Comparable sales in the U.S. were up 4.6% in the quarter and 8.4% in November alone, said CEO Brian Dunn. But international revenues and comparable sales were down 6% and 6.7% respectively, mainly due to currency fluctuations and slower economic recoveries abroad.

In the U.S., sales are perking up at a fast clip heading into the final stretch of the holiday season, said Dunn. Black Friday showed double-digit gains in year-over-year comparable sales, with higher traffic and higher average sale prices contributing equally to the growth, he said. Also, gift card sales were up 40% year-over-year in November, and up nearly 100% over the Black Friday weekend, which bodes well for the fourth quarter, since customers typically spend twice a card's value when they redeem it, said Dunn.

Growing Where Profits Are Shrinking

The improvement led Best Buy to raise its guidance for the fiscal year ending Feb. 27, 2010. It now projects earnings of $3 to $3.15 per share on revenues of $49 billion to $49.5 billion, up from earnings of $2.70 to $3 on revenues of $48 billion to $49 billion. Comparable store sales will be flat to up 1%, better than the flat to 2% drop Best Buy had expected three months ago.

But the company's gross margin is expected to fall slightly, by up to 0.1 percentage points. Just three months ago, while announcing second-quarter earnings, management had projected gross margins would grow by 0.1 to 0.2 percentage points.

Much of the sales growth is coming in areas where profit margins are under pressure, explained CFO Jim Muehlbauer. The margins are reflecting stronger sales of lower-margin items such as computers, video game hardware and entry level-priced flat screen TVs, he said.

Additionally, the comparison includes incentives provided by vendors last year to move inventory in the wake of Circuit City's shutdown, said Muehlbauer. Margins improved by about 0.4 percentage points a year ago, thanks in large part to those incentives, he said.

"We knew that was going to provide a headwind," said Muehlbauer.

Installing Itself Into a Geek-Powered Future

Falling electronics prices have been a drag on the sales of retailers from Wal-Mart Stores (WMT) to Costco Wholesale Corp. (COST) this year. Many have seen double-digit sales gains canceled out by equally drastic price drops. After the demise of Circuit City last October, Wal-Mart stepped in the gap, expanding its electronics departments, and other chains followed.

Best Buy purposely set out to gain market share in segments such as TVs and computers in spite of the margin pressure, and it has "no intention of remediating those gains," said Dunn. He said bundling several products such as TVs and computers along with installation and support services from its Geek Squad unit is a big part of a strategy that has helped the company to 15 quarters of consecutive market-share gains.

And there is plenty of growth left there, Dunn said. Most of Best Buy's sales growth is coming from connectable devices such as TV's, computers and cell phones; but except for cellphone buyers, few customers leave with their devices connected, he said. Attractively-priced bundles of equipment and installation services give Best Buy an edge, he said.

"Low prices are table stakes, but only the beginning of a value equation," said Dunn.

He said the company is looking forward to more products that lean even more heavily on tech-savvy installation. Dunn noted that most of the next generation of flat-screen TVs will have Internet connectivity and said Best Buy is in talks with electronics manufacturers to carry their upcoming lines of 3-D TVs.
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