Best Buy Co. Inc (BBY) — Q2 2015 Earnings Call Transcript

Good morning and thank you. Joining me on the call today are Hubert Joly, our President and CEO; and Sharon McCollam, our CAO and CFO. As usual, the media will be participating in this call in a listen-only mode. This morning's conference call must be considered in conjunction with the earnings release that we issued earlier today. They both contain non-GAAP financial measures that exclude the impact of certain business events. These non-GAAP financial measures are provided to facilitate meaningful year-over-year comparisons but should not be considered superior to or a substitute for and should be read in conjunction with the GAAP financial measures for the period. A reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures and an explanation of why these non-GAAP financial measures are useful can be found in this morning's earnings release. Today's earnings release and conference call also include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements address the financial condition, results of operations, business initiatives, growth plans, operational investments, and prospects of the company and are subject to risks and uncertainties that could cause actual results to differ materially from such forward-looking statements. Please refer to the company's current earnings release and SEC filings for more information on these risks and uncertainties. The company undertakes no obligation to update or revise any forward-looking statements to reflect events or circumstances that may arise after the date of this call. In today's earnings release and conference call, we refer to consumer electronics or CE industry trends. The CE industry, as defined by the NPD Group, includes TVs, desktop and notebook computers, tablets (not including Kindle), digital imaging, and other categories. Sales of these products represent approximately 65% of our domestic revenue. It does not include mobile phones, gaming, movies, music, appliances, or services. I will now turn the call over to Hubert.

Good morning everyone and thank you for joining us. I will begin today with an overview of our second quarter results and then update you on the progress we’re making against our Renew Blue priorities. Then I will turn the call over to Sharon for additional details on our quarterly results and commentary on our financial outlook. So first, our financial results. In the second quarter we delivered $8.9 billion in revenue and $0.44 in non-GAAP diluted earnings per share versus $0.32 last year. The ongoing benefits of our Renew Blue cost reduction and other SG&A cost containment initiatives drove these better than expected results. On the top line, as expected, sales in the NPD track consumer electronics category declined 2.5% in-line with our domestic comparable sales decline of 2.0%. Like other retailers, and as reflected in this quarter’s performance, we continue to see a shift in consumer behavior. Consumers are increasingly researching and buying online. As a result, traffic to our brick-and-mortar stores continues to decline, and yet our in-store conversion and online traffic continue to increase due to the execution of our Renew Blue strategy which is in direct alignment with this shift. Our Renew Blue strategy is designed to grow our online business, enhance our in-store customer experience, and leverage our multi-channel capabilities to deliver to our customers great advice, service, and convenience at competitive prices in the channel they want to be served. Each of these initiatives contributed to our second quarter results. And so I’m pleased to update you today on the progress we’re making against our renewable transformation roadmap which is built around the following areas: merchandising, marketing, online, stores, Geek Squad services, supply chain, cost structure, and employee engagement. So first, of these areas is merchandising. We believe we’re raising the bar in our retail channel by continuing to roll out compelling and differentiated customer experiences across major categories such as appliances, home theater, and mobile. In the appliance category, we opened 18 new Pacific Kitchen & Home stores within a store and are on track to end the year with approximately 115 stores versus 67 last year. In the Home Theater category, we opened seven new Magnolia design center stores within the store and are on track to end the year with approximately 50 stores versus 33 last year. Both of these premium stores within the store concepts continue to outperform our expectations. We also rolled out over 800 Samsung and Sony Home Theater stores within a store during the quarter. This represents the first major merchandising transformation in Best Buy’s home theater department in almost 10 years. We believe that home theater transformation further solidifies our position as the destination for customers to discover and interact with industry-leading home theater technology, particularly ultra-high definition or 4k TVs, and we’re encouraged by the early consumer response to our expanded ultra-high definition assortments. We’re excited about the future of this technology, even though we believe that the impact on our business this year will be limited. In the mobile category, in the second quarter we began offering customers the option to purchase installment billing plans with the top three U.S. carriers. While mobile phone demand in the second quarter, including year-over-year trading volume, declined as customers wait for highly anticipated new product launches, the penetration of installment billing progressively increased during the quarter and we believe we’re well-positioned to capitalize on the new products when they are introduced. In the area of marketing, we made progress in our evolution from analog to digital and targeted communications with our customers. During the quarter we continued to shift our marketing investment dollars toward digital media campaigns and away from print and television advertising. We’re also leveraging our Athena customer database to pilot new targeted email campaigns; we’re in the early stages of being able to personalize marketing messages to individual customers, which we view as a 2 to 3 year journey. We do, however, expect to see gradual and incremental improvements in marketing effectiveness as our customer insights improve and our new personalization capabilities are rolled out. In our online business in the second quarter, we continued to leverage our ship-from-store, digital marketing, and enhanced website functionality to drive a 22% increase in domestic comparable online sales. Similar to the first quarter, ship-from-store represented over half of the online sales growth. We’re also using ship-from-store to drive gross profit improvements on our clearance and end-of-life inventory by exposing it not only to our retail customers but also to our online customers. We launched several customer-facing improvements on the website to drive increased engagement and a more seamless online shopping experience, including a new global homepage that is easier for customers to navigate, significantly richer visual and editorial content for the ultra-high definition, digital imaging, and health and wearables category, new text messaging options for order confirmation and delivery that are garnering significant customer adoption, and visibility to customers' Geek Squad purchases instead of their My Best Buy accounts on bestbuy.com. As we head into the back half of the year, we will continue to launch online shopping experience improvements, such as additional product category redesigns, expanded wish list capabilities, and an improved checkout process in an expanded and more inspirational holiday gift center. Of course, we will also continue significant behind-the-scenes work on the transformation of our e-commerce platform. In our retail stores, the field and store structure changes we implemented last quarter are, to date, generating results in line with our expectations. We have consolidated and simplified the field organization, we organized to help drive local strategies and reduce the number of management-level roles. In total, our year-over-year retail labor cost is now lower, other investment in customer-facing labor, including vendor-funded labor, has increased. While we still have much to do in reinvigorating the customer experience, we are making progress and are pleased to see our in-store experience contribute significantly to the 400 basis point improvements in our overall NPS or Net Promoter Score that we saw in the second quarter. In our Geek Squad Services business, we continue to increase our net promoter scores and drive down costs to operational efficiencies. We also continue to focus on refining our existing service offerings, improving the merchandising of our services, and building new offerings that meet the needs of customers in the context of today’s rapidly evolving technology environment. In our supply chain, we continue to leverage and transform our distribution and fulfillment capabilities. In May, we implemented significant changes to our distribution operating model that aligned work schedules with customer demand, including expanding our days and hours of operation. This implementation was seamless and we’re now able to replenish inventory to our stores and deliver to our online customers faster, which is both a competitive top-line and improved customer service opportunity, particularly in advance of the holiday season. We also continue to leverage our ship-from-store capability. Not only does it continue to be a significant contributor to our online sales growth, it has also been expanded to drive increased sales out of our retail stores. Let me explain. In the past, when blue shirts were looking for a product that was out of stock in a store, the system they used could only see variable inventory in the individual store and distribution centers. Today, using the exact same system, the blue shirts can now see all available inventory in our distribution centers and our 1,400 stores. As a result, our blue shirts are gaining increased confidence in being able to serve their customers and drive incremental sales. In the area of returns, replacements, and damages, we continue to make progress in the second quarter, including launching a company-wide awareness program for our blue shirts, our Geek Squad agents, and our corporate support teams. This program is focused on raising awareness of the operational behaviors that are contributing to the over $400 million in annual losses that we have historically been incurring. The program is also rolling out new operating procedures to reduce these losses. These procedures include setting the right product the first time, enforcing the company’s return policy, and increasing the frequency of exchanges, inspecting return inventory, culturally resetting in-store perception of the value of return inventory, and exposing this inventory to our online shoppers. As we have consistently said, this online exposure is critical to optimize margin recovery because the majority of open box inventory is searched for and purchased online. In the second quarter, we began offering Geek Squad certified open box inventory online, primarily in the computing and tablet categories. In the fourth quarter, as new systems are implemented, we will begin offering additional open box inventory that is in excellent condition, which represents the majority of our open box returns. We’re seeing early sales and margin improvements from the rollout of these new procedures. We expect to see stronger results as the program matures, and we improve the online searchability and overall multichannel customer experience over the next several quarters. Relating to our overall cost reduction initiatives in the second quarter, we eliminated an additional $40 million in annualized costs, taking total renewable cost reductions to $900 million towards our target of $1 billion. Now, as it relates to our international segment, while we have made considerable progress in our Renew Blue cost reduction initiatives, we have substantial work to do on top line stabilization. To address this, we're following the same kind of Renew Blue transformation roadmap that we’re pursuing in the U.S. So to recap, while the other consumer electronics environment continued to be soft, the second quarter ended better than expected primarily due to strong expense control. In addition, we made significant progress against our Renew Blue priorities and clearly demonstrated our increasing ability to tightly manage what we can control. Looking ahead, our goal is to continue to create a significantly differentiated multi-channel customer experience such that every interaction customers have with us, regardless of channel, makes them a promoter of the Best Buy brands. In support of this, we will be intensifying our investments in customer-facing initiatives across both channels in the back half of the year, and Sharon will elaborate on this later in the call. In fact, I will now turn the call over to Sharon to cover more details on our second quarter financial performance and our financial outlook.

Thank you, Hubert and good morning everyone. Before I talk about our second quarter earnings results versus last year, I would like to talk about them versus our expectations. As Hubert said during the quarter we continued to make meaningful progress against our Renew Blue priorities, which resulted in a better-than-expected non-GAAP operating margin rate of 2.9% and non-GAAP diluted earnings per share of $0.44. These results versus our expectations were primarily driven by stronger SG&A cost containment initiatives, greater promotional effectiveness, and better performance of our new credit card agreement. I will now talk about the second quarter results versus last year. Enterprise revenue declined 4% to $8.9 billion. Enterprise non-GAAP diluted EPS increased 38% to $0.44, primarily driven by the flow-through of our Renew Blue cost savings and other cost containment initiatives. As expected, the positive impact of these cost savings was partially offset by the negative impact of lower volume, higher year-over-year sales in the lower margin gaming and computing categories, and the previously communicated negative impacts from our credit card agreement and structural price investments. Domestic revenue of $7.6 billion declined 2.4% versus last year. This decline was primarily driven by a comparable sales decline of 2% and a revenue decline of $20 million or 25 basis points due to the less favorable economics of the new credit card agreement. Domestic comparable online revenue, however, increased 22% to $581 million due to substantially improved inventory availability made possible by the chain-wide rollout of shipped from store last January, a higher average order value, and increased traffic driven by greater investment in online digital marketing. As a percentage of total domestic revenue, online revenue increased by 160 basis points to 7.7% versus 6.1% last year. From a merchandising perspective, growth in gaming, computing, appliances, and televisions was more than offset by declines in other categories, including mobile phones, tablets, and services. Services comparable sales declined 8.9%, primarily driven by lower mobile repair revenue due to our success in decreasing claim severity and frequency, lower attach rates, and higher mobile warranty premium costs, which translate into lower commission revenue. These were partially offset by a factory warranty recovery-related impact that occurred in Q2, fiscal ’14, that did not recur this year. International revenue of $1.3 billion declined 12% versus last year. This decline was primarily driven by a comparable sales decline of 6.7%, the negative impact of foreign currency exchange rate fluctuations, and the loss of revenue from store closures in China. Turning now to the gross profit, the enterprise non-GAAP gross profit rate for the second quarter was 23.1% versus 23.7% last year, an expected decline of 60 basis points. The domestic non-GAAP gross profit rate declined 50 basis points to 23.4% versus 23.9% last year. This decline was primarily due to a mix shift into the lower margin gaming and computing categories, structural investments, and price competitiveness, particularly in accessories, a 20 basis point negative impact related to the less favorable economics of the new credit card agreement. These declines were partially offset by an increased mix of higher margin large screen televisions and the realization of our Renew Blue cost reductions and other supply chain cost containment initiatives. The international gross profit rate was 21.1% versus 22.3% last year. This 120 basis point decline was primarily driven by our Canadian business due to increased promotional activity and an increased mix into the lower margin gaming category. Now turning to SG&A, enterprise-level non-GAAP SG&A was $1.8 billion or 20.2% of revenue versus 21.5% last year, a decline of $189 million or 130 basis points. Domestic non-GAAP SG&A was $1.5 billion or 19.9% of revenue versus 21.3% last year, a decline of $147 million or 140 basis points. This rate decline was primarily driven by the realization of our Renew Blue cost reduction initiatives and tighter expense management throughout the company. International non-GAAP SG&A was $290 million or 22.1% of revenue versus 22.3% last year, a decline of $42 million or 20 basis points. This rate decline was primarily driven by Renew Blue cost reductions and tighter expense management in Canada and, to a lesser extent, China. Merchandise inventories increased $146 million or 2.7% to $5.6 billion, primarily due to deliberate investments in high-demand back-to-school computing inventory and inventory to support our over 800 Samsung and Sony Home Theater stores within a store. As we enter the back half, we expect this increased level of inventory to continue in order to support our ultra-high definition TV and Pacific Kitchen & Home expansions as well as our initiatives to reduce retail out-of-stocks. In our consumer surveys, one of the top reasons customers say that they do not buy when they are in a Best Buy store is that the product they are looking for is not in stock in that store at that time. Now looking forward to the back half, as Hubert remarked earlier, industry-wide sales are continuing to decline in many of the consumer electronics categories in which we compete. We’re also seeing ongoing softness in the mobile phone category ahead of highly anticipated new product launches. Therefore, absent any changes in these declining industry trends and with limited visibility to new product launch quantities, we continue to expect comparable sales to decline in the low single digits in both the third and fourth quarters. From an operating income rate perspective in the back half, we’re expecting the following business drivers versus last year: one, a similar promotional competitive environment but with better promotional effectiveness internally; two, a greater mix of online revenue that will put pressure on the overall operating income rate; three, continued industry softness and higher promotionality in Canada and China; and four, a net positive impact from our Renew Blue cost reductions as they will more than offset our investments in structural pricing, the new credit card agreement, and the new incremental investments we’re making in the back half of the year totaling $40 million to $50 million or $0.07 to $0.09 per diluted share to support the customer-facing initiatives that Hubert referenced earlier. This $40 million to $50 million will break down by quarter as follows: $10 million to $15 million in Q3 and $30 million to $35 million in Q4. As a result of all of these business drivers, and particularly in light of the fixed cost deleverage that will accompany an expected low single-digit comparable sales decline, we’re expecting the non-GAAP operating income rate in Q3 and Q4 to increase in line with the year-over-year improvement that we saw in the first half. Additionally, in the back half, the estimated diluted earnings per share impact of the discrete tax items that we discussed last quarter will continue to be in the ranges of flat to negative one in Q3, and negative $0.09 to $0.10 in Q4. With that, I will now turn the call back over to the operator for questions. Thank you.

Just a couple of questions. First on the top line, I think you called out TVs both in the printed release and in the script, and then there should be product launches on the mobile side, and those are two pretty important categories between TVs and mobiles. We appreciate the status quo view on the top line, but shouldn't one look at, I guess, some of these trends and have a little bit more of a constructive outlook in the back half of the year?

I think anyone can have their view on the future. I think we have shared ours this morning. We have a backdrop of a consumer environment that’s a bit fragile. We see the trends; of course, in our space you always have ups and downs, so the net effect is what you need to look at. Specifically as it relates to TVs, while we’re excited by the new technology and the customer response, I think we all have to appreciate the fact that the actual impact this year will still be relatively limited before we ramp up into next year. So that’s something to take into consideration. Of course as it relates to mobile, the uncertainties around the quantities you get at this point in time, and frankly we have little visibility, a limited visibility at this point in time. So I think you can develop a view that there is upside, but we want to highlight that there are some factors that limit the potential top line in the back half of the year. But again, Simeon, forecasting is difficult, so we shared our view and we respect yours.

And then my follow-up is regarding the intensifying of investments. Can you hash out whether that is how you are reacting to some opportunity that you see or is something changing that is unfavorable? Because I think the topline outlook or picture that we see doesn't seem so different from the way that it was laid out or forecast by you, and so what is prompting the change?

I think what’s prompting change is from a strategic direction standpoint there is no chance. Meaning that our moves are completely consistent with the roadmap that we have outlined over the last couple of years and certainly this year. I think the investments are a combination of us seeing the potential of some of the initiatives we’re working on as well as the need to be in the game for some of these initiatives. So no dramatic change but increasing confidence and sense of reality around these opportunities. I don’t know whether Sharon McCollam wants to add any color to this, but that’s what I would say.

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Could you give us any sense of what these capabilities like ship-from-store to the customer at home or that inventory lookup that you talked about with associates in stores, and we have certainly experienced that when we are in stores, the frustration in the past with the associate's ability to say yes right now. As you look at turning that on, how much do you think you gave up an opportunity over time and in particular last year's fourth quarter?

Sure. David, I’ve to believe that it is an important number. First, let’s just ground ourselves on ship from store; that aspect of our business right now, which was over half of our online growth this quarter. In the store, what we’re seeing with that number is we launched it late April and the stores are just now starting to use it. We’re seeing the numbers increase each day and we’re looking again in these customer-facing initiatives I was talking about, we’re looking at some opportunities there to make that even a more efficient process once they found the inventory and getting it to the customer faster. So I think that last year we didn’t have it at all. Similar to ship-from-store, you’re seeing what it’s doing for us obviously. In the store side of it, they did not have this capability and then in ship-from-store when you think about the back half of last year, if you recall in Q2 and Q3 we really only had 50 stores that were shipping, October last year we went to 400 stores shipping and then in January of ’14 this year we went to all 1,400 stores. So in the back half we also expect the ship-from-store capability to benefit us in three ways. One, of course, is serving the customer where, when, and how they want that inventory, and we have opened up that $2 billion of inventory to give to them. The second is the margin improvement that we’re seeing because particularly on our clearance and end-of-life inventories, it is creating a much more efficient clearing method because we have so many viewers online to supplement the retail traffic, thus driving a better outcome on the markdowns. Another benefit that we have seen from ship-from-store is that when we’re allocating the inventory to all the stores, we used to send a lot of that inventory back for reallocation when we’re out of balance. We have significantly, more than half of the inventory returned a year ago; we didn’t have to return this year. Thus the cost and complexity that go along with that. So those are what we’re seeing now. The back half, of course, is a very different time of year and there is nothing in what I just shared with you that would say to us here that we’re not going to see the types of benefits at a much higher rate occurring in the back half for us, particularly again this is so big around Q4 when I’ve to have it, I need that gift, those kinds of demands from our customers, and we will be shipping faster and that will be important.

As a follow-up, the original Renew Blue perspective on the business outlined a long-term operating margin of 5% to 6%. Over the past 18 months, there have been various changes in the industry, and your team has implemented initiatives that have brought both incremental challenges and opportunities. Considering all these factors, do you still believe that achieving a 5% to 6% operating margin in the long term is feasible for the business?

Yes, I think that it's important though to recall that when we gave that, we said we need very low single-digit but single-digit positive comp sales. When you think about the revenue leverage that you see especially in quarters like Q4, on the fixed cost which I called out earlier in my business drivers for Q4, it's significant, and with our categories, these NPD categories tracking at this negative 2.5% rate, I know it makes it hard to see, but that 5% to 6% is predicated on that. What we’re particularly pleased with right now, while not excited about negative comps, don’t get me wrong, is that with the things that are within our control operationally and executionally, we’re continuing to improve in those areas. What that says is that when we get to that point, where we see the cycle come back into CE, we’re going to have the operational infrastructure and the cost structure that will highly leverage those sales and that’s the part that we’re greatly looking forward to, and I know as investors you guys are too. But that’s how we see getting to that number, is going to be through some top-line growth and then, in addition to that, continuing to make progress against these kinds of initiatives that we spoke of today.

I guess we will have to see if anybody ever makes a new phone or anyone wants a nicer TV again in the future. Thanks.

Thank you, David.

So first question surrounds the Renew Blue program. You had targeted $1 billion in cuts but for the last few quarters the expense savings have been declining sequentially with only $40 million realized in this quarter. As you look further out over the next couple of years, do you think $1 billion in totality is still the number? And in breaking it down between SG&A and cost of goods, where do you see the greatest incremental savings going forward coming from?

Yes, regarding the SG&A aspect of the Renew Blue cost reductions, we have indeed removed significant costs from the company, although the pace has slowed down. The $40 million in cuts this quarter is less than what we achieved in the previous quarter. A large portion of what we haven't accounted for in the billion dollar target relates to returns, replacements, and damages. The numbers we are reporting on our Renew Blue achievements do include some figures for returns, replacements, and damages, but progress has been quite slow so far. As a reminder, we anticipated a loss of approximately $450 million and expect to reduce that loss to $100 million, indicating a $300 million to $350 million opportunity. Our approach is quite systematic; by the fourth quarter, we anticipate seeing much of that online inventory become available. Hubert, in his prepared remarks, provided more insight into some operational changes taking place within the company. While displaying inventory online is crucial, given that most of it is sold that way, there are other operational improvements ongoing as well, including changes in procedures that we believe will enhance our efficiency moving forward. I see this as an opportunity for us throughout 2016. We will continue to identify operational areas for improvement, particularly in our services and task-related activities in our stores and replenishment processes, but many of these improvements will require structural system changes, which tend to take more time.

Okay. One more question if I may. Sharon, this is really the first time you have given definitive guidance on your comp outlook for the all-important fourth quarter, and you are now saying it will be down low single digits. Where does this number really compare to where your plan was at the beginning of the year and what really has changed, if anything, in terms of your guidance on the comp for Q4 specifically?

Yes, Alan, we initially thought that earlier this year we would experience less decline in those NPD categories. We were also more hopeful about the innovation in mobile. After last year’s Samsung Galaxy launch and other releases, we don’t want to compare each vendor individually. Although last year had its exciting product launches, the slow pace of mobile innovation this year was not what we anticipated. On a positive note, we have remained very cautious, as you know. We base our outlook on actual data rather than on hopes. From the industry data on these categories, the outlook still isn’t favorable. Observing industry commentary, even for a highly anticipated phone launch—without naming a specific vendor—the saturation in the mobile phone sector complicates forecasting. We believe there is potential, and the growth of installment billing programs, which Hubert mentioned, is accelerating rapidly. The changes in carrier plans have introduced dynamics we did not foresee. We're monitoring these developments closely, but until we understand their implications, we won’t include them in our forecasts. We're analyzing economic data similarly to you, focusing on consumer trends, and that aligns with what we indicated last quarter about Q2 results, which ended up being negative low single-digit comparisons. Even so, we gained market share in those NPD categories. So that’s our approach, Alan. Could conditions improve? Yes. Is the growth of Ultra-High Definition TV underway? Certainly, I saw an analyst report this morning on that topic. If that trend continues, it relies on a forecast of low single-digit negative comparisons and the current environment, with only minor excitement and no other compensatory factors for the mobile phone and UHD opportunities. I believe Best Buy is well-positioned to seize this new opportunity, especially with our new Samsung and Sony Home Theater stores. Our staff, the blue shirts, are well-equipped to support this initiative, and our expertise in UHD at Best Buy stands strong in the industry. While the data does not fully endorse all possibilities, we also need to manage inventory effectively. We will see what unfolds, but right now the data suggests we could see performance similar to current NPD trends.

Thanks, good morning, and we can feel just how hard you guys are working to achieve these results, so appreciate you sharing the time with us. A couple of things. If you looked at the NPD categories that you referenced, can you give us a sense of what the e-commerce penetration is of those categories and maybe kind of how you compare against that? Also, how is the profitability shift to e-commerce affecting the margins, SG&A, et cetera? I'm just not sure we have gotten any quantification around that.

E-commerce penetration in our categories is higher than in retail overall. We are one of the sectors with the highest e-commerce penetration, and this trend continues to evolve. We are observing a rapid change in consumer behavior where people are researching and purchasing online, or at least researching online before visiting physical stores. This approach reduces the number of trips to store since customers arrive well-prepared to complete their purchases. While this trend is not new, it remains significant and has been central to our Renew Blue strategy and transformation. We are pleased to report a 22% growth in our online business this quarter. We are excited about this because we aim to achieve an online market share that mirrors our performance in stores, and there is still much to be accomplished. Additionally, we are improving our operating income rate year-over-year, which we find very encouraging. Regarding your question about online profitability compared to stores, it is important to note that creating a detailed profit and loss statement by channel is challenging due to the interdependencies involved. For instance, how do we allocate marketing expenses or investments made online when many conversions happen in-store? This analysis has limited practicality. Generally, the profitability of products sold online isn't significantly different from those sold in stores. However, the products we sell online tend to be lower cube, lower touch, and more commodity-like, making them easier and more convenient to purchase. In contrast, in stores, customers are more likely to buy higher cube, higher touch products. Despite our advancements, online sales still show lower attachment rates for accessories and services. We believe we can improve this by encouraging customers to buy complete solutions online. Therefore, while we expect online profitability and in-store profitability to converge in the future, the current shift towards online sales is slightly impacting overall gross profit rates due to these lower attachment rates.

Just a clarification and then a follow-up. Of your business which is 7.7% penetrated online, what is your guys' best guess as to where the industry is on that same penetration?

In the Renew Blue presentation back in November of 2012, we had tried to estimate that and from memory we had estimated that the market share or the penetration of online in our industry was in the high teens, and so clearly we have room to grow here. The mindset of the company is that we see no reason why our online market share, or market share online, should be lower than in the stores, and we are determined to be agnostic from a channel standpoint and a profitability standpoint so as to be able to serve the customers the way they want to buy it.

And if you can just help by telling us in your fourth-quarter guidance or your back-half guidance what you have contemplated for the promotional environment in Q4 specifically as you compare it against last year's kind of free-for-all?

In my prepared remarks or in my prepared remarks I said, and was very clear, and this is for both Q3 and Q4 that we expected a similar promotional competitive environment. I left out irrational, but okay, that was your adjective. But what we said is that we’re going to have better promotional effectiveness internally. After Q4 last year, you will recall Hubert made many comments about what we would be doing differently this year, and has really done that each quarter, and we have seen it work each quarter. So going into Q4, the rational disciplines that we have implemented, and some of this is additionally also very operating procedure and systematic internally. We did not have the capabilities, pricing capabilities, and promotional tracking capabilities a year ago that prepared us well for that kind of an environment. This year we have made investments in those areas. We have talked about those in previous calls and our teams are getting stronger, obviously, every quarter. So we anticipate our ability to do better, but honestly we just believe that our competition will continue with similar behaviors to previous years.

On that last question, I was curious. It seemed like last year the sector business sort of softened late in the year, and people were culling too much inventory in the channel and then panic ensued. Are you seeing a similar buildup this year, or do you think you will see a buildup this year of the same level of inventory throughout the sector going into the fourth quarter?

We are uncertain about our competitors' inventory levels. However, if we reflect on last year, the market environment and demand in our sector during Q2 and Q3, along with our own performance, showed relatively positive trends, with Q3 seeing low single-digit growth. Although we were likely gaining market share, this also indicated a more encouraging business environment, particularly in the mobile category. In contrast, this year, the market conditions in Q1 and Q2, including mobile, look quite different. While there’s enthusiasm surrounding new products in the latter half of the year, smartphone penetration has reached very high levels, raising questions about the impact of inventory availability. This creates a notably different environment. Predicting Q4 is challenging, and we’re providing our best estimates. After Q3, we may gain more insight, but certainly, the sentiment heading into the latter half of the year differs from the current atmosphere. We’re not relying on a lack of competition in consumer electronics; instead, we are preparing for the holiday season this year with a different set of strategies than last. We have enhanced our promotional efforts and developed a range of initiatives, including our gifting strategy and wish list. We’ve improved the in-store experience with new store formats and expert labor focused on Ultra-High Definition TVs and appliances, along with more targeted marketing communications. Our ship-from-store initiative, implemented in January, is being utilized across all locations, and we have seen improved effectiveness due to organizational changes in our stores. Therefore, we are concentrating on what we can control, executing our plans, and will adapt to the market conditions as they arise.

Just a quick follow-up. Some people think that back-to-school is a harbinger of what is to come with holiday sales. Are you seeing anything with back-to-school that gives you reason for hope or cautiousness?

I would say that back-to-school so far is in line with our expectations. There is potentially, I think, in retail in general, a more positive environment, but we’re not just going to take a couple or three weeks as a source of excitement. This is an economy in general, in a sector where there is a lot of volatility week to week and month to month depending on this, this, and that. So, but yes, in general there is a sense that the retail environment in the last few weeks has been better, and certainly the beginning of the quarter has been in line with our expectations.

And David, I will just add, we’re very focused on the calendar at Best Buy and the things that go all around the calendar. One thing to consider, which I’m sure you’re all considering, is that I have seen several reports that because of the weather last year, many school districts are going back to school early, and we are also very focused on how much of this is lift versus shift because of the timing of earlier back-to-school dates than a year ago to cover up for snow days. So, that is just an add for you on some things that we’re looking at internally just to ensure we don’t get ahead of our lights in this.

A couple of questions. First, on phones, you have talked a few times about not being sure what the volumes you guys are going to get or the inventory. How has that played out in the past iPhone launches? Can you remind us what kind of allocations you have gotten, and has it actually been a positive to your business when it launches, or can it perhaps be a negative because people are going to go to the Apple stores because you guys won't have the allocations?

Yes, I mean what I would say without getting into excessive details, we have a very good relationship with all of our key vendors in that space. I think we’re mutually important to each other and we value that relationship. I think they value the channel. So, in general, that would be true in our business. Anytime there is significant innovation from a product standpoint, that is far from being a negative, if I can put it this way. So we look forward to the launch; I think our comments pertaining to the fact that every time in the initial weeks there is limited inventory, and now I think we are being treated by our vendors very, very fairly. There is no doubt about this, and I think in phones in the U.S., we have to keep in mind that while in the last five years you’ve seen a rapid increase in the penetration of smartphones, you will reach a point of penetration which is about 70% which is quite high, and it's about 90% plus of the new phones that are being sold being smartphones, but there is a point where there is a cap to the penetration of phone. So we’re not expecting a huge lift; that is not something that we would contemplate.

When did you expect that to launch, by the way? Is that a third quarter or a fourth quarter event?

I can give you a phone number in California to call for further details.

We have some more visibility to these things than you do.

Understood. One more question if I could on a different topic and just looking at the expenses that you referenced in the November 2012 Analyst Day; documented a few times. In that presentation, I think at the time you had said that your North American corporate G&A was about $4.2 billion, which I think was 10% of your North American sales at that time. Can you update us on where that number is 18 months later?

We have not been continuing to publish that number; we actually, because of the investments we have made in the stores and other things, we feel that it's little more competitive than it used to be. So we have made a decision not to continue to report on segments of our G&A.

My first question — you have mentioned the Ultra HD TV quite a bit, and others have as well. As we look at that product category, what do you see — maybe more from a qualitative standpoint, the consumer response right now? And are there certain things that need to change, whether it be content and such, to make Ultra HD maybe a bigger driver of better topline results at Best Buy?

What’s very exciting about Ultra-High Definition TV compared to 3D a few years ago is that the customer benefit is immediately tangible and meaningful in the form of improved image quality which, of course, is a huge driver of demand, particularly when you get to these very large screens, the number of pixels becomes critically important. What’s very positive today is that even without new content you’ve the upscaling, and so with the current content, the customers see a material difference. When they go to our stores, we can show them the difference between high-definition and ultra-high definition TV, and I encourage everyone on the call as well as the rest of the country to pay a visit to one of our stores where you’ve the Samsung and Sony customer experience. When you walk into the store you don’t know that you need an Ultra-High Definition TV. After 10 minutes seeing the product and talking with a blue shirt who is hyper-trained in Ultra-High Definition TV, you will know that you need it; the only question you will have is when and which one it will be. Now, beyond that, of course, there are various media companies that are working on 4k content. You can hear Netflix, you can hear Amazon, you can hear a variety of sources, but again we don’t need to wait for that to have that. The TV — Samsung and Sony also have storage devices that allow you to have access to. So what’s going to drive the penetration is the price decline. Now prices have started to go down and probably for many of you on the phone it's going to be highly affordable this holiday, but for the vast majority of the public they may want to wait until next year and the following year. There are price points that are significant from that standpoint. So, we think it's essentially a price discussion, but the product itself is very ready and exciting. So which is why we said this morning we are excited by the potential, but do realize that the impact this year will still be rather limited.

A second question is a follow-up if I may. I think someone else asked about back-to-school. In recognizing back-to-school period has shifted a little bit this year and it is obviously not nearly as big as the holiday season, but the question I have is we talked about some of these better internal promotional effectiveness. Are you seeing — is there a way to say that here in back-to-school we have seen these efforts on the part of Best Buy to drive better results and maybe that is a harbinger of how we should think about your promotional effectiveness come the holiday selling season?

Yes, I think that obviously every day we’re practicing better promotional effectiveness, and when we look at our performance as it relates to all periods, but back-to-school as well, we have been using that rigor, that promotional rigor around all that that we’re doing, and obviously we’re seeing outcomes similar to outcomes that we saw in the second quarter. So yes, I believe that what you’re seeing from us today as it relates to pricing and promotional rigor is going to be no different than what you see. I actually believe in Q4 it will be better because you guys got to remember there were some things in Q4 last year that of course were above and beyond exceptional target breaches and other things which I don’t even want to raise here. So I believe that all the disciplines we put in around and then those things that will not recur may put us in a very strong position, thus the reason that in the prepared remarks today we talked about the fact that despite all of these things, we’re still expecting operating margin expansion in the back half equal to what we have seen in the first half of this year. So despite some of these negative things that we’re talking about, despite the fact that we’re going to — we have guided to you slightly negative single-digit comps, we’re still saying we’re going to expand our operating margin even though, versus some of the first call estimates we could have 300 million or so less revenues. So it is that promotional effectiveness, and of course then there is the G&A side of it as well that’s driving that, but we’re expecting to see benefits in Q4 on both.

Thank you, Sharon, and I think we’re going to wrap this at this point. In closing, obviously I want to thank our teams across the business for their outstanding commitment and hard work serving our customers every day and driving the transformation of our company, and of course I would like to thank all of you on this call for your participation this morning and your ongoing support. So thank you and have a terrific day.