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Best Buy Got on Track in the Third Quarter

When it announced its third quarter sales, Best Buy (BBY) share prices fell off yearlong highs because management acknowledged that an intense competitive environment would pressure its margins in the fourth quarter.

From an investment perspective that might make sense, but from an operational perspective, Best Buy seems to be doing just the right thing.

Right now, Best Buy has an opportunity. Last year, Circuit City was in Chapter 11 during the holidays and discounting heavily. Best Buy watched its major competitor throw in the towel by mid-January, 2009, which created an opportunity for the company to pick up customers who had previously shopped its rival's stores. Yet, the opportunity wasn't limited to Best Buy. Some retailers had anticipated opportunities in electronics, with Costco (COST) and Meijer among those that had enhanced their operations over past few years. Others executed plans that had been in development just in time to challenge for Circuit City shoppers, Walmart, (WMT) with its recently expanded electronics departments and operations, a conspicuous example. Still others have been exploring what opportunities the market currently offers with Sears (SHLD), a retailer that hadn't been emphasizing electronics, lately promoting items such as flat-panel televisions.

In such a market, Best Buy has chosen to promote heavily with the goal of driving shoppers through its doors. Specialty stores have a certain handicap when they compete against retailers who have a broader range of products. Walmart, for example, can prompt consumers to check out electronics as they visit its stores to purchase socks, pots and groceries. The same is true of Costco, Meijer, and even Sears can get shoppers who are in the store for hardware and appliances to consider an electronics purchase.

Consumer have to make as special trip to Best Buy. Caught between an opportunity and intensified competition, the retailer has decided it's going to fight for its share of consumer spending. Its results suggest is has been successful in doing so.

In a conference call last week, James Muehlbauer, Best Buy senior vp and interim CFO, said that the company could report several bright spots in the quarter. Comparable store sales â€" those in locations open for at least a year â€" gained almost two percent after falling by four percent in the second quarter and over five percent in last year's third quarter. Earnings beat analysts' average estimate by about a dime. And customers showed up at stores, Muehlbauer noted:

Another bright spot was the three-percent increase in domestic store traffic during the quarter, which marks the second consecutive quarter of traffic growth for Best Buy. Traffic gains and strong coordinated execution by our store and corporate teams resulted in an estimated 230 basis point increase in our domestic market share for the three months ended October.
So, the retailer realized a gain in market share just slightly less than its gain in traffic, the measure of customers coming through store doors. In fact the increase in traffic and market share were among the factors that encouraged Best Buy to increase its guidance for the year.

Because of the intensity of promotions right now, Best Buy conceded an 80 to 100 basis point decline in expected gross margin, which would subject that figure to about a one percent subtraction. However, figured into that are incentives vendors provided last year to help move products that were stalled after the economy's autumnal dive, which means the decline isn't just due to promotional activity. And, given the improvement in traffic, Muehlbauer said the company expects to return more gross profit dollars in the quarter.

Add it all up and it's apparent that Best Buy is making a strong play for former Circuit City customers before retailers such as Walmart get a chance to convert them away from the specialty store sector. Also, Best Buy has made clear that it will be competitive with the range of rivals it faces in the market today. Trying to shore up margins now would cost it customers down the road. As it is now, those customers will not only spend money at Best Buy stores in the future, they will do so when the economy is better and promotions won't be as critical to driving sales, in others words, when margins are better.

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