BBY

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended June 2, 2001, for Best Buy Co., Inc., the nation's largest volume specialty retailer of consumer electronics and home office equipment. The reporting period reflects the company's transition to a two-segment structure following the acquisitions of Musicland Stores Corporation (completed January 31, 2001) and Magnolia Hi-Fi, Inc. (completed December 15, 2000). Results for these acquired businesses are included from their respective acquisition dates.

Key Financial Metrics

Segment Performance:

• Best Buy Segment: Revenues of $3,312 million; Operating Income of $101 million. Comparable store sales declined 3.1%.
• Musicland Segment: Revenues of $385 million; Operating Loss of $11 million. Comparable store sales declined 6.1%.

Material Changes vs. Prior Period

• Revenue Growth: Total revenues increased 25% year-over-year, driven by the addition of 69 new Best Buy stores and the inclusion of approximately 1,300 Musicland stores.
• Profitability Decline: Net earnings decreased 24% to $55 million. This decline was primarily due to a 3.1% drop in Best Buy comparable store sales and a $0.06 per share negative impact from Musicland's results.
• Margin Expansion: Gross margin improved to 22.9% from 20.4%, aided by Musicland's higher margins and a shift toward digital products (TVs, cameras, DVDs) at Best Buy.
• Expense Increase: SG&A expenses rose to 20.4% of revenues from 16.8%, largely due to Musicland's higher expense structure and $4 million in goodwill amortization.
• Liquidity Shift: Cash and cash equivalents dropped $281 million from the prior year period due to acquisition costs, debt retirement ($100 million), and capital spending ($115 million).

Guidance, Outlook, and Risks

Outlook for Fiscal 2002:

• Management expects operating performance to align with prior guidance.
• Gross margins are expected to improve, though less significantly than in Q1.
• SG&A is projected to grow as a percentage of sales in Q2 due to expected comparable store sales of -1% to +1% and Musicland integration, before improving in the latter half of the year.
• Net interest income is expected to remain lower than the prior year due to reduced cash investments and lower yields.
• The effective income tax rate is projected at 39.1% for the year.

Capital Actions:

• Convertible Debentures: On June 27, 2001, the company sold $337 million in 20-year convertible debentures with an initial yield to maturity of 2.75%.
• Debt Tender Offer: A tender offer was commenced on July 13, 2001, to repurchase Musicland's 9.9% Senior Subordinated Notes due in 2008 (face value $147 million).

Risks and Contingencies:

• Economic Conditions: Soft sales in desktop computers, appliances, and prerecorded music reflect a decelerating economy.
• Integration: Risks associated with integrating Musicland and Magnolia Hi-Fi operations.
• Product Cycles: Sales of personal computers were impacted by market saturation and anticipation of the Microsoft XP release.

Investor Verification Checklist

• Acquisition Impact: Verify the pro forma financial impact of the Musicland acquisition versus actual reported results to isolate organic Best Buy performance.
• Comparable Store Sales: Confirm the 3.1% decline in Best Buy comparable store sales and the specific drivers (PCs, appliances, music) mentioned in management commentary.
• Debt Structure: Review the terms of the new $337 million convertible debentures and the status of the tender offer for Musicland's 2008 notes.
• Inventory Levels: Assess the $667 million year-over-year increase in merchandise inventories to ensure it aligns with store expansion and does not signal overstocking risks.
• Goodwill Amortization: Note the $4 million quarterly goodwill amortization expense and its impact on the effective tax rate (39.1%) and operating margins.