Best Buy Adds New Services

Who knew the digital revolution could be such a rush? Best Buy did — and it's selling more pricey gadgets and hook-up services than anybody.

The temperature outside is five degrees above zero. But that seems to have escaped the dozen shoppers waiting on a recent morning for Best Buy Co.'s latest concept store, in suburban Minneapolis, to open at 10 a.m. Inside, salesclerks in blue shirts and khakis scramble to finish restocking.

A three-story-high display of flat-screen TVs blares on the rear wall — an inviting tower of babble at the center of pricey multimedia gadgets. This is try-and-buy at its most tempting. Play with videogames. Burn a CD. Watch or, better yet, make movies. One interactive pod in the center of the 45,000-square-foot store offers a leather recliner with power assist ($1,299). Hit the remote and the 42-inch Zenith liquid-plasma flat-panel screen ($2,999) roars to life. Another button surfs the Net or downloads tunes from a PC ($1,349). The video resolution is as good as you'll find in a theater. Check out the four sets of Klipsch speakers ($1,886): A $500 woofer is cleverly concealed inside the chair's seat, earning it the nickname "butt kicker." Total price for the complete "digital life room": $15,419 — cables and service plans could add 20 percent or more. The displays, the wares, the bundled offerings — all part of Best Buy's latest attempt to separate your wallet from you.

The Maple Grove, Minn., store is one of a few dozen Best Buy outlets putting on the glitz. It's offering more of the latest in the growing acreage of really cool stuff that's now widely available — MP3 players, digital cameras, giant TVs, DVD burners, satellite notebooks and radios, wireless gizmos. People can't get enough of these fun devices, and those who've already bought them can't seem to upgrade fast enough. More and more toys are on the way, thanks to the constant innovation that makes them more powerful, faster, cheaper, smaller in many cases and better able to "talk" to each other. So overhyped, so overly long in coming, the digital revolution is finally here, — and Best Buy has become its mightiest foot soldier.

If successful, such company outlets will spread to its other 576 U.S. stores. Yes, the retailer that is best known for grab-and-go electronics, videogames and software at low prices is reinventing itself again — the fourth distinct incarnation in its 37-year history. This time the focus is on bundling high-end electronics with service and installation — without losing its low-price reputation. If it sounds lunatic, it is. "Nobody has been able to do this before," says Bradbury H. Anderson, the chain's 54-year-old chief executive. "If we can only figure out the puzzle." He's muddling through with the support of founder, friend and Chairman Richard M. Schulze, who hired Anderson as a stereo salesman in 1973 and gave him the top job in July 2002.

Richfield, Minn.-based Best Buy is reinventing itself at the top of its game. Its 750 North American locations, including Canada, give the company a 16 percent share of the $130 billion-a-year market for electronics and packaged media, the number one spot. It's rolling toward its best results in five years, with earnings per share projected by analysts at $2.37, up 24 percent, on sales of $23.5 billion for the fiscal year ending March 1, 2004. Same-store sales rose 8.6 percent in the third quarter. The retailer has $1.8 billion cash and is buying back up to $400 million in stock; last year it started paying a 40-cent annual dividend. Despite a recent drop, shares have better than doubled in the last year.

So why mess with success? Anderson sees trouble ahead. Long-term, the store base is maturing. Best Buy still plans to open 60 to 70 new stores a year. But a lot of future growth will come from 20,000-square-foot stores (less than half the standard size) in smaller markets. Keeping annual returns on invested capital at 20 percent could be as tough as selling a used Betamax.

More worrisome are the short-term problems. The flood of imports and shorter product cycles exert severe price pressure on some of the most profitable products — digital TVs, cameras and home entertainment systems. A 60-inch Samsung DLP television that sold for $5,000 three months ago now sells for $4,700. No one believes that digital TVs can escape the price-plunging fate of PCs and anything else with transistors inside. Anderson counters that the lower the price of an LCD TV or a camcorder, the more of them he can sell.

But then there is Wal-Mart. Its share of the electronics market has galloped from 6.9 percent in 1996 to a current 11 percent, reports Credit Suisse First Boston. "If we do nothing, Wal-Mart will surpass us by the simple fact they are adding more stores than we are each year," says Anderson. With operating margins on electronics averaging 5 percent or so, there is no way Best Buy can win "trying to chase the customer out of Wal-Mart."

If it can't compete on merchandise alone, Anderson believes Best Buy can still get a leg up on Wal-Mart. One way is by bundling those goods with add-on services, from reselling Rhapsody, which charges $10 a month for Internet music plus 79 cents a song to burn CDs, to offering complete wiring packages to new-home owners. Another is to tap into private-label goods — not junk at low price points but gizmos that compete directly with major brands. In September Best Buy opened an office in Shanghai with the intent of sourcing goods directly. (Details remain scarce.) If it can increase its share of such merchandise from essentially zilch today to 15 percent of the mix by 2008, estimates Colin McGranahan with Sanford Bernstein, it could add a percentage point to its operating margin.

These are risky moves in the ever-shifting tides of retail. The company is spending an estimated $80 million a year on what it's calling "customer centricity," a massive effort to identify and serve its most profitable shoppers by rebuilding stores, adding to staff and upgrading wares. Best Buy has little choice. It also has some experience in navigating through the most treacherous storms. Twenty-two years ago, when the chain was called Sound of Music, a tornado ripped through its largest store, in St. Paul, resulting in a $200,000 loss for the year and a near-brush with bankruptcy. "We'd forgotten to buy business-interruption insurance," says Anderson. The water-damaged inventory was sold at a "best buy" sale — resulting in a cash bonanza for the company and a name change.

Best Buy's first superstore opened in 1984, a carbon copy of Circuit City Stores, which was then nearly 40 times its size. A year later Best Buy went public and began a climb that sent it past its chief rival in 1995; it has enjoyed the lead ever since. Then came the next calamity — a 1989 price war with Highland Superstores, which hurt Best Buy's bottom line and shoved Highland into bankruptcy. Emerging from the cocoon this time, Best Buy was then a bare-bones, warehouse-style electronics retailer and looked it every square inch: open ceilings, concrete floors, fluorescent tube lighting. Staff on commission gave way to hourly employees who did their best to make themselves invisible to shoppers simply wanting cheap electronics. Best Buy grew rapidly from sales of $240 million in 1987 to $7.2 billion in 1996. And nearly drove itself off a cliff. A year later Best Buy squeaked out a profit of $1.7 million on $7.7 billion in sales. Why? A problem familiar to watchers of Motorola camera phones: Best Buy missed out on the introduction of the new Intel MMX microchip — powering PCs that could run more sophisticated games, better graphics and music synthesizers, and video conferencing — during the Christmas season. Cheap credit promotions by others eroded Best Buy's top line.

Time for another makeover. Trimming overhead and revamping its supply chain, the company reshuffled its product categories into home office, electronics, entertainment software and appliances. Customers saw the difference, as higher-margin DVD players and camcorders replaced PCs, and they bought. Best Buy's gross margins climbed from 13.5 percent in 1997 to 21.3 percent in 2002.

During those fat years the company for the first time reached outside for growth, spending $1.2 billion to buy three electronics and music retailers — with mixed results. Magnolia Hi-Fi, a chain on the West Coast, and Future Shop, in Canada, put Best Buy into higher-end electronics, wares made by the likes of Mitsubishi and Klipsch. That proved to be a good move against Ultimate Electronics and other pricey competitors.

Acquiring Musicland, which operated as Sam Goody, Media Play and On Cue stores, proved less of a bargain. The acquisition was supposed to give Best Buy a national presence in malls and greater concentration in so-called packaged media. Although CDs and DVDs were a break-even proposition, they could stimulate sales of CD and DVD players. Moreover, Musicland's 1,300-plus stores would give Best Buy sufficient heft to negotiate bigger discounts with record companies and Hollywood studios. Or so the theory went. But weak sales, high rents, music piracy and a post-Sept. 11 drop in traffic forced Anderson to dump the money-losing chain in June 2003 for $500 million (in assumed debt alone), booking a $70 million charge to earnings.

Not a huge setback, in Anderson's view, but an opportunity … to refocus. Musicland fiasco aside, maybe there was a better way to combine hardware and software sales — and marry them to services. The slippery business of retail always comes back to figuring out what the shopper wants. So, store by store, Best Buy began reviewing each of its 25,000 or so SKUs to see what sells and what doesn't in order to adjust merchandise according to the income level and buying habits of shoppers at every location. To help sketch that customer profile, Anderson last summer introduced a Reward Zone program, which costs $10 to join and gives $5 in gift certificates for every $125 worth of purchases. By year-end the company was predicting 2 million members. That comes at a cost: up to an estimated half a percentage point of full-year gross margins, which were 26 percent for the year.

One thing learned from such numbers games and focus groups was the near universality of customer frustration. People loved the idea of buying the latest gadgets. But once they left the store and opened the box, many of them didn't know how to hook up the home entertainment center or how to make the remote-control surround-sound system talk to the DVD player. Digital warriors need some form of boot camp.

So changes in staff, as well as inventory, were built into Best Buy's new 45,000-square-foot stores, like the one in Maple Grove. Out went the lower-end toasters, blenders and coffee-makers (more pricey versions stayed). Photo-finishing labs replaced racks of CDs in the center of the larger stores, allowing customers to get instant prints by popping a memory stick into a self-service printer. And everywhere the eye alights, high-ticket office and home entertainment equipment are found. Sales folk might push a new DVD player on the poor schlub who comes in to buy the $30 set of the recent Rolling Stones tour, a four-disk DVD box set produced for and sold exclusively by Best Buy, until February. But they're really after bigger fish.

Best Buy will gently sic specialists (paid an estimated $20-$30 an hour, no commission) on shoppers in order to close a more lucrative deal. Buying a new house? Remodeling? You're a candidate for a new audiovisual system. For a $150 consultation fee, applied to the purchase of equipment and installation, you get someone to visit your house and help you draw up a plan. Such bundling raises the average ticket ($230 or so) and pumps up gross margins, particularly on high-end items like digital TVs (30 percent), by an additional 5 percent to 10 percent, says Sandeep Chungani, a retail consultant with A.T. Kearney. In Minneapolis and Dallas, Best Buy has partnered with 10 of the nation's largest home builders, including Pulte, Ryland and William Ryan, and has so far wired 6,000 new homes. That service raises the price of the home an average of $1,000 to $1,500 — plus the cost of the equipment, of course.

You don't have to be a new homeowner to buy services. Last year Anderson acquired a computer-maintenance company called the Geek Squad and installed its employees (men wear white shirts and skinny black ties; women put on skirts and black tights) in the new concept stores. They're herded into 500-square-foot offices, where they work on computers behind large picture windows. They'll install hard drives for $50 and do tune-ups ($30) on any desktop computer, not just those sold by Best Buy. The minimum diagnostic fee is $60 — or $150 if a geek in a black-and-white VW Beetle has to drive up to your door. "Sometimes," smiles Jeremiah Rush, head geek at the Maple Grove store, who sports spiked hair and a modest pair of earrings, "it's more economical to just buy a new machine."

Trained staff costs money, and Best Buy will have its hands full keeping expenses under control. Sales, general and administrative expenses rose to 22 percent of revenues in the first nine months of fiscal 2004 from 16 percent in fiscal 2002, despite an 8 percent reduction in the corporate head count. Those costs can only rise with the need for better-educated personnel to explain ever more complicated technology. This is not lost on Anderson. Says he, "You don't have a lot of margin for error."

Additional reporting by Evan Hessel.

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