Best Buy's Giant Gamble

By Matthew Boyle, March 29, 2006

NEW YORK (FORTUNE Magazine) - Wander around the executive suite at the Minneapolis headquarters of Best Buy, and near the CEO's office you'll encounter a strange tableau.

It's a mock "retail hospital"--including a row of truncated beds in which effigies of stricken retailers like Kmart and Woolworth, the old five-and-dimes, lie with their corporate logos propped up on pillows and with their abysmal financial results displayed on bedside charts. Declares a sign nearby: THIS IS WHERE COMPANIES GO WHEN THEIR STRATEGIES GET SICK. Keeping Best Buy (Research) out of those beds -- and staying a jump ahead of scary rivals like Wal-Mart (Research) and Costco (Research) -- is the challenge that Brad Anderson, Best Buy's jolly gambler of a CEO, wants his people to focus on.

The $30-billion-a-year company has ruled consumer electronics retailing for ten years by popularizing the superstore. Today its yellow-tag logo adorns more than 930 spacious, shrewdly located stores amply stocked with the latest flat-panel TVs, game consoles and discs, home-computing gear, and appliances.

Best Buy accounted for fully 17 percent of the consumer electronics market in the U.S. and Canada last year. For investors the payoff has been big: Throughout the 1990s Best Buy's earnings per share grew faster than Microsoft's, and its shareholder returns bested Intel's.

But the mock hospital is a reminder that in the volatile, low-margin retailing realm, complacency brings doom. Because of that awareness, Anderson has been willing to roll the dice again and again throughout a legendary retailing career, junking perfectly good business models in favor of high-risk innovations.

"When most of us say, 'Well, I'm more comfortable where I'm at,' " says CFO Darren Jackson, "Brad pushes us around the next corner."

Changing the business formula -- again
Anderson now is out to blow up Best Buy's entire success formula -- by shifting the company's focus from pushing gadgets to catering to customers. Known internally as customer-centricity, the plan is so far-reaching and risky that last year, when Best Buy announced that clumsy execution had hurt third-quarter results and that same-store sales growth had been sluggish, its stock price plunged 12 percent, to $44, in a single day.

Analysts also fretted that the company might be juggling too much -- Best Buy is preparing to open its first stores in China, seeding U.S. cities with technology boutiques, and recruiting techies by the thousands to expand its Geek Squad service business. Though a post-holiday surge has brought the share price above $57 -- most analysts now recommend the stock -- Anderson's great transformation has only begun.

"Whether we're doing it in the right way is a highly challengeable premise," he says. And he knows the risks: If the strategy fails, Best Buy could end up a consumer electronics also-ran, like those retailers in the mock hospital.

Working his way up the ranks
Brad Anderson does not look like a gambler. At 56, he has warm blue eyes, a hearty laugh, and an easygoing, self-deprecating manner. The son of a Lutheran pastor in Minneapolis, he started at Best Buy when it was a struggling regional chain called Sound of Music, way back in 1973.

Business during that oil-crisis year was so slow that it took Anderson two weeks to make his first sale, a set of Bose 901 speakers he had to drive 70 miles to install for the customer. The measly commission hardly paid for the gas.

But to Anderson that was better than losing the deal. "It was so frustrating to be unsuccessful that I didn't care that it wasn't a rational commitment of time," he recalls.

The company expanded and Anderson worked his way up, becoming founder Dick Schulze's right-hand man in 1981. In the 1980s boom, the two opened superstores and gradually built Best Buy into a Midwestern power. But unlike the long parade of regional players that blossomed and died -- from Crazy Eddie to Highland -- Best Buy changed and grew.

Its most controversial innovation came in 1989, when Best Buy stopped paying commissions to its sales staff and instead put them on salary. Among manufacturers like Toshiba and Hitachi that depended on salespeople to push premium-priced items, the move went over "like a fart in church," a former Best Buy executive recalls. But customers liked the no-pressure atmosphere in Best Buy stores, and overall revenues grew at a 25 percent-a-year clip, enabling Best Buy to far outpace its rivals.

The Schulze and Anderson approach set Best Buy on the path of a 12-year expansion. It entered markets like Chicago, Philadelphia, and Boston and became the biggest seller of home PCs in 1995, just in time for the Internet boom. In 1996 it surpassed Circuit City (Research) to become the nation's top consumer electronics retailer.

But Best Buy's big gambles did not always pay off. Hoping to wield more influence in the music industry, the company paid $696 million to acquire Musicland, a mall-based retailer of CDs, in early 2001. The timing could not have been worse -- Internet downloads soon crippled CD sales, and the acquisition became a financial drag.

Hard times
Schulze had long planned to have Anderson succeed him. But when Anderson became CEO in June 2002 (Schulze became chairman), economic shock waves from 9/11 had sapped demand across the industry, and sluggish sales, combined with a write-off of Musicland's goodwill, sent Best Buy's stock plunging.

Worse for Best Buy, Wal-Mart and Costco were ramping up their consumer electronics offerings. Direct seller Dell (Research) was gaining market share too. Anderson moved quickly to stave off the mass merchants.

That October, Best Buy bought Geek Squad, a Minneapolis startup that specialized in repairing and installing PCs. Though it had just $3 million in revenues and 50 employees, Anderson knew that digital devices and home networks were growing in complexity and that the technical services market had huge potential. (Best Buy today pegs the small-business and home services market at more than $20 billion a year.)

Better still, Anderson figured, Wal-Mart and its ilk were never going to provide the help many customers would need. Within a year Best Buy had Geek Squad "precincts" in more than 20 stores; by 2005 the geeks had set up shop in all Best Buys.

Creative solutions
Anderson faced another huge challenge as CEO: Wall Street had come to expect growth of 20 percent a year. But having saturated North America, Best Buy could no longer rely entirely on adding new stores. To the consternation of his management team, the new CEO would disappear for weeks at a time, going to conferences outside the electronics industry in search of ideas.

Anderson also invited big thinkers to Minneapolis. Among them was Larry Selden, a professor at Columbia's business school, who laid out a theory about where most businesses go wrong. Selden argued that, in their hunger for sales, companies are often oblivious to the fact that not all customers are profitable ones. Some are very lucrative to deal with, while others cost more to sell to than the business is worth.

Selden called the first group angel customers and the second demons. By catering to the angels, he argued, companies can reward customers, employees and shareholders alike. (Selden is co-author, with FORTUNE's Geoffrey Colvin, of the 2003 book, "Angel Customers & Demon Customers.") Selden's philosophy was just what Anderson had been looking for. In late 2002 he started preaching the gospel of centricity to upper management.

Centricity
In short, here's how it works: Figure out which customers make you the most money, segment them carefully, then realign your stores and empower employees to target those favored shoppers with products and services that will encourage them to spend more and come back often. By the summer of 2003, Best Buy was already testing the concept in a few dozen stores.

To see centricity in action, let's meet Barry, Jill, Buzz, Ray, and a person we'll call Mr. Storefront. They're archetypes of the lucrative angel groups Best Buy covets: Barry is an affluent tech enthusiast; Jill, a busy suburban mom; Buzz, a young gadget fiend; Ray, a price-conscious family guy; and Mr. Storefront owns a small business. Other segments interest Best Buy too, like young single women (Carrie) and empty-nesters (Helen and Charlie), but for now the company is focusing its redesigns on the core five.

Best Buy's researchers comb through reams of sales and demographic data to determine whether a particular location should be tailored to, say, Ray or Buzz. Nearly 40 percent of the 300 stores that have been redone aim at Barry -- in them you'll find a separate department of home-theater systems, expert salesmen, and specialists in mobile electronics.

Jill stores feature personal shopping assistants (PSAs) who know how to steer a homemaker to the right digital camera for her family. Buzz stores have broad assortments of video games. Stores can target more than one segment -- Jill and Barry departments often share a location -- and a handful of Best Buys, like the one in the Dallas suburb of Frisco, have all five segments going at once.

"Centrizing" a store is a big investment -- a typical Barry department alone requires as much as $600,000 for lighting and fixtures. Best Buy also invests in schooling employees in financial metrics such as return on invested capital so that they can gauge for themselves the effectiveness of merchandising displays. (Recent example: Buzz departments have an area where kids can try out Dance Pads, a video game accessory you activate with your feet.) Specialized salespeople, such as PSAs and home-theater experts, get additional training that may last weeks.

When centricity works, it can pay off in unusual ways. Reagan Dobbs, 20, is a lanky, goateed salesman at the Best Buy in Grapevine, Texas, under the flight path of the Dallas/Fort Worth airport. The store was redone in July (it's a Jill/Barry combo store), and Dobbs learned centricity's principles in two weekend workshops.

It didn't take him long to decide his store was neglecting at least one customer need. Megachurches are a hot phenomenon in the Dallas metroplex, yet Best Buy's assortment of contemporary Christian music was anemic. So Dobbs visited churches, learned which bands the faithful liked, and came up with a proposal for a much broader assortment of Christian rock and folk.

His bosses had him take the plan all the way to headquarters. Sales of contemporary Christian music in the Grapevine store have risen from 2 percent of music sales to 6 percent since November, and the idea is being taken up by Best Buy stores across the region. Just as important, empowering people like Dobbs has helped lower Best Buy's employee turnover from 81 percent last year to 69 percent now.

A few bumps in the road
That doesn't make the shift to centricity any less risky, however. Emboldened by the results from the first few dozen stores it segmented, where same-store sales grew at three times the rate of regular stores, Best Buy stepped on the accelerator in last year's third quarter, ended Nov. 30. In just three months it switched 154 stores to centricity -- three times the number converted before.

"There was an impression that we could do no wrong," says Anderson.

It turned out to be wishful thinking. With its earlier conversions Best Buy had carefully laid the groundwork; it then tinkered ceaselessly to get the mix of products and employees just right. Once that investment paid off, Anderson and his executives assumed subsequent stores could just flip a switch and convert to centricity.

"When we gave the operating manual to the stores for the fall," he says ruefully, "it was four inches thick."

Adds executive vice president John Walden, Anderson's point man for centricity: "The way we deployed was too confusing."

Instead of jumping as it had in previous quarters, same-store sales growth at the renovated stores was only slightly better than the chainwide average (5.4 percent vs. 3.3 percent).

When Anderson faced Wall Street analysts on Dec. 13, he tried lamely to rationalize that transformations aren't always smooth. The analysts didn't buy it, and Best Buy's market cap slid almost $3 billion that day.

"It wasn't one of the highlights of my career," Anderson says. The poor results persuaded him to freeze centricity rollouts for the fourth quarter. (They resumed in March.)

Juggling projects
Some analysts also complained that too many projects were competing for Best Buy's attention. Ramping up the Geek Squad was at the top of the list. A bulwark against the likes of Wal-Mart, the business has cashed in on consumers' desire to protect their PCs from nasty viruses and to create wireless home networks. The geeks can do this at your home, in a Best Buy store, over the phone, or online.

Last year, as consumer demand for flat-screen TVs exploded in the U.S., the need for techies to help with installations soared. That put pressure on Best Buy to recruit. Having added almost 10,000 technicians to its ranks last year, the Geek Squad now is more of a Geek Swarm -- it numbers over 12,000. In fiscal 2007 (beginning Feb. 26), it should earn $280 million in operating profits on just over $1 billion in sales, says Piper Jaffray analyst Mitchell Kaiser.

"I like that Best Buy has all these balls in the air, but they are not all going to work," says Morgan Stanley analyst Greg Melich.

Some, like retail investor Howard Davidowitz, fear that Anderson's revolutionizing is a bridge too far. "If they were doing everything without centricity, I would be optimistic."

But with centricity now in 40 percent of U.S. stores (it will extend to all in two years) and shaping all decisions -- each segment has its own finance manager at headquarters -- the commitment is made. "We will not back down from this," says Schulze.

A strong balance sheet
The confidence to gamble comes in part from Best Buy's balance sheet, which is among the strongest in retail and includes a war chest of over $3 billion in cash.

"This is a rich company," says CSFB analyst Gary Balter.

That not only allows Anderson to invest heavily in centricity and the Geek Squad, but also made the third-quarter shock easier to stomach.

Besides, Anderson loves risk. Remember Best Buy's controversial 1989 shift to a salaried work force? Chief operating officer Brian Dunn, then a store manager, recalls pleading with Anderson not to do it -- he was sure major suppliers would pull their wares. "Think about the next 15 years, not the next five," Anderson told Dunn.

Anderson was right, of course, and the move accelerated Best Buy's ascent. Now the stakes are higher, but radical innovation still represents Anderson's best bet to stay among retail's elite.