Best Buy (BBY)

Washington, D.C. 20549

FORM 10-Q

(Mark One)

ý           QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended November 26, 2005

OR

o           TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from        to        

Commission File Number: 1-9595

(Exact name of registrant as specified in its charter)

(612) 291-1000

(Registrant’s telephone number, including area code)

N/A

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes   ý  No   o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes   ý  No   o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes   o  No   ý

APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS:

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes   o  No   o

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. Common Stock, $.10 Par Value — 489,926,000 shares outstanding as of November 26, 2005.

BEST BUY CO., INC.

FORM 10-Q FOR THE QUARTER ENDED NOVEMBER 26, 2005

INDEX

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PART I —             FINANCIAL INFORMATION

ITEM 1.                  CONSOLIDATED FINANCIAL STATEMENTS

BEST BUY CO., INC.

CONSOLIDATED CONDENSED BALANCE SHEETS

ASSETS

($ in millions, except per share amounts)

(Unaudited)

NOTE:  The consolidated balance sheet as of February 26, 2005, has been condensed from the audited financial statements.

See Notes to Consolidated Condensed Financial Statements.

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BEST BUY CO., INC.

CONSOLIDATED CONDENSED BALANCE SHEETS

LIABILITIES AND SHAREHOLDERS’ EQUITY

($ in millions, except per share amounts)

(Unaudited)

NOTE:  The consolidated balance sheet as of February 26, 2005, has been condensed from the audited financial statements.

See Notes to Consolidated Condensed Financial Statements.

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BEST BUY CO., INC.

CONSOLIDATED STATEMENTS OF EARNINGS

($ in millions, except per share amounts)

(Unaudited)

See Notes to Consolidated Condensed Financial Statements.

5

BEST BUY CO., INC.

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY

FOR THE NINE MONTHS ENDED NOVEMBER 26, 2005

($ and shares in millions)

(Unaudited)

See Notes to Consolidated Condensed Financial Statements.

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BEST BUY CO., INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

($ in millions)

(Unaudited)

See Notes to Consolidated Condensed Financial Statements.

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BEST BUY CO., INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(Unaudited)

1.        Basis of Presentation:

In the opinion of management, the accompanying financial statements contain all adjustments necessary for a fair presentation. All adjustments were comprised of normal recurring adjustments, except as noted in the Notes to Consolidated Condensed Financial Statements. Due to the seasonal nature of our business, interim results are not necessarily indicative of results for the entire fiscal year. Our revenue and earnings are typically greater during our fiscal fourth quarter, which includes the majority of the holiday selling season. These interim financial statements and the related notes should be read in conjunction with the financial statements and notes included in our Annual Report on Form 10-K for the fiscal year ended February 26, 2005.

We reclassified certain prior-year amounts as described in Note 1, Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements in our Annual Report on Form 10-K for the fiscal year ended February 26, 2005. In addition, during the first quarter of fiscal 2006, we reclassified changes in restricted assets in our consolidated statements of cash flows from operating activities to investing activities; and during the third quarter of fiscal 2006, we reclassified variable rate demand notes from cash and cash equivalents to short-term investments. Prior-year amounts were reclassified to conform to the current-year presentation. These reclassifications had no effect on previously reported operating income or net earnings.

On June 23, 2005, our Board of Directors approved a three-for-two stock split. Shareholders of record as of July 13, 2005, received one additional share for every two shares owned. The additional shares were distributed on August 3, 2005. All share and per share information herein reflects this stock split.

The following table illustrates the primary costs classified in each major expense category:

Vendor allowances included in SG&A were approximately $32 million and $56 million for the three months ended November 26, 2005, and November 27, 2004, respectively; and $87 million and $111 million for the nine months ended November 26, 2005, and November 27, 2004, respectively.

2.        Long-Term Debt and Derivative Financial Instruments:

During the first quarter of fiscal 2006, we repaid the outstanding balance of $54 million on our master lease program. In addition, we terminated our only derivative financial instrument, an interest-rate swap related to the master lease

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program. The net loss recognized on the termination of the interest-rate swap and repayment of the master lease obligation was less than $1 million.

3.        Gift Cards:

We sell gift cards to our customers in our retail stores and through our Web sites. Our gift cards do not have an expiration date.

We recognize income from gift cards when: (i) the gift card is redeemed by the customer; or (ii) the likelihood of the gift card being redeemed by the customer is remote (gift card breakage) and we determine that we do not have a legal obligation to remit the unredeemed gift cards to the relevant jurisdictions. We determine the gift card breakage rate based upon historical redemption patterns. We apply the gift card breakage rate 24 months after the gift card sale date when, based on historical information, we determine the likelihood of redemption becomes remote. Gift card breakage income is included in revenue in the consolidated statements of earnings.

During the third quarter of fiscal 2006, based on the resolution of certain legal matters associated with gift card liabilities, we recognized $29 million in pre-tax income ($0.04 per diluted share) related to our initial recognition of gift card breakage.

4.        Net Interest Income:

Net interest income was comprised of the following ($ in millions):

5.        Earnings per Share:

The following table presents a reconciliation of the numerators and denominators of basic and diluted earnings per share ($ and shares in millions, except per share amounts):

Potentially dilutive securities include non-qualified stock options, nonvested share awards, shares issuable under our employee stock purchase plan (ESPP), as well as common shares that would have resulted from the assumed conversion of our convertible debentures. Since the potentially dilutive shares related to the convertible debentures are included in the earnings per share calculation, the related interest, net of tax, is added back to net earnings because the interest would not have been paid if the convertible debentures were converted to common stock.

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The computation of average dilutive shares outstanding excluded options to purchase 5.0 million and 4.3 million shares of common stock for the three months ended November 26, 2005, and November 27, 2004, respectively; and 5.0 million and 9.7 million shares of common stock for the nine months ended November 26, 2005, and November 27, 2004, respectively. These amounts were excluded as the options’ exercise prices were greater than the average market price of our common stock for the periods presented and, therefore, the effect would be antidilutive (i.e., including such options would result in higher earnings per share).

6.        Stock-Based Compensation:

We have a stock-based compensation plan, which includes non-qualified stock options and nonvested share awards, and an ESPP. Our outstanding non-qualified stock options have a ten-year term. Outstanding non-qualified stock options issued to employees generally vest over a four-year period, and outstanding non-qualified stock options issued to directors vest immediately upon grant. Nonvested share awards vest based either on established goals or upon continued employment (time-based). Outstanding, nonvested share awards that are not time-based vest at the end of a three-year incentive period based either upon our total shareholder return (TSR) compared with the TSR of companies that comprise the Standard & Poor’s 500 Index (market-based), or upon the achievement of company or personal performance goals (performance-based). Time-based share awards vest over a period of at least three years, during which no more than 25% may vest at the time of the award, and no more than 25% may vest on each anniversary date thereafter. Our ESPP permits employees to purchase stock at 85% of the market price of our common stock at the beginning or at the end of the semi-annual purchase period, whichever is less. Stock-based compensation expense associated with our performance-based and time-based share awards is not significant.

Prior to February 27, 2005, we applied Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations in accounting for these plans. Prior to fiscal 2006, no stock-based compensation expense was recognized in our statements of earnings for non-qualified stock options, as the exercise price was equal to the market price of our stock on the date of grant. In addition, we did not recognize any stock-based compensation expense for our ESPP as it was intended to be a plan that qualifies under Section 423 of the Internal Revenue Code of 1986, as amended. However, we did recognize stock-based compensation expense for nonvested share awards, as discussed in Note 5, Shareholders’ Equity, of the Notes to Consolidated Financial Statements in our Annual Report on Form 10-K for the fiscal year ended February 26, 2005.

On February 27, 2005, we early-adopted the fair value recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), Share-Based Payment (123(R)), requiring us to recognize expense related to the fair value of our stock-based compensation awards. We elected the modified prospective transition method as permitted by SFAS No.123(R). Under this transition method, stock-based compensation expense for the three and nine months ended November 26, 2005, includes: (i) compensation expense for all stock-based compensation awards granted prior to, but not yet vested as of February 26, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, Accounting for Stock-Based Compensation; and (ii) compensation expense for all stock-based compensation awards granted subsequent to February 26, 2005, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R). We recognize compensation expense on a straight-line basis over the requisite service period of the award (or to an employee’s eligible retirement date, if earlier). Total stock-based compensation expense included in our statements of earnings for the three months ended November 26, 2005, and November 27, 2004, was $31 million ($21 million, after tax) and $8 million ($5 million, after tax), respectively; and for the nine months ended November 26, 2005, and November 27, 2004, was $94 million ($62 million, after tax) and $12 million ($8 million, after tax), respectively. In accordance with the modified prospective transition method of SFAS No. 123(R), financial results for prior periods have not been restated.

Prior to the adoption of SFAS No. 123(R), we reported all tax benefits resulting from the exercise of non-qualified stock options as operating cash flows in our consolidated statements of cash flows. In accordance with SFAS No. 123(R), we revised our current year statement of cash flows presentation to report the excess tax benefits from the exercise of non-qualified stock options as financing cash flows. For the nine months ended November 26, 2005, $24 million of excess tax benefits were reported as financing cash flows rather than operating cash flows.

In November 2005, the Financial Accounting Standards Board (FASB) issued FASB Staff Position (FSP) No. FAS 123(R)-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards. FSP No. FAS 123(R)-3 provides an alternative method of calculating the excess tax benefits available to absorb tax deficiencies recognized subsequent to the adoption of SFAS No. 123(R). The calculation of excess tax benefits reported as an

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operating cash outflow and a financing inflow in the Statement of Cash Flows required by FSP No. FAS 123(R)-3 differs from that required by SFAS No. 123(R).  We have until November 2006 to make a one-time election to adopt the transition method described in FSP No. FAS 123(R)-3. We are currently evaluating FSP No. FAS 123(R)-3; however, the one-time election is not expected to affect operating income or net earnings.

The following table illustrates the effect on net earnings and earnings per share as if we had applied the fair value recognition provisions of SFAS No. 123 to stock-based compensation during the three- and nine-month periods ended November 27, 2004 ($ in millions):

¹       Amount represents the after tax compensation expense for vested share awards.

²       For purposes of this pro forma disclosure, the value of the stock-based compensation was amortized to expense on a straight-line basis over the period it is vested or earned. Forfeitures were estimated based on historical experience.

Non-Qualified Stock Options

The following table summarizes the non-qualified stock option transactions for the nine months ended November 26, 2005:

The weighted-average grant-date fair value of non-qualified stock options granted during the three months ended November 26, 2005, and November 27, 2004, was $18.85 and $14.20, respectively, per share. The weighted-average grant date fair value of non-qualified stock options granted during the nine months ended November 26, 2005, and November 27, 2004, was $18.53 and $14.17, respectively, per share. The aggregate intrinsic value of options (the amount by which the market price of the stock on the date of exercise exceeded the exercise price of the option) exercised during the three months ended November 26, 2005, and November 27, 2004, was $16 million and $103 million, respectively; and during the nine months ended November 26, 2005, and November 27, 2004, was $145 million and $142 million, respectively. As of November 26, 2005, there was $200 million of unrecognized compensation expense related to non-qualified stock options that is expected to be recognized over a weighted-average period of 1.9 years.

Prior to fiscal year 2006, we used the Black-Scholes option-pricing model to estimate the fair value of each non-qualified stock option.  For grants subsequent to our adoption of SFAS No. 123(R), we estimate the fair value of each non-qualified stock option using the lattice model. We believe the lattice model more accurately estimates stock-based compensation expense as it

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incorporates additional variables, including historical exercise behavior.

The fair value of each non-qualified stock option was estimated on the date of the grant using the lattice model in fiscal 2006 and the Black-Scholes option-pricing model in fiscal 2005.

¹       Forfeitures are estimated using historical experience and projected employee turnover.

²       Based on the Treasury constant maturity interest rate whose term is consistent with the expected life of our non-qualified stock options.

³       We use an outside valuation advisor to assist us in more accurately projecting expected stock price volatility. We consider both the historical volatility of our stock price as well as implied volatilities from exchange-traded options on our stock.

⁴       In fiscal 2006, expected life was derived from the output of the lattice model.  In fiscal 2005, expected life of non-qualified stock options was an input into the Black-Scholes option valuation model and was based upon historical experience.

Net cash proceeds from the exercise of non-qualified stock options were $25 million and $112 million for the three months ended November 26, 2005, and November 27, 2004, respectively; and $195 million and $192 million for the nine months ended November 26, 2005, and November 27, 2004, respectively.

The actual income tax benefit realized from non-qualified stock option exercises totaled $6 million and $38 million, for the three months ended November 26, 2005, and November 27, 2004, respectively; and $56 million and $53 million for the nine months ended November 26, 2005, and November 27, 2004, respectively.

The fair value of nonvested market-based share awards is determined based on generally accepted valuation techniques and the closing market price of our stock on the date of grant. A summary of the status of our nonvested market-based share awards as of November 26, 2005, and changes during the nine-month period ended November 26, 2005, is as follows:

No market-based share awards vested during the three months or nine months ended November 26, 2005, and November 27, 2004. As of November 26, 2005, there was $40 million of unrecognized compensation expense related to nonvested market-based share awards that is expected to be recognized over a weighted-average period of 1.7 years.

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The fair value of stock compensation expense associated with our ESPP was estimated on the date of grant using the Black-Scholes option-pricing valuation model.

¹       Based on the Treasury constant maturity interest rate whose term is consistent with the expected life of ESPP options.

²       We use an outside valuation advisor to assist us in more accurately projecting expected stock price volatility. We consider both the historical volatility of our stock price as well as implied volatilities from exchange-traded options on our stock.

³       Based on semi-annual purchase period.

The weighted-average grant date fair value of ESPP options granted during the three months ended November 26, 2005, and November 27, 2004, was $9.88 and $8.49, respectively. The weighted-average grant date fair value of ESPP options granted during the nine months ended November 26, 2005, and November 27, 2004, was $8.66 and $8.50, respectively.

7.        Comprehensive Income:

Comprehensive income is computed as net earnings plus certain other items that are recorded directly to shareholders’ equity. The significant components of comprehensive income include foreign currency translation adjustments and unrealized gains on available-for-sale equity securities. Foreign currency translation adjustments do not include a provision for income tax expense because earnings from foreign operations are considered to be indefinitely reinvested outside the United States. Comprehensive income was $168 million and $250 million for the three months ended November 26, 2005, and November 27, 2004, respectively; and $578 million and $528 million for the nine months ended November 26, 2005, and November 27, 2004, respectively.

8.        Segments:

We operate two reportable segments: Domestic and International. The Domestic segment is comprised of U.S. Best Buy and Magnolia Audio Video operations. The International segment is comprised of Future Shop and Best Buy operations in Canada. Our segments are evaluated on an operating income basis, and a stand-alone tax provision is not calculated for each segment. The other accounting policies of the segments are the same as those described in Note 1, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the fiscal year ended February 26, 2005.

Revenue by reportable segment was as follows ($ in millions):

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Operating income (loss) by reportable segment and the reconciliation to earnings before income tax expense were as follows
($ in millions):

Assets by reportable operating segment were as follows ($ in millions):

Goodwill by reportable operating segment was as follows ($ in millions):

Changes in the total goodwill balance since February 26, 2005, and November 27, 2004, were mainly the result of fluctuations in foreign currency exchange rates.

Other intangible assets included in our balance sheets is comprised primarily of an indefinite-lived intangible tradename asset related to Future Shop, which is included in the International segment.

9.        Investments in Debt Securities:

Our short-term and long-term investments are comprised of municipal and U.S. government debt securities. In accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and based on our ability to market and sell these instruments, we classify auction-rate debt securities, variable rate demand notes and other investments in debt securities as available-for-sale. Auction-rate debt securities and variable rate demand notes are long-term bonds that are similar to short-term instruments because their interest rates are reset periodically and investments in these securities can be sold for cash on the auction dates. We classify debt securities as short-term or long-term investments based on the date the security can be converted into cash.

In accordance with our investment policy, we place our investments in debt securities with issuers who have high-quality credit and limit the amount of investment exposure to any one issuer. We seek to preserve principal and minimize exposure to interest-rate fluctuations by limiting default risk, market risk and reinvestment risk.

On an annual basis, we review the key characteristics of our debt securities portfolio and their classification in accordance with accounting principles generally accepted in the United States (GAAP). If a decline in the fair value of a security is deemed by management to be other than temporary, the cost basis of the investment is written down to fair value and the amount of the write-down is included in net earnings.

During the quarter extend November 26, 2005, we reclassified our variable rate demand notes from cash and cash equivalents to short-term investments for all periods presented. The amortized cost of the securities reclassified at February 26, 2005, and November 27, 2004, was $116 million and $188 million, respectively. Additionally, in the fourth quarter of fiscal 2005, we reclassified our auction-rate debt securities from cash and cash equivalents to short-term investments and long-term investments, as appropriate. The amortized cost of the securities reclassified at November 27, 2004 was $1.8 billion. The unrealized gain on the securities in conjunction with these reclassifications was not significant.

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We revised the presentation of our consolidated statement of cash flows for the nine months ended November 27, 2004, to reflect the gross purchases and sales of these securities as investing activities rather than as a component of cash and cash equivalents, which is consistent with the presentation for the nine months ended November 26, 2005. Purchases of available-for-sale securities and sales of available-for-sale securities increased by $1.9 billion and $2.3 billion, respectively, for the nine months ended November 27, 2004.

The carrying amount of our investments in debt securities approximated fair value at November 26, 2005; February 26, 2005; and November 27, 2004 due to the rapid turnover of our portfolio and the highly liquid nature of these investments. Therefore, there were no significant unrealized holding gains or losses.

The following table presents the amortized principal amounts, related weighted-average interest rates (taxable equivalent), maturities and major security types for our investments in debt securities ($ in millions):