How Best Buy plans to beat Wal-Mart

(Fortune Magazine) -- The scariest six words a consumer electronics chain can hear are "Wal-Mart is getting into your space." That's exactly the problem Best Buy is facing this holiday season.

Wal-Mart (WMT, Fortune 500), for the first time, is offering shoppers installation as an extra on TV and computer purchases -- turf that Best Buy (BBY, Fortune 500) had carved out to differentiate itself from the discount retailer.

Best Buy CEO Brian Dunn says he's ready for the challenge. He plans to dull Wal-Mart's attack through the concept of "connectivity" -- getting all the gadgets in your life to talk to one another. If that sounds like a page from the Apple playbook, you're right.

Dunn, citing proprietary estimates, says connectivity holds the potential to be a $250 billion business -- that's far bigger than plain-vanilla sales of consumer electronics, which are expected to fall 7.7% this year to $165 billion.

Included under the connectivity umbrella are things like mobile services, satellite TV, and digital photography. Best Buy makes money by collecting installation and other fees from customers as well as from service providers such as DirecTV. Even better: Connectivity carries higher margins than sales of gadgets, which suffer from constant deflation.

To capitalize on this lucrative market and to offset declines in CD and DVD sales, Best Buy is experimenting with a new store layout. Gone will be the racks of CDs and DVDs that currently occupy valuable floor space. In their place will go stations for MP3 players, video Nanos, notebook computers, and cameras.

Each station will be manned by Best Buy employees -- known as "blue shirts" for the blue polo shirts they wear -- who will field questions like "How do I get the songs from my iPod to play on my TV?" Best Buy says it plans to open two prototypes in undisclosed locations before the end of its fiscal year in February.

Another edge for Best Buy: The technicians making house calls are part of Best Buy's Geek Squad division. By contrast, Wal-Mart is outsourcing installation to NEW, a firm based in Sterling, Va., that handles warranties for the retailer.

"The operative word here is 'owned,'" Dunn says. "Outsourcing works for back-office operations, but we believe that when an experience touches a customer, you must own it." Wal-Mart says it's very encouraged by early results of its program.

What about the lure of low prices that Wal-Mart has used to beat so many competitors (remember Circuit City) into submission? According to a recent Deutsche Bank study that compared flat panel TV prices at Wal-Mart and Best Buy over a 15-month period, Best Buy's prices actually averaged 1% less than the discounter's. "Low prices are table stakes," Dunn says. Creating a connected, wireless world -- that's the jackpot.