GameStop (GME) will announce earnings this Thursday, November 15. I expect an EPS beat of $.34 vs. $.33 consensus and revenue miss of $1.78B vs. $1.8B consensus. I doubt this headline will generate much immediate price movement either way (although I think a significant beat is more likely than a miss). While immediate reaction may be muted, a few key numbers will have an outsized impact on price action in the days following the earnings release. I hope to help the interested investor correctly identify and interpret these numbers.
In a prior article, I discussed the full year outlook in depth and reiterated my short thesis (following that advice would see you up ~4%). The confirmation or bucking of certain trends in Q3 will be critical for GME moving into the holiday quarter. Readers would be wise to closely follow management's reaction to Q3 and their expectations moving forward to Q4. Even if we get a rather "blah" quarter on the surface, there will be plenty of revealing tidbits to parse through.
Management guided Q3 EPS to a $.28-$.36 range. Analysts predict EPS slightly above the midpoint at $.33. From a product- or company-specific standpoint, Q3 has lacked notable news. There were no unexpected software or hardware product hits or misses. There were no significant announcements on the digital or mobile front. We learned that the company will open 80 GameStop Kids stores in mid-November, but that will have an impact on results moving forward. Industry-wide, hardware and physical software sales continued their double-digit declines. The sum of August, September and October hardware and software sales fell 38% / 19% YoY, respectively. That compares to 40% / 28% in FY Q2, and 28% / 28% in FY Q1.
Given that background, one might question the prediction for an EPS beat, but I will go even one step further. Despite (and perhaps because of) my short thesis, I would be less surprised by a significant EPS beat-north of $.40-than I would by a marginal miss (~$.30-$32). This is simply the numbers talking. If GME's sequential margin trends hold up (particularly in Used Products and New Software) and industry-wide sales declines continue to be partially offset by market share gains, Q3 will likely surprise to the upside. Expectations were well-managed ahead of the all-important holiday quarter.
Of course, there are good reasons to think that margins and growth will deteriorate more than sequential or YoY trends might suggest. This deterioration is more "baked in" to the estimates of analysts-including yours truly. If results come in at or near what I predict, the timing of my short thesis remains intact. If below, the time table is accelerated. If above, some parsing is required.
Below, find my projected Q3 statement of operations.
click to enlarge images
*Reference these tables for segment assumptions
I give in-depth revenue and margin assumptions for each segment below, with explanations where appropriate. Following the segments analysis, I indicate numbers and/or disclosures that I find to be particularly noteworthy.
Revenues: I expect a 29.4% YoY decline in Q3. New Hardware sales declined 19% in Q1 and 34% in Q2. Industry hardware sales declined 28% and 40% in Q1 and Q2, respectively. Q1 sales were buoyed somewhat by the PS Vita launch. Q3 industry sales declined 38%. If GME outperforms industry declines at the same rate as 1H (i.e. they realize 77% of the 38% decline), sales will decrease 29.4%.
Gross Margin: I expect gross margins of 7.5%. This is a 70bp decline YoY, but 50bps above 2011 full year margins (movement either way has a very minor impact given projected sales).
Revenues: I expect a 14% YoY decline in Q3. New Software sales declined 20% in Q1 and 21% in Q2. Industry software sales declined 28% in both Q1 and Q2, while Q3 industry sales rebounded to post a 19% decline. A comparison of new game launches between Q3 2011 and Q3 2012 suggests little in the way of upward momentum for Q3 2012. If GME outperforms industry declines at the same rate as 1H (i.e. they realize 73% of the 19% decline), sales will decrease 14%.
Gross Margin: I expect gross margins of 21.5%. This is a 60bp decline YoY, but 80bps above 2011 full year margins. Multiple store visits suggest that GME employed fairly aggressive promotional activity in Q3. If margins come in above 22%, expect a $.02-.03 effect on EPS.
Revenues: I expect an 8.5% YoY decline in Q3. Used Product sales declined 1% in Q1 and 11% in Q2. Given the double-digit industry-wide declines in physical software and hardware, GME's Used Products segment has held up relatively well. The sequential trends in YoY quarterly sales, however, indicate a steady decline (over the last 6 quarters-9.5%, 12%, 3.1%, 1.5%, -1%, -11%), and I believe this is only the beginning of a damaging trickle-down effect. After lackluster pre-owned growth in 2010 (3% compared to 18% in 2009), management aggressively (and successfully) scaled its PowerUp Rewards customer loyalty program and achieved 6.1% growth in 2011. The loyalty program, however, is saturated and no longer a driver for pre-owned growth. It also presents a difficult YoY comp. This is probably the most important number to watch in Q3.
Gross Margin: I expect gross margins of 47.0%. This is a 100bp increase YoY and 90bp decrease sequentially. I believe that management has begun to sacrifice some of its 1H margin story (49.1% and 47.9% in Q1 and Q2, respectively) to boost sales by way of the aforementioned promotional activity. If margins come in at ~48%, expect a $.03 effect on EPS.
Revenues: I expect a 33% YoY gain in Q3. Sales in the Other category depend on projections for digital, mobile and "everything else." I comment on each below.
Digital: With respect to non-GAAP digital receipts (management prefers this metric), I expect a 30% YoY gain in Q3. Non-GAAP digital receipts increased 23% in Q1 and 27% in Q2 compared to annual growth of 56% in 2011 and 62% in 2010. Management has suggested that Q1 and Q2 digital receipts suffered from difficult comps. Specifically, Call of Duty released map packs in 1H 2011 which generated significant digital sales, but no such map packs were released in 2012. The problem with this argument is that Call of Duty has moved to a premium subscription platform ("ELITE") that includes map packs as part of the service (although that changed again in recent weeks-ELITE is now free and map packs are a la carte), and GME has not been able to generate the same amount of growth selling digital subscriptions to this service. At this point, however, I give management credit for its ability to ramp up digital PC sales (up 38% and 76% in Q1 and Q2, respectively) and improve digital console sales in 2H 2012 until proven otherwise, although I expect the bulk of digital growth will take place in Q4. In Q1 and Q2 of 2012, digital revenues as a percentage of digital receipts were 39% and 41%, respectively, and I predict 40% for 2012. I predict digital revenue growth of 13% YoY on sales of $52M.
Mobile: I expect mobile revenues to reach $45.1M in Q3 (no YoY comp is available). My forecast is based on sequential revenue growth ($12.5M in Q1 and $28.8M in Q2) adjusted for quarterly revenue variation and the anticipated ramping of iDevice and tablet offerings to 4100 GME stores by mid-Q3. Management has been aggressive in rolling out its mobile offerings. I model sales per store at $12,500 (actual sales per store in Q1), which predicted Q2 sales within a 10% margin when normalizing for seasonal revenue variation.
Everything Else: I expect a 15% YoY gain in Q3. This sub-segment has the least visibility. My YoY growth assumptions for Q1 and Q2 were -8% and 21%, respectively. On an absolute basis, revenues in Q1 and Q2 are roughly in line with expected seasonal variations (whereas 2011 Q1 outperformed significantly on a seasonal basis). As such, I modeled 15% growth on expectations of more normalized performance, supported by the expectation that GME would continue to build out it its accessories offerings (e.g. headphones and controllers) and casual gaming platform to offset declining game sales.
Gross Margin: I expect gross margins of 39.0%.
Digital: I expect gross margins of 60% in Q3. This projection is a "filler" modeled from known mobile margins in Q1 and Q2 and historical "everything else" margins. It is also relatively in line with the blended 53% margin rate achieved in 2011. I expect additional margin expansion due to a higher percentage of commission-product sales and ramped up PC digital sales.
Mobile: I expect gross margins of 30% in Q3. Gross margins in Q1 and Q2 were 37% and 32%, respectively. Management has guided to at least 30% in the mobile category, and I give them credit for delivering in the first two quarters. I anticipate that a company-wide rollout of the mobile business will lead to some margin compression, as stores added later-presumably-will struggle more than hand-picked "trial" period stores.
Everything Else: I expect gross margins of 36% in Q3. I modeled Q1 and Q2 "everything else" margins at 37% and 35%, respectively. This compares to pre-digital/mobile era margins of ~34%. Given a choice between historical averages and the margin predicted by the most recent quarters in a business as dynamic as GME's, I choose the latter.
Key Takeaways-What to Watch For:
Pay particular attention to the following metrics and disclosures, as they should determine the market's reaction to GME's earnings over the next few weeks (listed in order of importance).
- Used Products: Will we see a repeat of Q2's unprecedented 11% sales decline? Mid-single digit declines are acceptable, but anything in the high single digits (e.g. my -8.5% forecast) will be a sign that the industry wide slowdown in new games is trickling down. Also, will margins stay in the historically high 48-49% range? A fall to more typical 46-47% levels may reveal the effects of promotions.
- Mobile: Is there sequential growth in the ~50+% range? Look for mobile revenues of at least $40M-if much lower then management's full year $200M target becomes a stretch. Gross margins also need to remain at 30+%--anything in the 20s is a significant sequential decline.
- Digital: Analysts won't expect 50% growth, but if we continue to see mid-20% growth in non-GAAP digital receipts, you can kiss goodbye to the full year $675M forecast (50% YoY growth). Digital revenues below $50M will be disappointing.
- Guidance: Will management provide and/or alter full year guidance in the three categories above? Will there be a hardware guide for the Wii U (even flat YoY would be OK)? If the full-year $3.10-$3.30 range is reiterated-as has been done all year-is it done on 128.5M shares out, or considerably less shares (e.g. Q3 guide is based on 124.5 shares out?
- New Software: Will sales declines ease along with industry-wide numbers? We should see a decline closer to 15% than 20% (as in 1H). What is the margin story? 22+% is very good, 21-22% is solid, but below 21% is likely a sign of aggressive promotions.
- OPEX: Will we continue to see relatively flat OPEX (SG&A + DA = ~$480M)? Flat OPEX and declining revenues is a sure recipe for profit declines.
In summary, I do not expect fireworks this quarter (maybe I should for precisely that reason). I do, however, expect clues that will provide more of an indication for how GME is handling the digital transition. As I've argued, I think this transition is closer at hand than many investors realize, and GME's ability to quickly adapt will determine the company's ultimate fate. If EPS and revenues are relatively in-line (or miss), investors should strongly consider a short position, especially if the market is slow to react.