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GameStop Corp. (NYSE:GME)

F3Q08 Earnings Call

November 20, 2008 11:00 am ET

Executives

R. Richard Fontaine - Executive Chairman of the Board

Daniel A. DeMatteo - Vice Chairman of the Board, Chief Executive Officer

David W. Carlson - Chief Financial Officer, Executive Vice President

Tony D. Bartel - Executive Vice President - Merchandising and Marketing

Julian Paul Raines - Chief Operating Officer

Analysts

Anthony Gikas - Piper Jaffray

Benjamin Schachter - UBS

William Armstrong - C.L. King & Associates, Inc.

David Magee - SunTrust Robinson Humphrey

Arvind Bhatia - Sterne, Agee & Leach

Mike Hickey - Janco Partners, Inc.

Edwards Williams

Operator

Welcome to GameStop Corporation’s Q3 2008 earnings conference call. Today’s call is being recorded. At the conclusion of the announcement a question and answer session will be conducted electronically. (Operator Instructions) I would like to remind you that this call is covered by the Safe Harbor disclosure contained in GameStop’s public documents and is the property of GameStop. It is not for rebroadcast or use by any other party without the prior written consent of GameStop. At this time I would like to turn the call over to Dick Fontaine, Executive Chairman of GameStop Corporation.

R. Richard Fontaine

Welcome to GameStop’s third quarter conference call. I’m Dick Fontaine, GameStop’s Executive Chairman. With me today are Dan DeMatteo, our recently appointed CEO, Paul Raines, our Chief Operating Officer, and David Carlson, our Executive Vice President and Chief Financial Officer.

In my new capacity as Executive Chairman I’ll be focusing on the development of our more immature European operations and future growth as well as concentrating on strategic issues and additional acquisition opportunities.

Before I turn the call over to Dan, I want to say how positive I am about his ascendency to the CEO position. Dan understands the video game business better than most anyone in retail and has played a huge role in moving our company to where we are today. Dan and I have worked side-by-side for all 11 years of GameStop’s existence and we couldn’t have a more experienced leader with a real passion for the business leading our company.

And with that I’ll turn it over to Dan.

Daniel A. DeMatteo

As you know, this morning we released our third quarter financial results and gave guidance for Q4. In spite of the current economic environment we grew sales and non-GAAP earnings over last year which was a record-setting quarter with the release of Halo 3 and 46% comps. Once again the consumers accepted the great entertainment value that video games provide. While sales were off slightly off our previous forecast due to unexpected softness internationally, we offset this through strong expense control and met the high end of our earnings guidance. Dave will give you more details on the specifics of our financial results.

In the quarter our video game sales grew 10% driven by new title releases across all console platforms. In addition the US installed base of next gen consoles continued to expand with 18% year-over-year growth led by Nintendo’s Wii. This continued growth in the next gen installed base gives us confidence that software sales will continue to grow this year and into next and this cycle will be longer and broader than any before. And our buy/sell trade model continues to work well in this economic environment as consumers traded in record numbers to buy new video games.

The fourth quarter has started well driven by a strong lineup of titles of new releases such as Call of Duty: World at War, Gears of War 2, and World of War: Wrath of the Lich King, again reflecting the resilience that video game sales have in tough economic times.

We have reduced our earnings estimates slightly in Q4 to reflect some level of uncertainty when we switch from the primary game player to the gift giver as a sales driver. But we are still forecasting double-digit earnings growth in the quarter and 30% to 33% growth for the full year.

In the quarter we opened 191 stores, 94 in the US and 97 internationally, putting the total number of new store openings for the year so far at 526. In addition in 2008 we began experimenting with stores in PX compounds on US military bases and these have proven to be homeruns delivering sales and profits well beyond the average store. To date we have opened 15 of these stores and expect to have 23 by year end. As a matter of fact, our new store program continues to deliver results well in excess of our IRR expectations.

As Dick mentioned in the release this morning we completed our acquisition of Micromania, the largest retailer of video games in France with 332 stores and now have an extremely well positioned company in the second largest European market. We expect to pay off the short-term loan we made for this acquisition by the end of the holiday season out of free cash flow.

In summary, we are well positioned both in the US and internationally to continue to capitalize on this growing industry. This year we will open over 600 stores, acquire Micromania and spend on other capital projects to improve infrastructure all out of free cash flow. While we share other retailers’ concern on the slowing economy, we see that consumers place great value on interactive entertainment and thus far have elected to buy this season’s hot new games.

Now I’ll turn it over to Dave for a review of the financial data.

David W. Carlson

Before the market opened today we released our sales and earnings results for the third quarter of 2008. GameStop sales for the third quarter increased 5% to $1.7 billion as compared to $1.6 billion in the prior fiscal year.

Comparable store sales for the third quarter declined by 1.8% due primarily to the difficult comparison to the Halo 3 launch last year which was the largest title launch in GameStop history. The slight moderation in comparable store sales in comparison to our original expectations was due entirely to weaker results internationally related to the global economic and financial crisis. New video game software, an important indicator of our success, increased 10% during the quarter even with the difficult Halo 3 comparison while used video games grew 19% with the current economic environment continuing to stimulate trade-ins.

GAAP diluted earnings per share for the third quarter were $0.28 which included merger-related expenses of $0.06 per share and the impacts of foreign currency fluctuations of $0.04 per share. Excluding these two items non-GAAP diluted earnings per share were $0.38 an increase of 19% over the prior year quarter.

Gross margin rate increased by 190 basis points as product mix shifted from low-margin hardware sales to higher-margin new and used software sales. The increases in the new hardware and new software category margins were due primarily to strong co-op advertising programs related to fall and holiday titles.

SG&A expenses came in significantly under forecast as costs and expenses were cut in response to the global economic issues and the resulting moderation in sales.

Our balance sheet remains strong with $478 million in cash at the end of the quarter, an increase of over $200 million from the prior year quarter held in anticipation of closing our acquisition of Micromania last week. Inventories as well increased 22% over the prior year as many hot titles released in the first weeks of November were shipped to our warehouses during October.

This morning we also issued updated guidance for the fourth quarter of 2008 and the full fiscal year. We continue to expect a solid fourth quarter although it’s obviously tempered by the global economic and financial issues. With the strong start to the holiday selling season we continue to believe our results should outperform most retailers due to the great value the consumer places on video game products.

For the fourth quarter of 2008 we are expecting diluted earnings per share to range from $1.29 to $1.34 representing EPS growth of 18% at the high end. Comparable store sales growth should range from +4% to +5% for the quarter. Updated guidance includes accretion of $0.05 per share at the midrange from the acquisition of Micromania offset by the impact of foreign currency fluctuations of $0.04 per share as the US dollar continues to strengthen.

2008 full-year EPS is now expected to range from $2.35 to $2.40 with full-year comparable store sales growing between 10% and 11%.

Finally as a reminder, we are going into our traditional holiday quiet period on Wednesday, November 26, until our holiday release on Thursday, January 8.

With that I’ll turn it over to Dick for some closing remarks.

R. Richard Fontaine

With the economic conditions like they are, almost a headwind with flying nails, everybody has been understandably nervous about the future. I want to assure everybody that the entire GameStop organization continues to be better managed and more focused on controlling that which is in our ability to control. We’re both cautious and appropriately aggressive. Our stores are well positioned, our cash flow is strong and our control of the business recognizes the current reality of worldwide uncertainty but it also recognizes that there are worldwide opportunities given the strong title lineup and the value aspect of our model that continues to attract customers.

With that we’ll open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Anthony Gikas - Piper Jaffray.

Anthony Gikas - Piper Jaffray

Moving through the next couple of months, how do you plan to execute differently over the holidays than you would relative to a few months ago? Secondly, how is the music genre trending right now, and if it’s trending below your expectations, how soft is that category, what products are working, what products aren’t working? And the third question, I think David touched on it just briefly. Inventories were up in the quarter and how do you feel about those inventories both corporate and store level?

Daniel A. DeMatteo

I’ll answer the first one, some of the things we’re doing differently now given the economic environment that we are in. We’re clearly more cautious in our merchandise ordering due to uncertainty and are ordering smaller amounts more frequently to make sure we aren’t overstocked.

We have re-evaluated all Q4 expenses. We’ve cut out anything that is not absolutely necessary including hiring in the offices. We’re still hiring in the field but we have put a freeze on hiring in the offices.

Lastly we’ve re-evaluated new store openings that were scheduled for ’09 and put some on hold due to concerns about co-tenancy in some of these centers. We’ll clearly open less stores in ’09 than we did in ’08.

David, I’ll turn it over to you on the music genre.

David W. Carlson

The overall category of the music genre is very healthy and we expect it to be popular throughout the holiday season but I think as everyone knows, it’s not as robust as it was last year. For example, the Guitar Hero band kit is selling extremely well and it is out of stock in many cases particularly the Xbox and the Wii versions. But again we think it will moderate somewhat for the holiday but it will still be a very popular category for our consumers.

Daniel A. DeMatteo

And the last question Dave was on inventories.

David W. Carlson

Right. The inventories were up 22% on a sales increase of 5%. The difference this year is we had a significant amount of titles that we were releasing in the first week of November that actually hit our warehouses in the last week of October. So we had nearly $100 million of inventory that went into our warehouses that we couldn’t sell until November. That was a little different than last year when that did not happen. That is the reason for the increase in the inventory.

The used inventory we’re very happy with. It’s up significantly from last year. We wanted it to be up significantly from last year and we see used selling very, very well during the holiday season.

Anthony Gikas - Piper Jaffray

In this tough economic environment, the used business is likely to start performing perhaps better than we expected. Do you think you have enough inventory in that category or do you feel like you’re still a little on the light side?

Daniel A. DeMatteo

We have more this year per store than we’ve ever had before so that’s the positive. Our experience has been to date that whatever we start our fourth quarter with we sell a certain percentage of that in the quarter and that percentage hardly ever varies. So we would expect to have a very good fourth quarter because our used inventory is up.

A point of clarification maybe on the store openings for next year. This year we will have opened between what we acquired and what we opened Greenfield over 1,000 stores so clearly we’re going to be off that pace for next year as we integrate the Micromania acquisition and we re-review the new store openings for next year again given co-tenancies in some of the centers as we see maybe other retailers maybe won’t be as aggressive and we don’t want to go into centers that aren’t full.

Operator

Our next question comes from Benjamin Schachter - UBS.

Benjamin Schachter - UBS

I was wondering if you could talk about the differences you’re seeing in the strip versus the mall stores first of all? And then aside from the Guitar Hero bundles, any other issues around supply? My final question is around the store format changes you’ve discussed in the past. Does the softness in the music genre make you rethink any of those store format changes, and just remind us how that’s rolling out?

Daniel A. DeMatteo

On the first question differences between the malls and the strip centers, we have not focused on that to tell you the truth. But my cursory review we don’t have it summed up says that there’s little differences between the malls and the strip centers as new titles have been driving the business in both formats. We have not focused on it but I don’t believe there are any significant differences in either one of them.

On the store format side on the size of store given what we see somewhat in the music is that I don’t see that driving us to change our strategy with new stores. Our new stores have been growing slightly in size. We will reposition some of our existing stores that we know are too small for the kind of volume that they’re doing and we believe that we’re leaving sales and profits on the table because of their size. We will upgrade those stores.

David W. Carlson

Your last question on produce supply, I think there were really only three things that are in somewhat short supply. Dan, you add if I miss anything here. Obviously we talked about the Guitar Hero band kits that are in short supply. Wii Fit is in very, very short supply. It sells through as quickly as it hits the stores. And although the Wii hardware is in very good supply right now we believe it may as well be out of stock by the holiday season. But those are the three things that come to mind of products that are in short supply right now.

Benjamin Schachter - UBS

Dave, in the past you’ve talked about EPS growth that you could see in the coming years. Any comments on what you are planning for next year in terms of EPS growth?

David W. Carlson

We think because of the current economic environment we’re going to wait until after the holiday season and then we plan to re-evaluate our 2009 sales and earnings guidance. Due to the current economic conditions and the retail outlook, we feel it would be prudent for us to see how our customers react over the next few weeks before we make any long-range forecasts.

Daniel A. DeMatteo

I would just add to that that prior to the economic crisis we were believing that there would be clearly growth in video game software sales given where we’re at in the cycles, etc. in ’09. But as David said, we will temper that after Christmas after we see our sales and earnings through Christmas.

Operator

Our next question comes from William Armstrong - C.L. King & Associates, Inc.

William Armstrong - C.L. King & Associates, Inc.

You mentioned gift givers before. I’m reminded of the Christmas season of ’02 when gift givers seemed to not show up to the stores. Are you seeing any early indications that gift givers are pulling back on video game purchases either anecdotally or anything that you can quantify?

Daniel A. DeMatteo

I might ask Tony Bartel, our Executive Vice President of Merchandising and Marketing, to comment on that. But no, given the comps that we’ve had the first couple of weeks clearly I can’t tell you exactly what percent have been gift givers. But Tony there has been an indicator we have that the gift giver share is picking up, is that right?

Tony D. Bartel

Absolutely. We do track the percent of people in our stores each week that are gift givers and that percent has actually been rising and is actually equal to and slightly above what it was last year at this time.

William Armstrong - C.L. King & Associates, Inc.

In your opening comments you did mention, talking about your guide down for Q4, some uncertainty about gift givers.

Daniel A. DeMatteo

I think that’s still prudent. While we don’t see an indication of it yet, we do know that when we get to Black Friday things really move into almost total gift giving mode. Right now it’s a split between the serious gamer and the gift giver and it really moves into almost total gift giving mode. So I think that prudence is worthwhile at this point.

William Armstrong - C.L. King & Associates, Inc.

With the 4% to 5% comps guidance, you’re up 20% in the first couple of weeks. Should we read anything into that in terms of anticipating a slowdown or are the first two weeks not really that material in the context of the entire quarter?

David W. Carlson

No, they’re fairly material and we are having really good launches of the new games. But again that really is dominated by the core gamer. The core gamer is definitely coming out and buying these games. It’s doing very, very well. When it gets to the gift giver, we’re a little more cautious. So yes, the guidance assumes that December and January are low positive single-digit comps.

R. Richard Fontaine

I would mention just for a second that that is a very good potential support that we have. If the core gamer is coming out and there have been a number of very, very good games and we’re selling them fully up to expectations which we are and in fact exceeding some of those, if the core gamers and the avid gamers are with us through these very unpredictable times, that’s a very, very good sign for us. As we shift as Dan has said very well into the gift giver and often it’s the one-time-a-year gift giver, that’s a little bit harder to predict.

One of the other things that we could look at however is that our Nintendo product, our Wii product, continues to sell through extremely well and that we can make some assumptions is the newer buyer and probably the advanced gift giver. So there are reasons to be positive but there probably are as many reasons not to be overly optimistic given what we’re all facing.

Operator

Our next question comes from David Magee - SunTrust Robinson Humphrey.

David Magee - SunTrust Robinson Humphrey

As you contemplate the fourth quarter and a slight reduction in terms of the guidance, what is your feeling about the relative contribution of the international versus the domestic operations towards that? Is more of the cut on the international side or is that too fine a line to draw?

Daniel A. DeMatteo

It’s probably too fine a line. When we talk about the international operations as you certainly can understand we’re talking about a number of variables that we really don’t face in our domestic operations.

Probably the biggest issue right now is not so much that we have significantly different visions as to sales, perhaps the same could be said for margins, currency fluctuations however which are really out of our control and as you know we took a hit this quarter will continue to be something that we’ll keep an eye on. By and large, what we have seen early in this quarter has been reflected internationally with probably a couple of countries feeling the downturn a little bit more than others; I would point out Spain and Ireland. But overall we’re feeling very, very good.

David Magee - SunTrust Robinson Humphrey

Secondly with regard to 2009 if it is tough out there economically next year, do you anticipate that the vendors might be more aggressive on price cuts particularly on the hardware side?

Daniel A. DeMatteo

I can’t speak for that. Nintendo has recently stated that at the sell-through they’re getting at $249 they have no intention to cut the prices. Microsoft has a $199 version of their system, the 360, which is selling extremely well. So I think that’s well positioned in price. I would think if there was an opportunity, it would probably be from Sony on the PS3 and maybe the PS2 for a price cut.

But I don’t see price cuts and while our price cuts should be good for us to accelerate sales on the hardware side, I do not envision price cuts on the software side as the $49 and $59 price points have been accepted by consumers in these tough economic times and all AAA titles are still coming out at $59 and $49.

David Magee - SunTrust Robinson Humphrey

Do you have any visibility yet in terms of the titles in the first half of next year?

David W. Carlson

We have a little bit of visibility which is typically the case. We don’t have a real good list of what’s going to take place but we do have a nice lineup. I would say the top five titles for the first quarter look to be probably Resident Evil 5, Street Fighter IV, Halo Wars, F.E.A.R. 2 and Killzone 2. There is a nice lineup at least at the very beginning of the year. Typically at this point we don’t really see anything much farther than that.

Operator

Our next question comes from Arvind Bhatia - Sterne, Agee & Leach.

Arvind Bhatia - Sterne, Agee & Leach

Dave, my first question is on margins for the used category. I noticed that there was a promotion at the stores, an extra 10% I think on two games and an extra 20% on three games, etc. which to me is a good sign in the sense that you’re still changing inventory, but is this promotion any different than last year or is this a pretty normal promotion at this time of the year as you continue to build inventory? I guess what I’m getting to is what should we be expecting as far as margins on the used category in the fourth quarter?

Tony D. Bartel

This is a typical promotion that we run at this time of year so we are not more promotional on the trade or the used side this year than we have been in years past. We are as mentioned earlier seeing a nice increase and welcomed increase in our used inventory.

David W. Carlson

The margin rate actually for the fourth quarter should be very similar to last year’s fourth quarter margin rate.

Arvind Bhatia - Sterne, Agee & Leach

What was stock-based comp if you have that?

David W. Carlson

It was $8.8 million.

Arvind Bhatia - Sterne, Agee & Leach

You mentioned the first half Dave in terms of the titles. What about January, the first month of the new year or last month of your fiscal year? How does that look like versus last year?

David W. Carlson

Last year there was very little new. There was Burnout: Paradise and that was really the only new title that came out in January. This year to be honest with you it’s somewhat similar. It looks like we may have Skate 2 coming out and we may have Lord of the Rings: Conquest coming out. Typically though in January you only have one or titles coming out and the titles from the holiday season sell very well in January.

Operator

Our next question comes from Mike Hickey - Janco Partners, Inc.

Mike Hickey - Janco Partners, Inc.

Can you talk to how your market share has trended year-to-date?

David W. Carlson

I don’t know that I have the year-to-date number in front of me. I do have the Q3 number in front of me and we’re very pleased with our growth in Q3. As we expected we lost market share in September because of our strength with Halo 3 last year, all-time high. But in the month of October we have gained market share and we’re very pleased with that. We’re really believing is our market share strength in October primarily was driven by, we had a lot of promotions of course, etc. like usual, but our buy/sell trade model where consumers needed currency in order to buy the hot new games that they wanted I think really proved itself to be valuable.

Daniel A. DeMatteo

I would just point out that one other element. While the data is nowhere near as consistent or available for that matter in a lot of our international operations due to the expansion over the course of the year and in fact the growth, I’d venture to say that we have picked up market share probably in every one of the major countries that we’re doing business in. I’d like to have more accurate data but as I said in many countries that’s just not available. As we would point out and remind everyone, the market share data that we talk about is totally exclusive of any of our used business.

Mike Hickey - Janco Partners, Inc.

Obviously the consumers are the X factor this holiday and certainly in ’09, but what we do know is that the growth in the installed base this year you acquired Micromania which should be accretive in ’09. You have had guidance of 25%. I’m not asking you to reiterate that but can we model for growth in ’09?

David W. Carlson

Let me just speak to the installed base growth. We earlier in the year predicted that there would be 32 million next gen console and handheld units sold in the year and we believe that given where we’re at and if November and December were just flat with LY, we would hit that 32 million. We think the industry is on track with the installed base which should set up well for software sales in 2009.

As far as giving ’09 forecast at this time, we’re not going to do that until we see the fourth quarter results.

Operator

Our last question comes from Edward Williams - BMO Capital Markets.

Edward Williams - BMO Capital Markets

Can you give some granularity on the used business and really how it was trending? You alluded to October being good for getting some trades to come in but can you talk a little bit about how it’s trended in the October quarter and what you’re seeing at this point, what you’re expectations are going into the holiday quarter?

David W. Carlson

I will say, and I don’t think we give out the number on the trade side, but we had record trades in Q3 of this year. That sets up very well for sales in Q4. We had 19% growth in sales in Q3 and we believe we’ll see something similar to that in Q4.

Edward Williams - BMO Capital Markets

You alluded to it again for November and December, but what are your thoughts for hardware units and the percentage change we may see in those for the January quarter?

David W. Carlson

We’re still looking at more than 32 million units in the US for hardware sell-through. Maybe I’m not quite understanding your question but it probably will moderate a little. I think at one point we said it could be larger than 32 million units of hardware sell-through in 2008 but with the economic environment we’re in, we may not sell quite as many. But I still think we’re going to do very, very well.

Edward Williams - BMO Capital Markets

Looking at Micromania, what has the new store growth been like for Micromania the last couple of years? What’s that trend line been [inaudible]?

Daniel A. DeMatteo

New store growth over the past couple of years has been reasonably aggressive, something in the neighborhood I believe of 25 stores a year. Our expectations being better together which is the approach that we take with all of our acquisitions and finding what I might say is an outstanding management team. We’re looking to ramp that up. We’ll wait and see as we always do what the fourth quarter is but we’ll probably be looking at anywhere from 40 to 45 stores next year in France.

Thanks much for joining us today. We appreciate you being on the call. As I said, going into the fourth quarter we’re well aware of everything that is making everyone cautious but at GameStop we remain very, very positive about not only our fourth quarter but our future. Thanks for believing in us.

Operator

This concludes today’s conference. We thank you for your participation. Have a nice day.

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