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GameStop Corp., (GME)

Q1 2006 Earnings Conference Call

May 18, 2006, 11:00 a.m. EST

Executives:

Dick Fontaine, Chairman and CEO

Dan DeMatteo, Vice Chairman and Chief Operating Officer

Steven R. Morgan, President

David Carlson, Executive Vice President and Chief Financial Officer

Analysts:

Arvind Bhatia, Sterne, Agee & Leach

Patrick, Citigroup

Edward Williams, Harris Nesbit

Stephanie, Piper Jaffray

William Armstrong, C.L. King & Associates

Mike Hickey, Janco Partners

Edward, JP Morgan

Operator

Thank you for standing by and welcome to GameStop Corporation’s first quarter 2006 Earnings Results Conference Call. Today’s call is being recorded. At the conclusion of the announcement a question and answer session will be conducted electronically. Anyone wishing to ask a question may signal us by pressing the “*” key followed by the digit “1.” If you find your question has been asked, you may remove yourself by pressing us the “#” key. I would like to remind you that this call is covered by the Safe Harbor disclosures contained in GameStop’s public documents and is a property of GameStop. It is not for rebroadcast, reviews by any other party without prior written consent of GameStop. Now, at this time, I’d like to turn the conference over to Dick Fontaine, Chairman and Chief Executive Officer of GameStop Corporation. Please go ahead.

Dick Fontaine, Chairman and CEO

Thank you and welcome to GameStop’s First Quarter Conference Call. I am Dick Fontaine, the Chairman and CEO of GameStop. With me today are Dan DeMatteo, our Vice Chairman and Chief Operating Officer; Steven Morgan, our President; and David Carlson, GameStop’s Executive VP and Chief Financial Officer.

This morning we released our first quarter numbers, which were outstanding. Entering the first quarter by the way ever as a combined company, we had some very real goals that were underlying the forecast that we shared with you last March, and I am happy to say that all of those goals have been achieved: Number one, we continued to bring the two companies together utilizing the best practices to drive sales, realize the synergies that we forecast, and improve our overall profitability. Two, we’ve made the necessary systems conversions to supply all stores from a single system with a single buying staff shipping from two distribution points, a very critical step in making this company as efficient as we know it can be. Three, we reorganized our field organizations. Steve will be talking about this in just a minute. We’ve got a closer partnership between our district and regional managers in the stores and we’re achieving economies of scale by doing so. Four, we had a goal of keeping the merger integration plans on schedule. We still have work to do but we are on schedule, we will keep it on schedule, and we’ll be in a position with again the synergies that we forecast are going to be achieved. Five, even in the midst of this very heavy workflow with a great many people accomplishing and doing a great many things, we continue to open new stores. We’ve defined ourselves as a rapid growth company and we’re not taking this year off even though we’ve got a tremendous amount to do in the integration.

During the first quarter, we opened 102 stores worldwide and are well on our way to reaching our goal of adding 400 stores for the year. In addition to that, we will continue to work off the overlapping or the poor performing stores in the portfolio, and during the first quarter we did close 27 stores and we’ll probably close very close to the same amount in second quarter. Again, while these are closings, these are good news and they’re really shedding of assets that are less than productive.

I’m going to keep my comments today relatively short because I want to leave ample time for David, Steve, and Dan. Particularly, I’m sure you all want to hear in more detail our observations from E3, which Dan will be taking you through. David is going to briefly go over the numbers in the forecast. Steve will highlight the key elements of our integration, and then as I said Dan will have quite a bit to share with you in terms of our observations at E3. And with that, I’ll turn it over to you, David.

David Carlson, Executive Vice President and Chief Financial Officer

Good morning. Before the market opened today we released our sales and earnings results for the first quarter of 2006. Game subsales for first quarter increased 119% over the prior year quarter to $1.40 billion. Comparable store sales decreased 3.3% for the quarter due to difficult comparisons with the launch of the SONY PSP hardware system in the prior year, but were dramatically better than the expected 7-9% decline due to improved flow of X-Box 360 hardware and much higher than anticipated sell through of new video game software. Square Enix and Kingdom Hearts 2 topped the best seller list for the quarter with two X-Box 360 titles Elder Scrolls IV: Oblivion and Ghost Recon: Advanced Warfighter showing the acceptance of the $59.99 price points with our X-Box 360 customers.

Although U.S. industry software sales as tracked by MTD decreased 3.5% during our fiscal quarter, GameStop increased software sales by 3.1% in the quarter, again gaining market share and proving that our used trade end model drives new video games software sales. Net earnings for the quarter were $11.7 million including merger-related expenses of $0.8 million and stock-based compensation expenses of $3.3 million. Diluted earnings per share for the quarter were $0.15 significantly exceeding previous guidance of $0.04 to $0.05 per diluted share. The better than expected earnings were driven by higher sales, better gross margins, and other synergies related to the combination of GameStop and EB Game.

We also issued updated guidance for both the second quarter of 2006 and the full year. As is typical for the industry, our second quarter is the slowest of the year, and this year is no exception. Few new software titles are scheduled for release from May to June. But as Dan will discuss in a few minutes, the fall and holiday periods look for very robust for both current-generation software titles and next-generation software titles. Based on this, we are now expecting second quarter comps to range from –2% to +1% with diluted earnings per share between $0.04 and $0.05. For the full fiscal year 2006, we are now expecting sales to grow 15-17% on a pro-forma basis with comparable store sales increasing between 7% and 9%.

Diluted earnings per share are now expected to range from $1.93 to $2.03 including projected stock-based compensation expense of $0.17 per share. Excluding this, our projected stock-based compensation expense, diluted earnings per share are expected to range from $2.10 to $2.20.

Under a separate press release we also announced the exchange offer for our Senior Floating Rate Notes and Senior Notes. In addition, our Board of Directors has approved a $100 million note repurchase program to be used from time-to-time if market conditions warrant. With that, I’ll turn it over to Steve to discuss our integration efforts.

Steven R. Morgan, President

Thanks David and good morning everyone. In regards to our integration update, all stores are planned to complete new merchandise layouts by July 1, 2006, in preparation to accommodate our current initiatives and the addition of two new platforms in time for the fourth quarter. 2700 of our 3600 stores have already completed these and have shown increased sales as a result. The field integration was completed in the first week of February with a smooth transition and no integration-related layoffs were suffered. During this, much attention was paid to creating geographic efficiencies thereby allowing all our multiunit managers more productive time spent in stores and less on the road.

In March all EB stores were connected to the GameStop inventory management replenishment system and by August 14th all GameStop stores should be converted to the EBPOS system. As a result, of these two points alone, it will allow the entire company, as Dick had mentioned earlier, to operate on a single replenishment system from a single buying office from two very well positioned distribution centers.

Our new benefit plan was rolled the week of May 29th. It will become effective July 1st to all 25,000 combined GameStop and EB associates. This plan is intended to reduce the cost of payment of total employee participation while providing GameStop a substantial savings over the next five years. The entire payroll system conversion took place the week of April 6, 2006 including all employees on one payroll system with substantial cost saving realized here as well.

In regards to real estate, the sale of EB’s Westchester offices and Coatesville distribution center has been agreed upon by both partners and expected to be completed by June 15th of this year. Our re-branding effort should begin in August and include 200 stores this year, all in the Miami, New York, and Dallas Forth Worth markets. The balance of all re-branding will be planned to continue into 2008.

On Monday, May 16, 2006, the last truck of any merchandise left the Coatesville distribution center, and our Louisville distribution center has now been refitted and is now testing its upgrades and should be online and functional by June 16th. All in all, the integration continues to be on schedule. Now I’d like to turn it over to Dan DeMatteo.

Dan DeMatteo, Vice Chairman and Chief Operating Officer

Good morning. This morning I’d like to give you a brief update on our observations from E3 and then discuss several issues relating to the GameStop business model. First, E3, Nintendo; quite simply they had a fantastic show as this was their first major unveiling of the Wii, their new console system and over its 25 anticipated games. Due to the innovative controllers and the stable of Nintendo properties, the Wii will certainly be desired by the core gamers, but it has the potential to expand well beyond this group into non-traditional game players. We view the release of a new Legend of Zelda at the Wii launch at an anticipated lower console price, most significant and the most pleasant surprise of E3.

Some of the most highly anticipated titles for the Wii are Red Steel from Ubisoft, the Legend of Zelda that I just mentioned, Dragon Ball Z from Atari, and Tony Hawk’s Downhill Jam from Activision.

In addition, Nintendo will be shipping a new model of the successful hand-held system, the DS in June preferred to the DS Lite because it is smaller and the screen much brighter. We expect this and a new group of franchise titles to fuel sales in this handheld category. In some of the most anticipated titles for the DSR, Final Fantasy 3 from Square Enix, Zelda Phantom Hourglass, Super Mario Brothers, and Big Brain Academy all from Nintendo; and Mega Man ZX from Capcom.

Now, let’s discuss the Microsoft X-Box 360. As we previously stated, the supply of 360s have been much better and Microsoft seems confident that that supply will not be an issue. At the show, they announced several new innovative accessories for the 360 that should really enhance game play such as the wireless headset used in online gaming and a new wireless steering wheel for racing games. Our editors of Game Informer rated Gears of War the game of the show, and that is due out this fall. Other bestsellers for this year for the 360 looked to be Call of Duty 3 from Activision, Maden, and it just simply looks quite fantastic graphically on the 360. Splinter Cell and Brothers in Arms from Ubisoft, Saint’s Row from THQ, and 99 Knights from Microsoft.

And now to Sony; as you know, they announced the release date and the price for the PS-3. While there seems to be some concern about the price, we feel that given all that it delivers, it is very acceptable to the consumers that will be in the market at this time. The quantities they expect are at an all time high range for a console launch, $2 million day one, another $2 million by the end of the year, and $2 million by the end of their fiscal year March 2007. These are worldwide numbers and it will be reasonable to estimate that the U.S. portion would be in the 35% to 40% range. As always, we will take a conservative approach to new launch forecasting. As we have stated before, the PS-3 launch numbers will not have a significant impact on our earnings this year.

In addition, they expect to sell another 5 million PS-2s and 5 million PSPs. The recent price reductions on the PSP and PS-2 have increased sales about 20% to 25%, and we feel that Sony will drive further cuts if necessary to keep the momentum in these two platforms. Some of the most anticipated games for Sony platform of PS-3 this year are Metal Gear Solid from Konami, Tekken 6 from Namco, and Resistance Fall of Man from Sony. And some of the bestsellers for the PSP, Grand Theft Auto, Liberty City Stories from PEG2, SOCOM U.S. Navy Seals from Sony, and WWE Smackdown plus Raw from THQ. And lastly for the PS-2, Final Fantasy 12 from Square Enix, ScarFace from Vivendi, and both NCAA and NAD and Football from Electronic Arts.

And lastly on the E3 product front, we have what we expect to be the best selling PC titles and hopefully the World of Warcraft, expansion pack, will probably be the best selling title of the year, Neverwinter Knights 2 from Atari, and Battlefield 2142 from Electronic Arts.

So, as you can see, we have a lot going on with an all time high number of active platforms. In the handheld, we have the PSP, the Nintendo DS, and the Nintendo Game Boy Advance. On the console side, we have the X-Box 360, the PS-3, the Wii, the PS-2, and the Game Cube, and both in the PC platform.

Yes, this is a transition year and therefore one where our focus and experience will allow us to continue to succeed and gain market share as we just have. In fact, our market share for this past quarter on a pro-forma basis hit an all time high. This performance is driven by our model which consists of conveniently located stores, the best assortment, knowledgeable sales help, and our unique trade in youth games sales program. We have continuously improved this trade in model over the years and the consumer has embraced it in all markets that we serve. We know that it helps drive sales of new videogames as it gives currency to enable these purchases. In fact, we gave over $1.5 billion in credit last year that were applied to the purchase of new videogames. The used games are then sold to a budget oriented consumer who struggles to afford new games. The data proves that this program enhances and works in concert with the new game business, much like the auto industry. Our major partners understand the benefits to all of us provided by the trade in model and to quell a rumor from last week, we asked Sony and have been told that the technology plan for the PS-3 will not impact this category.

Now, I’d like to turn it over to the moderator for a Q&A session.

Question-and-Answer Session

Operator

Very good. Today’s question and answer session will be conducted electronically, and if you would like to ask a question you may do so by pressing the “*” key followed by the digit “1”. And as a reminder, if you’ve been utilizing your mute button, you want to make sure that’s disengaged. We’ll pause just a moment to assemble the question roster. All right, and we’ll first go to Arvind Bhatia with Sterne Agee.

Arvind Bhatia, Sterne, Agee & Leach

Good morning guys, fabulous numbers. Just trying to address another rumor, if you want to do that from last week, maybe not so much a rumor, but EA talked about all of their PC titles being available for digital downloads by the end of the year. Could you shed some light on overall PC, what that represents as a percentage of your sales and what your take is on that business? Second, if you could talk about the performance of your new stores as you’re opening them, is it in line with your historical model, is it doing better, just any color on that would be helpful?

Dan DeMatteo, Vice Chairman and Chief Operating Officer

Sure Arvind, thank you. Yes, digital download, we’ve analyzed the issues relating to this digital distribution of products and have some opinion. First, we’ll discuss the PC games as you mentioned, which last year was 7% of our business. Digital distribution of add-on content has been here in that category and is continuing to grow. It could be viewed as a plus for the business because it adds new game play into game soon after release. Digital distribution of full games on the PC is in its infancy, considered to be a matter of customer choice rather than pulling customers from retail. The core gate PC gamers or techie capable of dealing with this complexity, we expect the full game digital distribution will grow, but its impact on us will be minimal over time. On the console side, I don’t if you asked that but I might as well as talk about it. Microsoft has developed the capabilities we all know in X-Box Live to distribute add-on content. These micro transactions would be handled for the third party publishers by Microsoft. We understand the publishers are excited about it, of generating incremental income for their games. Sony announced their intent to do the same thing with little detail at this point. We think that these add-ons delivered this way make sense for some genres and will probably generate some revenues incrementally for the publisher, but given overall game growth anticipated, we don’t see any impact on GameStop. And I’ll turn it over to Dick to talk about the new store opportunity.

Dick Fontaine, Chairman and CEO

Just an additional comment on the digital downloading is that, just to reinforce what Dan says, I think right now it’s extremely exciting. It’s another element of the business. We as a company I think have sometime, but have been paying attention to it. One of the things that we need to do is develop our own strategic plans to see how as a retailer we can further benefit by getting on it, if you will. It certainly is a trend. I don’t think it’s going to be a trend that is going to be anything more than an added feature, but I certainly believe that there is some value added that as the world’s largest retailer we can bring to the vendors that are heading in this direction. I think it’s up to us to find them. Secondly, Arvind, pertaining to the new stores, we’ve always taken pride that our new store performance was extremely solid and that we were achieving our goals. That has not changed with the new stores that we have opened in the first quarter of this year, and I will tell you that my expectations internally and expectations that we’ve shared with our real estate people is that the quality of our real estate and the return should be better than it has been in the past due to the fact quite honestly that we are not out there moving faster than in some cases we would like to keep other competitors from getting these specialty sites. There are very few competitors as you know that are expanding and it just gives us more opportunity with better projects to look at. So, we feel very good about the direction we’re heading there.

Arvind Bhatia, Sterne, Agee & Leach

Got it, just one last question if I may, do you have any feedback from your European operators, what they’re seeing in that market place from the standpoint of the transition that is going on there as well.

Dick Fontaine, Chairman and CEO

The transition continues to go well there from a real estate standpoint. The truth of the matters is we are fine tuning some of our criteria in certain countries as we go forward with our real estate. A number of the countries I think really are absolutely on top of all of their possibilities and they’ve really fine tuned their criteria. A couple of the countries are still in the process of doing that, particularly Spain, which for us is a very new business and a new operation, but we’re heading towards criteria that I think will serve us very well. I think, in general, you can say we’re a little bit behind where we are in the U.S. but you would probably expect that given how many stores we’ve opened in the U.S. over the years.

Arvind Bhatia, Sterne, Agee & Leach

Right, congratulations, and great numbers.

Dick Fontaine, Chairman and CEO

Thank you.

Operator

Our next question comes from Elizabeth Osur with Citigroup.

Patrick, Citigroup

Hi guys, great numbers, this is actually Patrick for Liz. I just had a question following to that store addition. It looks like the U.S. store additions were a little bit higher. Do you think you’ll still be able to reach your 50/50 target for the rest of the year?

Dick Fontaine, Chairman and CEO

Well, the 50/50 target is a relatively general target. The 400 stores to be opened in the year is not — we’ll consider that hard target. As I look at the first quarter, I would say that we will likely surpass the 200 range in the U.S. and probably be in the 175-200 range in Europe. But again, I want to reinforce what I think many of you heard before, we are not going after new stores for aggregate numbers. Every store has got to achieve its goals. We got to believe in the stores before we’ll sign leases. So, I spend not as much time or concern in terms of that aggregate number as I do to the quality of each deal. So, if we shift somewhat, it will only be because the opportunities made sense to shift.

Patrick, Citigroup

Great and another question just in terms of used game margin; it looks like you have above 50% this quarter. Do you think that’s sustainable and how do you see that going for the rest of the year?

David Carlson, Executive Vice President and Chief Financial Officer

Yeah, we obviously had about 51% margins in the used game business. I think we’re probably at a peak in the used game margins with the 51%. I would say it may even come down slightly from that as we go through the year, as we kind of test the elasticity of the used game business. So, that being said, I wouldn’t expect it to be quite that high going forward.

Dan DeMatteo, Vice Chairman and Chief Operating Officer

Yeah, I think I go with what Dave said, I think you could see us get more promotional in the used game business that may drive margins down a little bit, but would drive sales up.

Patrick, Citigroup

Great, thanks guy.

David Carlson, Executive Vice President and Chief Financial Officer

But, our goal there is to maximize gross margin dollars, not necessarily the right percent.

Operator

And as a reminder, it is “*1” for a question. We’ll next go to Edward Williams with Harris Nesbit.

Edward Williams, Harris Nesbit

Good morning. A couple of quick questions for you; first of all with regards to the European market. Can you just comment on what your current store base is, and how are the used games performing in that market relative to the U.S. market?

Steven R. Morgan, President

Sure, I can give you our store count as of the end of April. We has 443 stores in Europe, we had 187 stores in Australia and New Zealand, we had 260 stores in Canada, and the rest in the U.S. for a total of 4565 stores.

Dick Fontaine, Chairman and CEO

And generally speaking the European markets are embracing really the same formula as we have in the U.S. It’s a combination of mixing new and used. The only real difference I think really would probably be that certain countries still have a much higher percentage of their business in PC, which is not part of the trade. Germany as a case in point is still in the 40% range. But the goal is, as you look at the international stores, in some cases you need to market the GameStop formula if you want to call it that, it should applicable in virtually every country that we do business.

Edward Williams, Harris Nesbit

How are the Spanish stores performing, how is that converging going for the jump stores?

Dick Fontaine, Chairman and CEO

The early jump stores, the early convergence where we’re fully into the video game business, the early sales have been quite good. As you intimated, we’re still working our way out as we had planned out of the original jump store inventory and moving out of the jump store small electronics business in the market place. It’s going well. There is a lot of work still to be done, but we’re heading in the right directions and the stores, as we’ve converted them, really are looking spectacular.

Edward Williams, Harris Nesbit

Okay, and then going back to the downloadable content for a moment. Have you give much thought to using the gamestop.com website as a downloadable portal for PC games or for mobile phone games or the like?

Dan DeMatteo, Vice Chairman and Chief Operating Officer

Definitely, yes, we have; this is Dan, and I think you’ll see in a relatively short period of time on the PC games that we will have that option. Mobile phone games we are investigating that and we’re not as clear on that right now, but definitely we are on the PC side.

Edward Williams, Harris Nesbit

Great, thank you very much guys.

Operator

Next, we’ll go to Tony Gikas with Piper Jaffray.

Stephanie, Piper Jaffray

Good morning everyone. Congratulations on a great quarter. This is Steff for Tony. Three questions; first, if you could speak primarily to the trade model and given concerns around the U.S. consumer specifically, have you seen any change over the last 12 months given the increasing gas, home heating costs, maybe talking last year summer versus looking at this year summer, any shift in the kind of consumer that’s going to use the trade profile or the amount of trade activity that’s actually happening?

Dick Fontaine, Chairman and CEO

The trade activity is relatively consistent over the years and it goes up with the volume of new games that come out, and it is directly relational to new video game releases as consumers need currency, they’re trading games to buy the new games. So, it’s relational and as a percentage of our percentage of our business it’s been relatively constant and the same. So, I can’t say that we have seen based on economic conditions anything in our used game business, at the macro level is driven by the new game business.

Steven R. Morgan, President

I would add that we had really such a robust first quarter that any downward pressure that may have been felt as a result of rising gas prices was certainly nothing that we could clearly identify. I certainly am aware as are all of you that Wal-Mart has indicated that they’re concerned that rising gas prices may have some effect in the second quarter. I think we would be foolish to say that we’re not aware of that and don’t see that. But, about the only place I would expect that we would get some minimal downward pressure would be in our true tertiary stores, very small market stores where the consumer has to drive a considerable distance to get to the shopping area. And while those stores have real growth potential for us, the fact of the matter is that they represent really less than 4% of our portfolio. So, I would think that in those markets we may see consumers cutting down their traditional twice a week shopping in some cases, but overall I think the impact given the total amount of stores we have is going to be relatively negligible.

Stephanie, Piper Jaffray

Okay great, and then my second question, just on the economics of the stores, speaking to those that you have converted or in the process of converting, maybe just speak to that runrate and how that’s compared to historical game side of standalone.

Dick Fontaine, Chairman and CEO

I’m not sure, are you referring this to the Spanish stores?

Stephanie, Piper Jaffray

Yeah, any international or even those in the U.S., any changes to the economic profile of the new stores.

David Carlson, Executive Vice President and Chief Financial Officer

Right, the EB and GameStop models were basically the same, so there’s really no convergence per se that we’re talking about in the U.S., and Dick maybe you want to talk about the Spanish stores.

Dick Fontaine, Chairman and CEO

Yeah, in broad strokes there’s not radical change to the Spanish groups. There is some difference in the formula relative to the margin, the occupancy cost, and in a smaller sense some personnel costs. But, we have not adjusted our return on investment model because of that. They tend to be a balancing. We will as we get these stores fully convert it and obviously get more empirical evidence of these stores. We’ll try to update everybody on Spain specifically, because it is the newest of our international ventures.

Stephanie, Piper Jaffray

Great, just last two housekeeping; at what level on the comp do you sort of leverage your occupancy? And then, secondly, in relation that on our average transaction vales, any changes there?

David Carlson, Executive Vice President and Chief Financial Officer

On occupancy leverage, we tend to leverage it at about 3% comp. That’s approximately the number, and then what was the second…

Dick Fontaine, Chairman and CEO

Average transaction value, have we seen much change there.

Steven R. Morgan, President

Not really. The average price point on the software has actually stayed fairly consistent because the X-Box 360 titled at $59.99, that SKU’ed that up even though the PS-2 average transaction or ASP is down slightly. So now our average transaction has been about the same. It has really deteriorated.

Stephanie, Piper Jaffray

Okay, thanks guys.

Operator

As a reminder, it is “*” for a question. We’ll next go to Bill Armstrong with C.L. King & Associates.

William Armstrong, C.L. King & Associates

Good morning, I’ll also add my congratulations to really great numbers. Dan, just getting back to that rumor about your games being encoded so people can use them on a different machine, what exactly did Sony tell you about that?

Dan DeMatteo, Vice Chairman and Chief Operating Officer

Well, they told us that there is no feature in the PS-3 that will prevent consumers from having transferrable games.

William Armstrong, C.L. King & Associates

It is nothing that the publisher can encode into the DVD itself or the CD itself to prevent that?

Dan DeMatteo, Vice Chairman and Chief Operating Officer

That’s exactly right, that’s what they told us.

William Armstrong, C.L. King & Associates

I see, so it’s a hardware thing? Okay, is Microsoft taking a similar stand or have they not commented?

Dan DeMatteo, Vice Chairman and Chief Operating Officer

Well Microsoft 360 is out, but there’s nothing built into the 360 that locks the game into a particular machine. We’re trading 360 games as we speak.

William Armstrong, C.L. King & Associates

Got it, okay. Moving on with the inventory management system, rollout for the EB stores, does that include the used game inventory management or just the new product?

Dan DeMatteo, Vice Chairman and Chief Operating Officer

It includes both, yes.

William Armstrong, C.L. King & Associates

Second quarter comps, looking at it, down 2 and up 2, could you remind us…I know you had about 6% a year ago, was there still some lingering positive impact last year from the PSP launch, or was there something else that’s making comparisons difficult?

David Carlson, Executive Vice President and Chief Financial Officer

It’s definitely that. The PSP was still very strong into the May-June timeframe. But in addition to that, the title release schedule is very strong. The Star Wars Episode III title did very, very well, the Pokemon Emerald was a very large seller, and then Grand Theft Auto San Andreas came out on the X-Box and sold very, very well in addition to some others. This year there isn’t quite the lineup that we had last year. We still have NCAA in July in both years, but the May and June timeframes are a little bit less robust.

William Armstrong, C.L. King & Associates

Okay, you mentioned you may do some promotional pricing for used games to drive sales, do you think the demand is peaking for used games?

Dick Fontaine, Chairman and CEO

No, I certainly don’t see anything. As a matter of fact, from my perspective, I think we probably have been perhaps less promotional than we could have. I think we have somewhat let the momentum of the business pretty much drive us instead of us trying to drive that. The quality of the games that are out there…and I must put this into perspective, the quality of all of the games that are out there, going all the way back to the PS-1, going back to the Cube games, the quality of the entertainment at the right price is outstanding, and as long as you’re delivering a hell of an entertainment value at a very good price, the demand is really, really there. No, I don’t think we have reached peak. I think if we get better at what we do well, we can continue to drive demand, and again I want to pick up on what Dan is saying; we maybe driving the interest in used games, but that will definitely downstream to increasing the amount of new title sales as well.

Dan DeMatteo, Vice Chairman and Chief Operating Officer

I might add, traditionally in the second quarter, we are promotional in the used game categories for some of the reasons Dave just mentioned, there is not as much excitement in the new. So, we did it last year, we would probably do it again this year.

William Armstrong, C.L. King & Associates

And then finally, I think hardware gross margins again were up substantially year-over-year. I think you may have addressed this in the past, but what’s driving that and is that sustainable?

David Carlson, Executive Vice President and Chief Financial Officer

Actually, the main reason for the increase in the hardware margin is the warranty program that EB had, and we actually adopted it at both EB and GameStop. So that allowed our hardware margins to increase quite substantially from the prior years.

Dan DeMatteo, Vice Chairman and Chief Operating Officer

I think this is another instance of a best practice being applied as we looked at the practices of both companies and defined what we’re going to do going forward.

William Armstrong, C.L. King & Associates

Are you talking about selling manufactured warranties…it’s a GameStop warrant, okay. And that’s something that GameStop really hadn’t done before this merger?

Dan DeMatteo, Vice Chairman and Chief Operating Officer

Very minimally.

William Armstrong, C.L. King & Associates

Okay, what sort of penetration are you seeking to get from that?

Dan DeMatteo, Vice Chairman and Chief Operating Officer

I don’t know that I have that at the top of my head.

Dick Fontaine, Chairman and CEO

Our point would be, if we can get that fully out, I don’t think any of us at the table know that, but I think all of us who are the table believe that there’s tremendous upside potential in that, and I would reinforce because this has come into play so many times. This is a classic case of best practice as well. We both had this program. It was under marketed on the GameStop side and appropriately marketed on the EB side. And now that we see that there’s upside potential, we think particularly as we get into the fourth quarter this will be an important added feature to the company.

William Armstrong, C.L. King & Associates

Okay, great, good luck.

Operator

We do have time for two more questions. We’ll take our next with Mike Hickey with Janco.

Mike Hickey, Janco Partners

Hey guys, good quarter. If you would, could you compare and contrast what you’re saying in pre-sale software activity for the PS-3 and Wii right now versus what you saw last year for the 360? And then the second question, fixed dollar price point for Nintendo Wii software, a bit of a surprise there. Obviously, there’s a lot of buzz, are you seeing a pretty warm reception in the channel to that or from gamers from that sort of price point, and do you think that will stick at launch? And then the third, obviously you guys are excited for Nintendo’s Wii coming up close to E3, how do you integrate that sort of increase and buzz for that hardware into your holiday strategy and financial assumptions?

Dick Fontaine, Chairman and CEO

Let me take a couple of them. First of all on the Wii software, we’re not expecting nor have I heard it would be $59.99. As a matter of fact, I’m pretty sure Nintendo has said it would be $49.99, at least the first-party titles, and I’ve not heard of $59.99 titles from third party, I wouldn’t expect that. The Wii is going to be a lower price machine. I would expect more traditional pricing. At the $59 level, we’re not seeing any resistance from the core consumer on the 360. I don’t expect we would see any resistance on the PS-3 for a period of time. Whatever that period of time is I’m not sure, if it’s a year or so. Anyway, both of those machines, I think the $59 is sustainable. On marketing of the Wii this year, we have been in discussions with Nintendo, demonstration systems in our stores prior to the launch to get consumers excited that they will actually be able to see the machine, see the unique controller, etc. So, that will go on prior to the holiday. And then, I lost the third question. The third may have had to do with reservations of their ramping up and the truth of the matter is that we’re very confident we will sell every copy that we get of both the PS-3 and the Wii. We’ve come out of this conference being very excited about the technical wild factor of the PS-3, given Sony’s stated worldwide launch, we can say that we will continue to push for the best allocation we could get. But having said that, we will blow through these machines and therefore, beyond that it’s going to be a tight allocation. So, we’re not too concerned about reservations. In terms of the Wii where we expect there will be more allocation, hopefully a very good allocation, the excitement on the part of our buyers and more importantly the excitement on the part of our buyers and more importantly the excitement on the part of our store managers who have got hands on that, we’re now of the opinion that the same thing is going to hold for Wii. We’re going to blow through every copy we have. So, in a wonderful sense, these reservations are going to take care of themselves.

Mike Hickey, Janco Partners

Thank you.

Operator

And we’ll next go to Edward with JP Morgan.

Edward, JP Morgan

Hi, thank you very much for taking my question. Most of them have already been answered, but just a quick update on your X-Box 360 availability. I know you mentioned that flow through has been improved significantly. Does supply meet demand now or are you still out of stock in stores?

Dick Fontaine, Chairman and CEO

That’s a good question. I’m not quite sure. We’re running still a wee bit leaner than what we would choose to, and we’re running still out of stock but much, much better. And with the anticipated flow over the next two or three weeks, I think we will be there. We will be fully in a lot of stock and then we’ll see what real runrate is.

Edward, JP Morgan

Great, and a followup to another question asked previously, to this experimentation you might take with the used business to drive demand. To your comments earlier, I had always thought that the problem with the used business is really a lack of the inventory. So help me understand, I mean are you more comfortable now with the used inventory position or your ability to ability to used games and not allowing to experiment with the price? Thank you.

Dick Fontaine, Chairman and CEO

Well, I wouldn’t put it that way, particularly experimenting with the price, but you’re 100% right. Our inventory now is somewhat better. It certainly has been improving. As you stated, this has been a category where since we’ve been in the business, we have been chasing added supply, so I would still say that that’s still true to a degree, but we found through our promotions depending on exactly how we do promote this, that as long as we can generate excitement in the store — every promotion that we run focusing on new seems to bring new customers in that that prior to that promotion had not realized what the new and used model was. So, it’s an investment not only in driving the current sales, but as I stated every time, depending on the promotion, we do get new people through the door that are amazed that they can trade their old goods in and that they can get credit on new. So, we don’t look at it as a step back and if it is, it’s a very temporary one. So, we feel very good that ultimately these promotions get the word out to an ever wider audience and that just down streams very good for us.

Edward, JP Morgan

Thanks, congratulations on a great quarter.

Operator

And with that this does conclude today’s question and answer session. I’d like to turn the conference back to Dick Fontaine for closing remarks.

Dick Fontaine, Chairman and CEO

Thank you. Thank you all for joining us today. I hope you can tell not only by the items that we discussed but the tone of our voice that we’re extremely positive about our business. We’re very enthused about this stage that we’re at in the growth of the business, and we’re feeling better every month about our ability to maximize all the opportunities that are out there. So, we’re off to a great start. We feel we’re going to have an outstanding year, and we appreciate everyone following. Thanks for joining us today.

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Source: GameStop Corp. Q1 2006 Earnings Conference Call Transcript (GME)
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