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GameStop Corp. (NYSE:GME)

F2Q09 Earnings Call

August 20, 2009 11:00 am ET

Executives

Daniel A. DeMatteo - Chief Executive Officer, Director

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

Julian Paul Raines - Chief Operating Officer

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

Analysts

Matt Hickey - Janco Partners

David Magee - Suntrust Robinson Humphrey

Edward Williams - BMO Capital Markets

Colin Sebastien - Lazard Capital Markets

Benjamin Schachter - Broadpoint Amtech

Anthony Chukumba - FTN Equity Capital Markets

Operator

Good morning and welcome to GameStop Corporation’s second quarter 2009 earnings conference call. (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 Mr. Dan DeMatteo, Chief Executive Officer of GameStop Corporation. Please go ahead, sir.

Daniel A. DeMatteo

Thank you, Moderator and welcome to GameStop's second quarter conference call. With me today are Paul Raines, our COO, David Carlson, our EVP and CFO; and Tony Bartel, our EVP of Merchandising and Marketing.

This morning we released our second quarter results and re-forecast for the back half of the year. As our release indicates, a lack of compelling new releases, a slow down in the sale of new consoles, and a general lack of traffic diminished sales compared to last year’s record results for us and the industry. But as you can see from our results, we greatly exceeded the industry growth in the United States and picked up market share gains in all categories.

In order to drive sales of used games in this environment, we were very promotional and increased used sales 19% over last year, albeit at a lower margin rate. Also, the cash strapped consumer used trades as currency at a record pace, so our used inventory going into the back half is excellent.

Lastly, we opened 110 stores worldwide towards our goal of approximately 400 for the year that as a group are performing well above expectations.

We reforecast our third and fourth quarter sales and earnings. While we expect to grow earnings over last year, uncertainty over the economy and the timing of its recovery and some key title slippages, such as Bioshock 2 and Starcraft 2, have affected our outlook. Paul will give you more color on the back half later.

While we are not in a position to give guidance for 2010, it is shaping up to be a growth year for us and the industry. Hopefully the economy will rebound and given our market share gains, we will be well-positioned to capitalize on that. Historically at this point in the cycle, we see sales growth in both new and used games, which translate to higher earnings.

Also the recently announced Sony price cuts and most likely others should get the installed base growing again and we now know of about 10 major titles that are scheduled for 2010.

Lastly, new initiatives to drive sales through our stores, like our interactive gaming guide, will begin to roll out in the quarter, thus allowing consumers to view content before they buy, which should translate to increased sales.

With that, I will turn it over to David for a more in-depth financial review and then Paul will discuss in more detail product that will drive sales the rest of the year. David.

David W. Carlson

Thanks, Dan and good morning. Before the market opened today, we released our sales and earnings results for the second quarter of fiscal 2009. GameStop sales for the second quarter decreased 4% to $1.74 billion as compared to $1.8 billion in the prior fiscal quarter. Comparable store sales for the second quarter declined 14.1%, due to weak consumer traffic worldwide, a slow-down in hardware unit sell-through, and a lack of new game titles for the summer quarter.

New hardware sales declined 21% during the second quarter, with some sell-through strength coming from that $199 Xbox 360 systems and the new Nintendo DSI handhelds. New software sales declined only 11%, indicating GameStop picked up a significant amount of market share as compared to NPD reported declines.

Top titles for the quarter included USC 2009, Prototype, Fight Night Round 4, NCAA Football 2010, and Ghostbusters.

Used product sales increased a strong 19%, as lack of new game releases and significant promotions converted budget conscious customers to our buy-sell trade model.

Net earnings for the quarter were $38.7 million, decreasing 32% from the prior year quarter’s net earnings of $57.2 million. Diluted earnings per share for the quarter were $0.23.

Gross margins increased by 170 basis points, as product mix shifted from low margin hardware sales to higher margin software sales. This positive mix shift was augmented by exceptional control of inventory shrinkage.

Category margins were fairly consistent with the prior year, other than the used product category, which decreased to 45.8%, as we were highly promotional during the quarter in an effort to drive traffic to our stores.

SG&A expenses on a per store basis decreased 3% as we reigned in costs in response to slower-than-anticipated traffic.

Our balance sheet remains strong with over $190 million in cash at the end of the quarter. We were also able to maintain tight control over our inventories during the second quarter, with average store inventories declining 1% on a 4% sales decrease.

This morning we also issued initial guidance for the second half of fiscal 2009 and lowered EPS guidance for the full fiscal year.

For the third quarter of fiscal 2009, we are now projecting comparable store sales to decline between 6% and 11%. We continue to see weakness in hardware unit sell-through and expect that total hardware dollars will decrease in both the third and fourth quarters compared to the prior year, due to weakness in consumer spending and later-than-anticipated hardware price cuts. These negative hardware dollars are the main contributor to the negative comparable store sales we are projecting.

Despite continued slow consumer traffic in the first two weeks of August, we are projecting positive new software growth for the third quarter with the strong lineup of new titles, while used product sales are projected to grow similar to what we saw in the second quarter.

Based upon these assumptions, we are projecting earnings per share to range from $0.27 to $0.33 in the third quarter, as compared to $0.28 per share in the prior year quarter.

For the fourth quarter of fiscal 2009, we are projecting comparable store sales to decline between 1% and 7%. Consumer weakness related to the recession and new title slippage into 2010 has caused us to be more cautious in our outlook for the holiday period. We project earnings per share to range from $1.47 to $1.65, as compared to $1.39 in the prior year fiscal quarter.

Full year 2009 comparable store sales are now projected to decline between 4% and 8%, with earnings per share for the full year ranging from $2.40 to $2.64, representing EPS growth of flat to plus 10%.

With that, I will turn it over to Paul for his comments.

Julian Paul Raines

Thanks, David. I would now like to discuss the drivers of sales for the second half. Although we have seen some title slippage, we still see a strong fall lineup, led by Call of Duty Modern Warfare 2, Assassin’s Creed 2, and Halo 3 ODST, and expect that Modern Warfare 2 could be the best-selling title of all time. We also see a better title lineup for Wii over last year, including a new Super Mario Brothers title.

In addition, the anticipated price reductions for consoles will drive demand and expand the installed base for our core audience.

In terms of our marketing efforts, we have expanded our successful Go Big strategy to maximize these title launches with integrated customer exclusives, in-store launch events, public relations, and media buys. We have also planned compelling offers to drive the use of trade currency, and increase our day one market share on these new title launches.

As David mentioned, our decline in used margins last quarter related directly to promotional activity -- it is not the new norm. In fact, our used margin is back to the historical range of 48% to 50% quarter to date.

In terms of other merchandising investments, we will launch e-commerce websites in Canada, Australia, New Zealand, and Italy in the back half to add to our domestic gamestop.com web business. As Dan mentioned, we have also begun the rollout of interactive game guides, an interactive digital kiosk that is driving reservation and customer excitement in our test stores. Our goal is to roll out the interactives to over 1,750 stores by early 2010.

In terms of operations, we continue to be better prepared than ever for our holiday season. Our reductions in turnover have given us the most tenured store managers in our history, allowing us to execute at a high level and provide great customer service.

In addition, we continue to invest in upgrades for our stores to reduce tasking and add customer-facing hours. Our real estate process is yielding great results, with our first and second year store portfolio performing well above our pro forma targets. We are also seeing efficiencies in our lease renewal process through a structured approach to negotiation, which is yielding lower rents.

Lastly, our market share gains throughout this year position us well as the seasonal traffic increase occurs. We look forward to a great back half of 2009 and with that, I would like to turn it over to the moderator for questions and answers.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll take our first question from Matt Hickey with Janco Partners.

Matt Hickey - Janco Partners

Thanks for taking my questions. Two -- on the -- you guys have started a digital initiative and you have hired Chris Petrovich. I was just curious if you could give us some more color on what you guys are doing there.

And then on the used side, Paul I think you said that the used margin quota today is back up to the 48% to 50% range, and I’m curious on the low-end of your guidance for Q3 if you are assuming a sub of 48% gross margin from used.

Daniel A. DeMatteo

Okay, two questions here -- I’ll have Tony Bartel take the first one. Tony.

Tony D. Bartel

Chris is obviously a seasoned veteran in terms of the digital media space and we understand that the gaming arena is growing in new areas and much of that growth is being driven on the West Coast, so we opened an office with Chris leading that office. He wanted to be close to the growth in innovation and investment that is happening in this digital space. Our primary focus and Chris’ primary focus is going to be on using our vast distribution and education channel that we have in brick and mortar to become the world’s largest digital aggregator.

Daniel A. DeMatteo

Thanks, Tony. And then Dave, do you want to take the question on the margin rate?

David W. Carlson

Sure. Our third quarter guidance actually has our used margins at the 40% to 50% at the high-end and it does assume that we use some promotional activities to drive the used business at the low-end, so as always, our used business runs in the 48% to 50% but if we decide that we need to drive traffic, it’s a very good traffic driver and so we could use it in the third quarter but we haven’t made that decision yet.

Matt Hickey - Janco Partners

Okay. Thanks, guys.

Operator

We’ll take our next question from David Magee with Suntrust Robinson Humphrey.

David Magee - Suntrust Robinson Humphrey

Good morning. Could you talk a little bit about the international performance? That’s question one. And then the second question I have is just what are your thoughts about the impact of other digital downloads for smartphones, whether games or apps, whether that’s having some kind of a [inaudible] impact on the [sector] that we haven’t really measured yet.

And then I guess just thirdly, your assumption as far as additional hardware price cuts over the balance of the year, you know, [inaudible] to the numbers?

Daniel A. DeMatteo

Okay, thanks, David. Dave, the first question on international performance.

David W. Carlson

For the second quarter, our comps were very, very consistent across all of our segments from the U.S. to Australia to Canada to Europe. They all comped very, very similarly.

Daniel A. DeMatteo

I’ll take the second one on the smartphones. I don’t know that I would have any way of really measuring impact on our business by people gaining on their smartphones. I just don’t know that we would. I think if it had any impact, it might be on the handheld category but again, I have no way of being able to measure that.

On the price cuts, you know, historically what has happened is that the other manufacturers who follow the others with a price reduction. We assume in our forecast and some time in Q3 that that will occur but we don’t have any data on that though. But we have an assumption it will.

David Magee - Suntrust Robinson Humphrey

Great. Thank you, Dan.

Operator

We’ll take our next question from Edward Williams with BMO Capital Markets.

Edward Williams - BMO Capital Markets

Good morning. A couple of questions -- first of all, just to follow-up on Matt’s question with regard to [inaudible] gross margins, can you give us some color as to the balance of the year, what you are looking for from there?

Secondly, can you clarify how much of the hardware impact is weighing on comps in the balance of the year?

And then thirdly, if you can just give us an idea as to what your thoughts are with regard to the use of cash flow and the free cash flow that you are producing this year? And then the last question is, if you look at the visibility for calendar 2010, relative to what you typically know at this point in time, how are -- how is calendar 2010 shaping up in that regard?

Daniel A. DeMatteo

Sure. Those are a lot of good questions. David, if you take the first one, the first two, if you would, on the used gross margin and the use of cash.

David W. Carlson

The used gross margin, as I said a little bit earlier, we are looking at our used gross margins to be in the 48% to 50% range, and both in the third and fourth quarters, if we decide to use the used business as a promotional tool to drive traffic, it would be lower than that. But again, we have not made a decision either way, whether we will or will not. The use of cash, we -- as we said in the press release, we are looking for free cash flow this year between $400 million and $425 million. We have already committed $100 million of that to debt buy-back and at the end of the year when we actually generate most of that cash flow obviously, our board will be making a decision of what we will do with that cash but at this point, we do have $100 million of debt buy-back authorized.

Daniel A. DeMatteo

And then on your other two questions, the effect of -- on the back half on hardware price reductions on comps, a quick back-of-the-envelope I just did, it’s somewhere in the 5% to 7% range would be. You know, we’ve got 25% declines roughly and the back half of the year has hardware as a higher percentage, so I would say it’s in the minus 5% to minus 7% range.

And then lastly on 2010, I never remember a time when we had as much knowledge this far in advance of titles that are going to be releasing into the following year. Many of these titles have moved either because of they just weren’t complete or not ready, which I believe are probably the majority, or some of them may have moved just because of the competition in the back half of the year and maybe the economy.

So Tony, do you want to add to that?

Tony D. Bartel

Sure. I’ll just articulate where we’ve -- some of the titles for you that we think are going to be very strong in 2010. You have Halo Reach that is coming out. Final Fantasy 13, Gran Turismo 5, God of War III, Metal Gear Solid, Super Mario Galaxy II, Bioshock 2, Splinter Cell Conviction, Starcraft 2 -- those are great titles, close to a dozen great titles that we have that will impact us favorably and impact the entire industry favorably in 2010.

Daniel A. DeMatteo

I would expect that given this title lineup that the software industry will grow, thinking about it without again -- without defining it a lot, grow similar in 2010 like it did in 2008.

Edward Williams - BMO Capital Markets

Okay, great. Thank you.

Operator

We’ll take our next question from Colin Sebastien with Lazard.

Colin Sebastien - Lazard Capital Markets

Thanks very much for taking my question. I have a couple. I guess first of all, could you comment on pre-order levels for some of this year’s key second half titles, and I guess put it in some context, the visibility you have thus far on at least the three or four that you mentioned?

Daniel A. DeMatteo

Tony, I’ll pass that to you.

Tony D. Bartel

Yes, we are -- we see very robust reservations on the titles that we talked about, particularly as Dan shared with you earlier. We believe that Modern Warfare 2 has a chance to be the largest title of all times and obviously we are basing that on the reservation activity that we are seeing in our stores, so we continue to see strong reservation activity. We did on Madden. We continue to see it on Modern Warfare 2, Assassin’s Creed 2, but we are -- our reservation history is actually reflecting the optimism that we feel in the back half of the year.

Colin Sebastien - Lazard Capital Markets

Okay, and then I guess also in the software side, in the music genre, given the significant contribution of that segment over the past couple of years at high ASPs, I wonder what your perspective is there on that genre this year on a year-over-year basis?

Daniel A. DeMatteo

Tony.

Tony D. Bartel

Yeah, well I think that the ASPs will probably most likely be down because there is going to be -- there will probably be a lot of activity, both just in the game space and obviously as you know, we have some very high dollar accessories coming out that will also impact us favorably but we do believe that there will -- with four very strong titles that are coming out, we do think that there’s going to be activity but we do not believe that there are going to be the boxes that -- the amount of boxes that were in our stores last year, so we think that a lot of unit sales will be driven but the ASPs will definitely be down as there is less plastic going out of more games.

Colin Sebastien - Lazard Capital Markets

And then on the hardware side, Tony’s plans for the PSP Go, it looks like you are carrying it but given the software distribution model, I am curious -- are you able to get higher margins there on the hardware unit sales?

Tony D. Bartel

Actually on the PSP Go, we are excited to be carrying that for a couple of reasons. We do participate in the downstream revenue via both [inaudible] cards and through the points cards. The good news about that is we hold a very dominant market position in both of those categories as it relates to digital downloaded games. So we are very excited about selling the PSP Go. We are very excited to be reserving it. Reserves are picking up on the game and we have a very clear roadmap as to how we can drive profitability on the sale of games. It will also be a strong contributor to our trade-in process where you have people that will have UMD games that will no longer work on that platform that will fuel additional currency for GameStop.

Colin Sebastien - Lazard Capital Markets

Okay and then just lastly, if I may, Dave, following up on the margin questions, I guess on the used, I think you’ve been pretty clear -- on the SG&A, on the operating expenses, I wonder if you could talk about how much that is fixed versus variable and how much of getting to your full year profit number is -- with respect to any leverage on those numbers.

David W. Carlson

As I had said in my comments, we actually did reduce our per store SG&A by about 3%. Now that being said, as you point out correctly, we do have a fairly hefty fixed cost structure from our occupancy to our store manager salaries to our telephone and utilities. We need to pay those whether we have sales or not, so that’s why you will never see that kind of leverage if you have a negative 14% comp. You can’t bring your SG&A down that much on a per store basis.

So going forward, no, I don’t believe that we will have a lot of SG&A leverage during the second half. It will probably be flat to slightly negative.

Colin Sebastien - Lazard Capital Markets

Okay. Thanks very much.

Operator

We’ll take our next question from Ben Schachter with Broadpoint Amtech.

Benjamin Schachter - Broadpoint Amtech

Hey, guys. Just a quick follow-up on the music genre question -- I was wondering if you could help quantify what you think that category as a whole will do year over year in terms of dollars?

And then any sort of qualitative discussion around how pricing of those boxes is impacting sales and anything specifically you might want to add on The Beatles game which comes out very soon? Thanks.

Tony D. Bartel

In terms of quantifying it, we have not been -- we have not quantified that from a dollar perspective. Obviously The Beatles is testing the new price point that we have seen and we are ordering according to our reservations but -- and clearly you are going to sell less of the $250 price point than you are at the $189 price point, and so you see that and there’s obviously been a lot of discounting in the category on the old plastic that is there as well. So I guess that’s what I would say to answer that question.

Benjamin Schachter - Broadpoint Amtech

And then any comment on the other games that are coming out this year that are at $100 plus price point, the non-music stuff?

Tony D. Bartel

We have historically had a very well on the -- I’m assuming you are talking about the collectors editions?

Benjamin Schachter - Broadpoint Amtech

Collectors editions and also Ride, the Tony Hawk game.

Tony D. Bartel

Absolutely, which -- we have historically done very well on the Collector’s Edition. Obviously it depends on ensuring that we have great product in there, which is great value to the customer and we have seen that in the past and we continue to see that here, so we feel like the market will support those price points, provided that the value is there for the consumer and so far, we’ve been working very closely with publishers and do believe that the value is there.

So we anticipate that we will have a comparable sell and a comparable market share on those higher dollar SKUs than we have in the past.

Daniel A. DeMatteo

Tony, you might want to comment on what you are seeing on the Call of Duty really premium edition Call of Duty reservations.

Tony D. Bartel

Absolutely. We have very strong reservations on the Call of Duty premium edition and that’s obviously a price point. There’s a lot of excitement around the goggles on that, so we have a very strong demand that we are seeing in our reservations. Once that was announced, we had a lot of reservation to move from the base version to the premium version, which is a very good sign.

Benjamin Schachter - Broadpoint Amtech

Thanks and good luck with the back half.

Tony D. Bartel

Thank you.

Operator

It appears that we have time for one more question. We will take that from Anthony Chukumba with FTN Equity Capital Markets.

Anthony Chukumba - FTN Equity Capital Markets

Thanks for taking my question. Just one question and then one sort of follow-up -- I mean, as you think about the reduction in your guidance for the full year guidance, I mean, is there any way you can sort of break that down even just sort of directionally between sort of the weak macro environment as opposed to the later than expected console price cuts as opposed to some of the slippage with the different titles, as you mentioned?

Daniel A. DeMatteo

David, would you like to take that, please?

David W. Carlson

You know, it definitely is a piece of both. You know, the weak consumer trends that we have seen, as well as some of the title slippages, and in addition to that what we have seen with hardware sell-through -- I think it’s hard to say is it 50-50 or is it 25-75% but it’s definitely all three pieces of it.

Anthony Chukumba - FTN Equity Capital Markets

Okay, that’s a fair answer and then the only other question that I had, you know, you’ve indicated that the reduction in your used videogame gross margin was due to increased promotional activity and that certainly makes sense but have you seen any impact either from a profitability perspective, a used game trading perspective, or a used game sale perspective from some of the new entrants into the used game business, which have -- such as Amazon and Best Buy and Walmart testing used game trade-ins?

Daniel A. DeMatteo

That’s a good question, Anthony. I’ll have Paul answer that.

Julian Paul Raines

Yeah, Anthony, as you can imagine, we follow very closely every single location where competitors are involved in trades and as we said before, it’s a fairly complex business from a pricing point of view, from the immediacy point of view, as well as from pawn shop compliance. So on all of these latest competitor tests, we have not really seen any meaningful impact from those. You know, certainly we will continue to watch that and we just continue to try to get better and better at using that currency but have not seen any impact yet competitively from those.

Anthony Chukumba - FTN Equity Capital Markets

Okay, thanks, guys. Good luck on the back half of this year.

Operator

And at this time, I would like to turn the conference back over to Mr. DeMatteo for any additional comments.

Daniel A. DeMatteo

Okay. Thank you for attending today and we look very forward to a better back half and hopefully a recovering economy and all of you that follow this industry, I would like to begin thinking in perspective of 2010 how it is going to look like, what it is going to look like and I think if you look at the model of 2008, you are going to find a very similar set of circumstances in 2010 that will drive the business, drive the business bigger for both us and the entire industry. Thank you for attending.

Operator

Ladies and gentlemen, that concludes today’s conference. Thank you for your participation.

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