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GameStop Corp. (NYSE:GME)

F3Q07 Earnings Call

November 20, 2007 11:00 am ET

Executives

R. Richard Fontaine - Chairman of the Board, Chief Executive Officer

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

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

Steven R. Morgan - President

Analysts

David Magee - Suntrust Robinson Humphrey

Benjamin Schachter - UBS

Bill Armstrong - C.L. King & Associates

Colin Sebastian - Lazard Capital Markets

Edward Williams - BMO Capital Markets

Arvind Bhatia - Sterne, Agee & Leach

Presentation

Operator

Good morning. Welcome to GameStop Corporation’s third quarter results conference call. (Operator Instructions)

I would like to remind you that the 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 parties without the prior written consent of GameStop.

At this time, I would like to turn the call over to Dick Fontaine, Chairman and Chief Executive Officer of GameStop Corporation. Please go ahead, sir.

R. Richard Fontaine

Thank you and welcome to GameStop's third quarter conference call. I am Dick Fontaine, the Chairman and CEO. With me today are Dan DeMatteo, our Vice Chairman and COO; Steve Morgan, our President; and David Carlson, GameStop's Executive VP and Chief Financial Officer.

I am going to make some preliminary comments and turn it over to David, who will take us through the numbers in some detail, and Dan will be commenting more on the titles, give you some insights into the products of the fourth quarter and touch on our marketing plans.

This morning we announced another very strong quarter which continued to build on the exceptional results of the first half of the year. Our third quarter was not only outstanding in total but what was particularly pleasing was that all of our divisions turned in solid performance and perhaps as important, laid the groundwork for an excellent fourth quarter and holiday season.

While the highlight of the quarter was probably the phenomenal sales of Halo 3 from Microsoft, it was far from a one-trick title quarter. In fact, the diversity of platform sales and supporting titles continues to be amazing. Total hardware sales by units and as a percentage of sale have never been higher in the third quarter, and while that put pressure, as expected, on our gross margin, the margin decline was more than offset by our operating efficiencies and a 5.8% improvement in our SG&A expenses. In short, a great deal of our incremental performance slid through to the bottom line.

Every segment of our business exceeded expectations, led by our domestic sales, earnings growth, and comp store numbers, but followed closely by similar strong performances in Australia, Canada, and Europe.

Furthermore, GameStop.com turned in its best third quarter ever in both sales and unique visitors and completely redesigned the site, while Game Informer surpassed 3 million audited subscribers to increase its dominance in the game magazine field.

In short, we have a top flight, high-tech broadcast channel and a top flight, traditional broadcast channel pushing videogames and the success of the categories.

Once again, our U.S. market share, according to NPD, increased and while I don’t at this time have specifics from each of the countries, I believe our strong performance and the addition of many new stores is resulting in GameStop growing share in all countries where we do business.

During the quarter, we held the biggest private videogame training conference and vendor show in the world in Las Vegas, with 4,418 store and field managers and 88 vendors coming together to discuss upcoming titles and sales techniques for the holiday season and to exchange ideas for growing the business.

Beyond the sheer size, the conference was notable this year for two seminal events; one, it marked the official launching of the GameStop brand under power to the players, and we now have over 95% of our U.S. stores rebranded, which will allow us for the first time to roll out national media marketing, PR, and advertising campaigns.

I truly believe that with the continued spreading of the GameStop brand, we stand more to gain than normal retail brand extensions in that our model, combining the dominant selection of new product and the consumer value of being able to recycle their used videogames, is unique and perhaps not as clear as a traditional straight retail model. Therefore, the more people that begin to understand what the GameStop brand stands for, the brighter our future and we’re just beginning to push the brand.

Secondly, the conference focused our store managers on the need to better serve the more broad-based demographic being attracted to videogames. We are seeing more first-time gamers in our stores, more girls and women, more gift-givers, and more product being developed to build on this trend. And we’ll be merchandising our stores accordingly in the fourth quarter.

Our real estate teams around the world continue to do an outstanding job. In the third quarter, we opened 181 stores; 101 in the U.S. and 80 internationally, bringing our store count year-to-date to 417, and we are on course to at a minimum reach the high-end of our forecast for 2007 openings, which was between 500 and 550 stores.

It’s clear that GameStop is rapidly growing into a growing worldwide market for video game product and we continue to see many more opportunities to expand. And our strong balance sheet puts us in a position to continue to stay aggressive and to underline this point, I do want to point out that during the quarter, Standard & Poor’s raised GameStop's corporate credit and senior unsecured debt rating to double B from double B minus.

In summary, I can say with confidence that the management team at GameStop is as broad and deep as the business itself. We have a great group of people throughout the company and we are accomplishing outstanding results. Needless to say, we are positive about our business, excited about the fourth quarter, and very sure of our future.

And now I would like to turn it over to David.

David W. Carlson

Thanks, Dick. Good morning. Before the market opened today, we released our sales and earnings results for the third quarter of 2007. GameStop sales for the third quarter increased 59% to $1.61 billion, as compared to $1.01 billion in the prior year quarter. Comparable store sales for the third quarter increased 46.3%, far more than originally anticipated due to strong industry fundamentals in all geographic regions.

Videogame hardware grew an eye-popping 149% during the quarter, helping to build a strong foundation for software sales in the coming years, while videogame software grew at an astonishingly strong rate of nearly 60%.

Halo 3, Madden NFL 2008, and Guitar Hero III topped the list of best-selling games for the quarter.

Net earnings for the quarter grew 283% to $52 million, including debt retirement costs of $2.4 million, far exceeding last year’s third quarter net income of $13.6 million.

Diluted earnings per share for the quarter were $0.31, including $0.02 per share of debt retirement costs. These results were $0.12 per share higher than the high end of our guidance issued in mid-August.

Gross margins declined year over year in the quarter, as expected, due primarily to a higher mix of lower margin hardware related to the strong sell-through of next generation systems, and due to lower co-op advertising funds related to the prior year incremental co-op funds we received for the launch of the new hardware systems.

SG&A leverage improved from the prior year quarter by 580 basis points. This leverage came primarily from the strong comp sales and continued efficiencies from refining our business model. As such, we were able to grow operating margins by 160 basis points during the quarter.

Our balance sheet remains very strong, with nearly $280 million in cash at the end of the quarter. Inventories grew 38% from the prior year, significantly lower than the sales growth experienced during the quarter.

In addition, we finished the call of our senior floating notes in early October, calling $120 million of debt and bringing our total debt to a very manageable $580 million at the end of the quarter.

We also issued updated guidance for the fourth quarter of fiscal 2007 and the full year. Fourth quarter comparable store sales are expected to grow a strong 7% to 9%, when compared to our 26.5% comps in the year-ago quarter, when the PlayStation 3 and Nintendo Wii were first launched. Note that this is an increase from our prior implied guidance of 4% to 5% comps for the fourth quarter.

Diluted earnings per share for the fourth quarter are expected to range from $0.95 to $0.97, as compared to $0.81 per share in the prior year quarter, an increase of $0.03 per share from our prior guidance.

Also please note that the prior year fourth quarter included an additional 14th week, which added approximately $0.05 per share to EPS.

Based on the strong results experienced in the third quarter and our improved fourth quarter outlook, we are raising our full year 2007 EPS guidance by $0.15 to range from $1.61 to $1.63 per diluted share, with sales increasing between 28% and 29% and comparable store sales increasing between 20% and 21% for the full year.

With that, I’ll turn it over to Dan.

Daniel A. DeMatteo

Thanks, Dave. Both Dick and Dave have given a great account of our best third quarter ever, so I will discuss what we see driving our fourth quarter.

First, we have never been in better shape to cater to the gift-giver, the casual gamer, as well as the avid gamer. We have just completed store remerchandising that will help the gift-giver by creating sections for kids entertainment, music entertainment, and the young female gamers. With the average gamer at 33 years old, we have something for those from six to 60.

Our holiday advertising will be focused on the gifters and the newly emerging casual gamer, with media buys in print, online, TV, and radio. Our store associates have been trained to help those customers who need more service and we have analyzed and refined our scheduling to ensure better coverage during peak sales periods. We will have the best sales support in the category.

We expect our in-stock position of games will be better than ever through continued refinement in our systems and distribution capabilities. As a matter of fact, no one does this better than GameStop, so from an execution perspective, we feel confident that we are in the best position ever to capitalize on the growth in this fastest growing entertainment category.

Now we will discuss the products that will be driving the sales line. Hardware unit sales are expected to reach an all-time high with the momentum of next generation consoles and handheld systems. The Nintendo Wii continues to be a sellout and the price reductions on the PS3 and X-Box 360 have increased sales dramatically. On the handheld side, the new PSP Sony bundles are a sellout and the Nintendo DS continues to sell well.

So record sales of hardware in the fourth quarter will be a strong set up for 2008 for growth in software.

Never before have we had such a great lineup of games across all platforms and genres. As a matter of fact, the new titles that have released this month have all either met or beat our expectations.

The relatively new music genre, led by Guitar Hero III from Activision and Rock Band from EA will be sellouts, so if you want one you better start following the UPS truck to your local GameStop.

On the avid gamer’s gift list will be newly released Call of Duty 4 from Activision, Assassin’s Creed from Ubisoft, and Mass Effect from Microsoft.

Sports enthusiasts will be asking for WWE Smackdown from THQ, Need for Speed from EA, and NBA 2K8 from Take Two, and the Wii gamer will be buying Super Mario Galaxy and Mario and Sonic Olympic Games from Nintendo.

Also, we are pleased that the $59 price point for the new 360 and PS3 games has continued to hold as the consumer understands the value in these outstanding games.

In closing, our stores are full of games. As a matter of fact, our distribution centers have shipped over 11 million units in the last two weeks in preparation for Thanksgiving weekend. Our refurbishment center has been working seven days a week, so our used games are available for the budget consumer.

Our store associates are ready to help the new customers with gaming information and our marketing is set to drive them to GameStop.

Remember, at GameStop, games are our business, our only business.

With that, I will turn it over to the moderator for the question-and-answer period.

Question-and-Answer Session

Operator

(Operator Instructions) We will go first to David Magee with Suntrust Robinson Humphrey.

David Magee - Suntrust Robinson Humphrey

Good morning. Good quarter. I may have missed this, did you comment about used inventory going into the fourth quarter, how you thought about that?

Daniel A. DeMatteo

Our used inventory has grown in the third quarter. Our sales, as a matter of fact, have accelerated to 22% growth in Q3 from mid-teens in Q1 and Q2, so we are expecting good growth in used videogames, a continued acceleration in Q4. So inventories are in good shape and we expect accelerating sales.

David Magee - Suntrust Robinson Humphrey

And how much insight do you have now in terms of title releases in the first part of next year? Have you seen -- besides the obvious one that was delayed, have you seen much information on the other titles?

Steven R. Morgan

We have a list. Now obviously sometimes these titles don’t always come out when we anticipate but in the first half of the year, it looks like there is a pretty good lineup of titles, including Super Smash Brothers for the Wii, which should be a very big hit; obviously Grand Theft Auto is scheduled currently I believe to come out some time in April. We have Army of Two which slipped out of the fourth quarter into the first or second quarter, and Metal Gear Solid is projected for either the first or the second quarter.

So we have a really good lineup of games and I probably missed some. Those are just the ones off the top of my head, but those are some really big titles coming in the first quarter.

Daniel A. DeMatteo

Also, I would expect that the number one thing that will drive hardware sales in Q1 will be the continued growth in the installed base that we saw in Q3 and Q4 from this year, so we are growing the ever-growing installed base again, as Dick mentioned, Q3 hardware sales reached a record as a percentage of our business and we expect hardware sales will reach a record in units as a percentage of our business in Q4 -- not in dollars, because we’ve had price declines on the X-Box 360, the PS3, and the PSP, but certainly in units we will have a record fourth quarter.

R. Richard Fontaine

Also to add to that, continuing with comments that we’ve made earlier, the diversification of hardware platforms continues to be very strong. We have never had as many platforms represented, so it’s very broad-based, something for everyone, from the handhelds to the super powerful but totally unique in the Wii, great diversification in the hardware.

David Magee - Suntrust Robinson Humphrey

Thanks a lot and good luck for the holidays.

Operator

We’ll go next to Ben Schachter with UBS Securities.

Benjamin Schachter - UBS

Congratulations on another excellent quarter. A few questions for you; you talked about Rock Band and Guitar Hero. Could you walk through what SKUs exactly you think are going to be sellouts? And what other items do you think there will be supply issues with in the quarter?

And then also, on the PlayStation 3, after the price cut we’ve seen some positive momentum. How do you feel about that product going into ’08? And then I have one follow-up. Thanks.

Daniel A. DeMatteo

As usual, there are always product shortages in this category so this year is no different than any other year. Rock Band just released -- as a matter of fact, its first day of sales are today. We are expecting that to be a sellout. Guitar Hero for the 360 and the PS3 especially have been sellouts, and we are expecting to be resupplied, or we’ve gotten resupplied and we are expecting to get resupplied again right after Thanksgiving.

And the Wiis continue to sell as quickly as we can get them into our stores. You really do have to follow the UPS truck to get one of those, so -- let’s see. I think I hit all of them. And the PS3, we saw a little better than a doubling in sales after the price cut. Of course, now we have seasonality but we are still very pleased with the sale now of the PS3.

Benjamin Schachter - UBS

Okay, and then Dave, a quick question for you; when you think about the debt level by the end of ’08, how should we think about modeling that? And any color you can give on modeling actually the net interest income line?

David W. Carlson

You’re talking about next year?

Benjamin Schachter - UBS

Yes.

David W. Carlson

Well, obviously we’ll be giving guidance on that in March, but we obviously have cash flows coming and we will have to discuss with the board exactly what we want to do with those cash flows. But one of the options is to pay off some more debt, so we’ll probably be discussing that after Christmas with our board.

Benjamin Schachter - UBS

Okay. Thanks.

Operator

(Operator Instructions) We’ll go next to Bill Armstrong with C.L. King & Associates.

Bill Armstrong - C.L. King & Associates

Good morning. I’ll add my congratulations on a fantastic quarter. Dan, you just mentioned PS3 run-rate a little better than double since the price cut, was that enough -- it occurred very late in the third quarter. Was that enough to move the needle much in Q3 or is that going to be more of a Q4 event in terms of significance to your top line?

Daniel A. DeMatteo

Well, I think it’s more a Q4 event in our top line and it’s just one of many, many things though that are significant events in our top line for the fourth quarter. I would add that equally important was the price cut on the PSP and the new bundles that have come out on the PSP. Equally important was the new SKU on the 360, the arcade pack that has come out on that, and equally important are the expected sales of the Nintendo DS, which is the other handheld that is doing extremely well.

So I think altogether, there’s just many factors that we are putting together that we expect record hardware sales in units in the Q4 this year over any other year.

R. Richard Fontaine

I would also point out that it’s definitely, in my opinion, much more of a fourth quarter event. It not only was late but if you’ve been watching any television of late, you’ll see that Sony has really put on almost a saturation advertising campaign around the software titles for the PS3 and with the PS3 having a price point now that’s more accessible, a combination of both the marketing and the price point should see it really being driven through the fourth quarter.

Bill Armstrong - C.L. King & Associates

Okay, and could you elaborate on the availability of Wii hardware and the outlook for the fourth quarter there?

Daniel A. DeMatteo

Well, Wii hardware will be in short supply. We will have it in our stores the day after Thanksgiving. We have it in our Thanksgiving ad, so you again better get there early. But each store will have a supply of Wii and then I expect it to be gone, and then we’re getting resupplied in December a couple of times and we are expecting a resupply also in January.

So it’s going to be -- we think we have our forecast accurate with what the anticipated flow of the Wiis are going to be, but the Wii will be short throughout the quarter.

Bill Armstrong - C.L. King & Associates

Okay, and finally on the gross margin side, within the new hardware, new software categories, gross margin is down year over year. Could you elaborate on that, please?

David W. Carlson

Sure. As I said in the earlier comments on new videogame software, we received some additional co-op last year for the launches of the new systems, the PS3 and the Wii. The preorder programs we had in place and a lot of marketing that was going on in the third quarter for the launches, so that is the reason for the decrease in the -- the slight decrease in the new video game software margin.

The same reason for the new video game hardware but in addition, we have a mix issue there. The Wii and the PS3 were not in sales last year during the third quarter, so that has brought the margin down some, so it’s a mix issue in addition to the co-op funds that we received for the launches.

But if you look at the numbers, they are very consistent with the first and second quarter. In fact, I think they are up a little bit from the first and second quarter gross margin numbers on both of those lines.

Bill Armstrong - C.L. King & Associates

Should we see that co-op dollar impact flattening out in ’08?

David W. Carlson

That was a one -- the ’06 third quarter co-op number was a one-time incremental item so you shouldn’t -- you should see similar gross margins going forward that we are experiencing now.

Bill Armstrong - C.L. King & Associates

Got it. Okay, thanks a lot.

Operator

We’ll go next to Colin Sebastian with Lazard Capital Markets.

Colin Sebastian - Lazard Capital Markets

Good morning. Just following up first on the hardware unit lift and looking at the 7% to 9% comp store sales growth for Q4, I wonder if you can drill down a little bit in terms of the mix between hardware and software. And related to that, have you made any changes to your industry or platform growth assumptions for this year?

David W. Carlson

The platform growth assumptions haven’t changed significantly since we talked about them in the third quarter.

On the mix issue --

Daniel A. DeMatteo

As I said, we expect positive units growth in hardware and very slight, if any, dollar growth. So you can compute that, so we expect much stronger growth therefore in software and accessories than we do in hardware because hardware will be more like flat -- not in units but because of the dollar declines on the PS3, the PSP, and the 360.

R. Richard Fontaine

So for the sales mix variance, to Dan’s point, you will not see the same proportionate impact in all likelihood that you saw in the third quarter.

Colin Sebastian - Lazard Capital Markets

Right, okay. Thank you. And then you also talked about a record quarter for the online sales and I was just curious how material that is for the business at this point.

R. Richard Fontaine

Well, at this point, from a pure financial standpoint, honestly it’s not tremendously material to our earnings but it’s extremely important to, as I said, our high-tech broad promotion of the business and the category. Perhaps what is more important to us at this point in time is the amount of unique visitors, which I’ve said established an all-time record.

But truthfully, from the standpoint of its earnings contribution, given how fast the company has grown and our total size, it’s relatively immaterial but important.

Daniel A. DeMatteo

Just to add to that, we believe that our e-commerce site with all the information it provides about games, what’s coming, et cetera, is a big driver of customers also to our stores. It’s hard to quantify that but as Dick calls it, a very great broadcast channel, the best broadcast channel in the industry about videogames.

Colin Sebastian - Lazard Capital Markets

Okay, and did you mention the number of stores you closed during the quarter?

R. Richard Fontaine

No, I didn’t but the total number was 12 during the quarter. Yes, that’s right, 12 stores, so we had a net of -- what was it, 169 stores net that we opened during the quarter.

Colin Sebastian - Lazard Capital Markets

Great. Thanks and congratulations.

Operator

We’ll go next to Edward Williams with BMO Capital Markets.

Edward Williams - BMO Capital Markets

Good morning. A couple of quick questions for you; first of all, with regard to the supply of Wii games, have you experienced any issues with software being in tight supply going into the holiday season? And then secondly, I have some questions on the international store base.

Daniel A. DeMatteo

Actually, no, not on the Wii software. We have not experienced any shortages. That doesn’t mean -- I mean, any is a strong word but we don’t anticipate shortages in that. As a matter of fact, I was looking this morning at our best-selling Wii games going into Thanksgiving weekend, all of our stores are in stock.

Edward Williams - BMO Capital Markets

And then looking at the international business, can you just give us an idea as to how the businesses in Canada and Europe performed relative to what the company average was in the third quarter? If the top line growth or comp store sales were stronger or materially different? And then, what the operating margins looked like?

David W. Carlson

For the third quarter, the comps in Australia and in Europe were just slightly less than the U.S. but they -- I believe it was the Halo effect there. They didn’t have quite as impactful Halo sales. Canada was slightly better than the U.S. but they are all very significant comps, so to be honest with you, there is not a huge difference between any of the geographical regions in comps.

Edward Williams - BMO Capital Markets

Okay, and what about the profitability?

David W. Carlson

We’ll be releasing that with our 10-Q in about a week.

Edward Williams - BMO Capital Markets

Okay. All right. Thank you very much. Congratulations on the quarter.

Operator

At this time, we do have time for one more question. We’ll go next to Arvind Bhatia with Sterne Agee.

Arvind Bhatia - Sterne, Agee & Leach

Thank you. I would like to add my congratulations as well. I have a couple of questions. The first one is it looks like you opened about 180 new stores during the quarter, a little bit faster than we had expected. I was wondering if you could update us on where you are on your store opening plan for the year. I know you had stated 500 to 550 this year. If you could also perhaps give us the mix at this point of new store openings that you would expect.

And I wanted to follow up on Ben’s question on the debt and cash at the end of the year, as opposed to next year. If you could just touch on that.

And last question is on Game Informer, you haven’t talked about that in a while. I’m wondering if we can get some color on where you are on the impact of that on the bottom line, if any, and the number of subscribers, et cetera. Thank you.

R. Richard Fontaine

Let me take the first; as I indicated in my opening comments, we are in a position now where at the very least, I think we are going to hit the high end of our range for new store openings for the year. That would be in the 550 store range. The amount of stores that we have in the queue, that is deals that are signed for the fourth quarter, we’ll almost certainly achieve that. It is not unusual as we get into particularly the December time period that certain things will drag, so it’s conceivable that could go into January but still within the quarter.

And if all of the stores that we currently have signed and anticipated do open, it is likely that we will in fact exceed the high-end of our range slightly. And more importantly, I’ll use this as a forum, more important than the store number, which is I think you would say very impressive, to say the least, are two factors.

Number one, we continue and our real estate and operations people continue to do a great job identifying unserved markets and unserved areas where we can continue to put new stores.

Secondly, more important than the store count is how well these stores perform. And as a group, the 2007 stores to date are performing better than any previous group since we have been public, so not only are we opening many stores but those stores continue to be extremely productive.

David W. Carlson

On the debt and cash levels, we believe that we will have the $580 million of fixed rate debt as of the end of this year, and then in the beginning of next year, we’ll discuss what we are going to be doing with our cash flow.

Total cash at the end of the year is projected to be very similar to the end of last year, somewhere in the I believe $550 million to $600 million range.

Daniel A. DeMatteo

And I’ll answer on the Game Informer, we don’t break out the profitability of Game Informer but it is indeed profitable. At 3 million subscribers, as Dick mentioned, this is another broadcast channel to our best customers about videogames, so I look at it as every month, we get to talk to our best people about the best games that are going to come out. So it’s a very important broadcast channel and lastly, it’s the cornerstone of our loyalty program.

With Game Informer, you get a discount card good on selected discounts in the stores. We recently did a survey of our customers to find out what they thought about our loyalty program and found that it’s very well-received and very well-respected, so again it’s the cornerstone of our loyalty program also. So it’s a very important piece of the total GameStop communication channel.

R. Richard Fontaine

I would also point out that Game Informer is just another indication of how all-in we are in this category and to Dan’s point, it is disproportionately important. It runs as a stand-alone separate division. It’s based in Minneapolis. It has got a unique group of editors who are very independent. They say it the way it is. It gives us a tremendous amount of insight and information in terms of how they evaluate the games that are coming forward.

As a matter of fact, it’s notable that in 2007, 11 of the 12 issues really featured world exclusive cover stories. That is to say, the editors up there got insights into some of the products that are coming in the future and had a chance to get a first look.

I would point out that we have scrupulously kept this as a separate, stand-alone entity with its own culture specifically so that the editors up there are not affected by GameStop per se. But nevertheless, it is building a reputation in this business for knowledgeable and informed reviews of products at second to none. We are very proud of the job they’ve done.

And I’m sorry. I thought there was going to be another question but we thank you for joining us today. I certainly hope that you can see how enthused we are about this business, how positive we are about the fourth quarter. I know that the comp and the earnings numbers that we have been turning in are almost unique to retail. We feel we have a very strong business operating in many degrees as a very unique growth story. We intend to continue this. We think the industry is heading our way. Clearly we are operating into a growth market. You can be assured that we are going to go after every opportunity that is out there and try to achieve every sale that is available.

Thanks for your support. We really appreciate you being on the call.

Operator

Once again, that does conclude today’s call. We do appreciate your participation. You may disconnect at this time.

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