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GameStop Corp. (NYSE:GME)

F2Q08 Earnings Call

August 21, 2008 11:00 am ET

Executives

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

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

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

Analysts

Bill Armstrong - C.L. King & Associates

Edward Williams - BMO Capital Markets

Mike Hickey - Janco Partners

Tony Wible - Citigroup

Arvind Bhatia - Sterne, Agee & Leach

Benjamin Schachter - UBS

Operator

Good morning. Welcome to GameStop Corporation’s Q2 2008 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 Dan DeMatteo, Vice Chairman and Chief Operating Officer. Please go ahead, sir.

Daniel A. DeMatteo

Good morning and welcome to GameStop's second quarter conference call. I am Dan DeMatteo, GameStop’s Vice Chairman and Chief Operating officer. Dick Fontaine, our Chairman and CEO, could not be with us this morning, as he is recovering at home from minor surgery from this past weekend. With me today is David Carlson, our Executive Vice President and Chief Financial Officer.

This morning we released our financial results for our second quarter 2008 and gave guidance for the remainder of the year. Given the economic environment we are operating in, our performance could only be described as spectacular. Clearly the consumer has accepted the great entertainment value that videogames provide. With sales increasing 35%, comps increasing 20%, and earnings increasing 162%, we could not be more pleased with our results. These results were achieved through great leveraging of our SG&A expenses on strong comp sales. David will give you more details of the specifics for the quarter financially.

Once again our model, which creates value for the old games consumers are no longer playing, did well with the budget-stretched consumer. As a matter of fact, we had five of our top 10 trade weeks of all time in this second quarter and our June trades set a new monthly record.

Also, our Nintendo Wii trades, which some people were concerned about, grew five times faster than the average, as we focused on converting this new consumer to our trade model through our marketing activities and sales associates.

You may have seen our TV ads this summer promoting our trade-in message. As a result of all this trade activity, our used sales grew 32% and we expect continued great sales growth over the rest of the year in the used category.

If we analyze U.S. videogame sales in the quarter, as reported by NPD, the growth has been driven by an ever-growing installed base of next generation consoles and handheld systems and new genres. And the installed base growth continued in the quarter, with these systems growing 44% on top of 55% last year, led by growth of the PS3, Wii, and Xbox 360. Also, handheld systems performed well, with 32% growth in the category during the quarter.

Clearly the installed base this year will grow over last year, the year in which many predicted was the peak. Again, we believe this cycle will be broader and longer than any cycle of the past, as videogames are truly becoming mass entertainment for consumers of all ages.

As we all remember, last year had the release of Halo 3 in the third quarter, GameStop’s best-selling title of all time, which resulted in 46% comps. This year we see a much broader lineup of titles that will drive sales in the third and fourth quarter and, along with growth in our used sales, has allowed us to increase our back half sales and earnings guidance. And again, David will discuss this further.

The title lineup for the back half includes Fable 2 for the Xbox 360, Call of Duty: World at War for the Xbox 360 and PS3, Gears of War for the 360, Animal Crossing for the Wii, World of Warcraft again for the PC, Guitar Hero World Tour all platforms, Rock Band 2 all platforms, and Kirby Superstar for the Nintendo DS, and many others. You can see the breadth of titles that we have across all of these new platforms.

Now I would like to discuss our new store growth. First, we do not add new stores solely for store count and we try to avoid cannibalization of sales in our existing stores. The goal of our new store program is the expansion of the market by growing our used sales, capitalize on the growth in the industry, and take business from our competitors. Our new stores that opened this year as a group are performing as well as the year before group, and the year before that. In other words, our new store selection process and financial performance continues to succeed our model as it has in the past. In the quarter, we added 125 new store, 68 in the U.S., 28 in Europe, 25 in Australia/New Zealand, and four in Canada.

As we have said in the past, the specialist model, which includes the buy/sell/trade, largest assortment of games, and best-in-class sales support continues to be accepted around the world in all areas we operate.

As a matter of fact, we believe we now have the number one market share of game sales in the U.S., Canada, Australia, Italy, Ireland, Scandinavia, and are closing in on it in the Germanic countries. Therefore, we believe that we have many opportunities for expansion in all countries we operate and continue to look at new countries to expand into.

In our release, we stated that we believe our earnings will continue to grow extremely well next year by at least 25%. While we do not have visibility to many releases next year, we expect the continued growth in the next generation installed base and historical tie ratios, as well as growth in our used games to drive top line sales and earnings.

Now, before I turn it over to Dave this morning, this morning we have had some questions about the apparent loss of share in the quarter. First, comparing our total software growth to U.S. NPD data will not give an accurate picture, as over 27% of our sales are international, and in the second quarter, their release schedule was not as robust as the U.S. As far as we know, there isn't a comparable data source outside the U.S. like NPD.

Next, the mix of titles sold in the quarter will have an effect on our market share like last year in the third quarter where we way over-indexed with Halo 3.

And lastly, we have the used category, which other retailers don’t, growing at the rapid rate of 32% in the quarter.

We are making investments in our infrastructure to support our growth. We continuously make improvements in our used model to drive more trades and manage this inventory.

Our Game Informer magazine just broke the 3.5 million subscriber barrier and we even have an Italian version of it. We are hosting our annual store managers conference in a few weeks that will be attended by all of our field management and 56 of our suppliers. We feel that we are ready for the back half of the year, both U.S. and internationally, and are well-positioned to continue to grow in this fast-growing industry.

With that, I will turn it over to Dave for a more in-depth financial review.

David W. Carlson

Good morning. Before the market opened today, we released our sales and earnings results for the second quarter of fiscal 2008. GameStop sales for the second quarter increased 35% to $1.8 billion, as compared to $1.3 billion in the prior fiscal year. Comparable store sales for the second quarter increased 20%, significantly exceeding our prior expectations of 12% to 14% comps. These results were driven by exceptional performances across all categories.

New hardware sales grew 29%, again exceeding our expectations and building a massive installed base for future growth.

New videogame software sales grew 43%, with the U.S. game release schedule far exceeding the more modest European and Australian releases for the quarter.

Used videogame sales grew an astonishing 32% with the current economic environment continuing to stimulate trade-in. As we’ve explained previously, used videogame growth lags new game growth by six to 12 months and this is playing out as expected.

Net earnings for the quarter were $57.2 million, increasing 162% over prior year quarter’s net earnings of $21.8 million.

Diluted earnings per share for the quarter were $0.34, beating the high-end of previously released guidance by $0.06 per share.

Please note that the acquisition of three record shops in Norway and Finland reduced operating earnings by approximately $2 million during the second quarter and will show up as a reduction to European segment operating earnings when our 10-Q is filed later this month.

Gross margin rate decreased by 20 basis points, due primarily to product mix and the stronger-than-expected sales of hardware during the quarter.

Used videogame margins were especially strong, increasing 120 basis points from the prior year quarter, as fewer promotional activities were needed to drive the business.

SG&A expenses were leveraged by 150 basis points due to strong sales comps and cost controls, particularly in the U.S. segment. This allowed operating earnings to nearly double and operating margins to increase 170 basis points to 5.5%.

Our balance sheet remains strong with $540 million in cash at the end of the quarter and inventories growing ratably to the sales increase during the quarter.

This morning we also issued initial guidance for the third and fourth quarters of 2008, and updated guidance for the full fiscal year. Based on the strong results of the first half and increased confidence in the second half title release schedule, we are increasing various components of our guidance.

First, we had previously expected U.S. videogame software sales to grow between 15% and 20% for 2008, and now we are expecting that growth will exceed 20% for the year.

For the third quarter of 2008, we are expecting diluted earnings per share to range from $0.36 to $0.38, with comparable store sales ranging from flat to plus 2%. As you may recall, the amazingly successful release of Halo 3 and the related hardware sales in the prior year quarter resulted in 46% comps, with no similar title being released in the current quarter.

For the fourth quarter of 2008, we are expecting diluted earnings per share to range from $1.37 to $1.40, representing EPS growth of 23% at the high end.

Comparable store sales growth should range from 8% to 10% for the fourth quarter, with strong results expected across all product categories.

We are raising our diluted EPS guidance for the full year of 2008 to range from $2.45 to $2.50. We now expect full year comparable store sales to grow between 12% and 14% and total sales to grow between 23% and 25%.

Operating margin is expected to be 7.8% at the midpoint of guidance, with gross margins improving 20 basis points from the prior year and SG&A leverage improving by 40 basis points.

Store openings are on target to hit the high end of our 550 to 600 new store range, with new stores performing above expectations, even in this current economic environment.

With that, I will turn it over to the moderator for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from Bill Armstrong from C.L. King & Associates.

Bill Armstrong - C.L. King & Associates

Dave, if we look at inventory on a per store basis, going into the third quarter it is up about 21% by my calculation and you are looking for roughly flat comps. Are there any concerns about your inventory position maybe being a little too high at this point?

David W. Carlson

No, we’re not concerned at all. We obviously had inventory for the significant increase in the second quarter. Sales growth in the second quarter, yes, we’re looking at comps of 2% but we are looking at obviously total growth higher than that. So we’ve been building our used inventory, we want to be building our used inventory for both the third and the fourth quarter, so we are actually very happy with where our inventory levels are at at the end of the second quarter.

Bill Armstrong - C.L. King & Associates

You mentioned less promotional activity on the used games side during the quarter. I was wondering if you could flesh that out a little bit and maybe talk about your thinking behind that.

Daniel A. DeMatteo

Because of the economic conditions, we didn’t have to be as promotional on the buy side of games because it just seemed like we were naturally getting consumers trading them in, so that’s why we -- our margins are slightly better than they were in the second quarter last year.

Bill Armstrong - C.L. King & Associates

And typically, you always feel like you wish you had more used inventory. How do you feel right now, with your used inventory position?

Daniel A. DeMatteo

Well, I feel very good about it, just because it’s much higher than it was at this time last year and Bill, you’re right -- we always say that we can’t have used inventory too high going into the back half of the year. So we feel very good about it and as I said, we expect used sales to be very strong in the third and fourth quarter because of that inventory.

Bill Armstrong - C.L. King & Associates

Got it. Okay, thank you.

Operator

Your next question comes from the line of Edward Williams from BMO Capital Markets.

Edward Williams - BMO Capital Markets

A couple of quick questions for you guys -- first of all, can you give us an idea as to what sales were like in the European market, what you think the market growth was like in the European market? And if you can, some profitability and sales breakdown on an international basis.

And then looking at your store count, how many stores did you close and what’s the end number that you have at quarter end, and then what is your expectation at this point for the balance of the year and how will those stores split, international versus U.S.?

David W. Carlson

On the European sales level, we won’t give a whole lot of detail here because you will get more details when the 10-Q is filed but the comparable store sales in Europe were slightly lower than they were in the U.S., just because of the title lineup, basically, as we had mentioned earlier. The title lineup in the U.S. was much more robust than it was in Europe, so the comparable store sales in Europe were slightly lower than they were in the U.S.

And then what was the second question?

Daniel A. DeMatteo

The second question was related to store closings.

Edward Williams - BMO Capital Markets

Store closings, store count at quarter end.

Daniel A. DeMatteo

Store count at quarter end and end of year store count.

David W. Carlson

Sure. We had 5,557 total stores at the end of the quarter. We opened 125 stores during the quarter and we closed 21 stores during the quarter.

Edward Williams - BMO Capital Markets

Okay, and then what’s your expectation for new store adds for the balance of the year and how will those split?

David W. Carlson

We’re looking at the high-end of our guidance for about 600 new stores for the full year, and again we believe -- I believe we said earlier, we thought that was about half in the U.S. and half internationally, and that looks like that should be about right.

Edward Williams - BMO Capital Markets

Okay, and just to clarify the point, if I can for a moment, or just to touch upon it again, the 43% software growth that you reported, which obviously includes international markets and the 49% growth that NPD shows for the U.S., if we were to look at your U.S. number, how does it compare to NPD?

David W. Carlson

For the first half and for the first and second quarters, it compares much more favorably to the NPD number.

Edward Williams - BMO Capital Markets

Okay. Thank you.

Operator

Your next question comes from the line of Mike Hickey from Janco Partners.

Mike Hickey - Janco Partners

I was curious on -- Sony just announced new a PS3 SKU with a larger hard drive and I was curious if you could talk about digital distribution and how you expect that will [inaudible] your business today and into the future?

Daniel A. DeMatteo

I think the primary reason why Sony has introduced that 160-meg hard drive is they want consumers to use that as a hub of their media system, with both movies and music. We do not expect publishers -- we do expect publishers will develop some revenue stream by adding on digitally distributed content on selected games but the forecast for this in total is pretty insignificant.

We don’t expect full distribution of new games to be a threat due to the game size and distribution speed, so again we are looking at this as Sony’s introduction of a system to act as a media hub.

Mike Hickey - Janco Partners

Okay, and then on your store count, are you still thinking 50-50 U.S./international, or are you going to -- or are you over-indexing in one geography versus the other? And then do you expect that you might ramp up your store count in Q3 versus Q4 to try to hit the holiday period?

Daniel A. DeMatteo

Well, as Dave mentioned, we still expect about 600, the high-end of our range, and we still expect that to be about 300 international and 300 U.S. based, so it’s pretty much an even split. And so that’s where we will be at the end of the year and I guess I would have to add what we did in the first quarter. I know we did the acquisition of the Norway stores in the first quarter, so first quarter was pretty high. Second quarter was about average at 125, and the next two quarters will be probably whatever the difference between that is.

Mike Hickey - Janco Partners

Okay. All right, thanks, guys.

Operator

Your next question comes from the line of Tony Wible from Citigroup.

Tony Wible - Citigroup

Congratulations on the quarter. I know the market isn't recognizing it but I think you guys did a great job in a tough environment. First question, David, really deals with the Wii and I’m curious what kind of inventory outlook do you see for the Wii? And do you anticipate any new Wii titles coming out between now and year-end that might fit into being bigger seller, aside from animal crossing?

Daniel A. DeMatteo

Animal crossing I think is for the DS, is that right, or is that for the Wii? That’s for the Wii, okay. I’ll take the first one, Tony, on the Wii allocation. Nintendo has told us that allocations will be higher than they have been compared to last year and indeed we have seen that but we still expect shortages on the Wii allocation. The Wii Fit though will probably actually be the most, at least what we see now, the most highly allocated of the Wii products. It’s in very short supply, even more short supply than the Wii. But at a $90 ring, and we didn’t have it last year, it’s a big plus over LY when it didn’t exist.

Some of the other big Wii titles that we see this year will be Wii Music -- that’s from Nintendo -- Rock Band, Guitar Hero, and the Ray Man.

Tony Wible - Citigroup

Do you believe that there could be another title announced between now and year-end?

Daniel A. DeMatteo

I would not have any color on that. That would just be a guess. I don’t have any color on that. We will have our managers conference, as I said, in three weeks and Reggie will be there as well as the other executives, and I’ll be meeting with them privately and maybe they’ll give me something then but I don’t know right now.

Tony Wible - Citigroup

Last two question is I was hoping you could provide some qualitative commentary on just how we should think about the hardware margin rate. I guess it’s flat sequentially and running a little bit under what it’s been last year. Was there anything in the second quarter that caused it to be at the 6% level? I know in the first quarter you had some Zune impairments but is there anything in the second quarter that caused it to be there?

David W. Carlson

No, other than mix and our warranty program. We’ve reduced a little bit of our warranty program from the prior year and we think that going forward, we should be looking at the 6% margin rate in hardware, pretty much consistently as we go forward.

Tony Wible - Citigroup

Okay, and what are your thoughts on the use of cash with I guess interest rates where they are at and the stock at its current level. Do you guys have any bias towards buying back stock?

David W. Carlson

At this point, we actually -- as we’ve said before, we first cover our capital expenditures. Then we look at potential acquisitions. As you know, we have done a couple of acquisitions this year, Norway, Finland, and in New Zealand. And after that, after we’ve done the appropriate due diligence on whatever acquisitions we may be looking at, then the board I am sure will be looking at whether we should do [debt] and/or stock buy-back.

Tony Wible - Citigroup

Great. Thank you.

Operator

Your next question comes from the line of Arvind Bhatia from Sterne, Agee & Leach.

Arvind Bhatia - Sterne, Agee & Leach

Just one question on the margins again -- Dave, I think on the other margin category, I noticed that was also down slightly. I know that’s primarily PC and things like strategy guides, et cetera. Was there anything unique there this quarter that impacted that, and what do you expect that category going forward?

And then housekeeping question, what was stock-based comp during the quarter?

David W. Carlson

The other category, as you know, has videogame accessories and PC software and some other things in it as well, but I believe the PC software piece of the category was very strong in the second quarter. The title is escaping me. I think it was Age of Conan was very, very strong and that obviously brought the margins down in the other category slightly.

Stock-based compensation -- give me one second. Stock-based compensation was approximately $8.4 million during the quarter.

Arvind Bhatia - Sterne, Agee & Leach

And final question is as we look at next year and you look at kind of the margin improvement with the changing mix, can you give some broad idea of how you are expecting margins to trend next year, gross margins in particular?

David W. Carlson

We believe that gross margins will increase next year, as the mix of new and used software increases and the mix of hardware decreases slightly. But we are probably not going to be giving any guidance on that at this point.

Arvind Bhatia - Sterne, Agee & Leach

Great. Great job, guys. Thanks.

Operator

It appears we have time for one more question, and that question will come from Ben Schachter from UBS.

Benjamin Schachter - UBS

Congratulations on a really exceptional job of executing. A few questions -- one, with Wii, could you just talk about what you are seeing over the last month? Is there any change in terms of demand? And then secondly, I just want to go through the music genre a bit and just understand how important this is for the holiday and for the year. And do you expect it really to be driven by the higher ASPs or units or both? And then how can you -- can you talk a little bit about how you are doing in the used, with the music genre? Are people trading in hardware and the software? Is it more software? Just some qualitative thoughts around the music genre. Thanks.

Daniel A. DeMatteo

Let me take the first one on the Wii demand -- the Wii demand is still extremely strong. I mean, probably three months ago, whatever we got into our stores would sell in two days. Now, it’s three or four days but it’s still extremely strong compared to -- I mean, for a system that’s been out for -- what’s it been, a year-and-a-half? A year-and-a-half now, the demand continues. It’s really very strong and as I said before, I think it’s going to continue and I think there will still be shortages throughout the year.

The music genre has been important. I mean, it’s been important to the Wii sales, it’s been important to PS3 sales, it’s been important to 360 sales. Even DS sales, now we have the Rock Band on the DS, and you saw 32% increase in handhelds, and those handheld systems are fairly old, in the second quarter and I think some of that demand has been driven by the music genre. And I think the music genre is becoming an important genre to the business and to the category.

And yes, people are trading it in. As a matter of fact, I was just going through some comments from my store associates, what issues they want me to address at the managers conference and they said, what the hell are we going to do with all these used guitars that we got traded in as people upgrade to the different guitars? They are filling up my store. So -- they are big, and so yeah, we are getting trades in the music genre. And as I mentioned earlier, specifically we really targeted the Wii customer and the DS customer with our marketing this summer, both TV and in-store, and in-store promotions especially targeted to those people and we were really pleased with our overall Wii trades and DS trades and the Wii trades, as I said, grew five times faster than the average group. And so by definition, since music is a big piece of the Wii, we had to have gotten -- while I didn’t dig into the detail, I have to think that Wii music, we had a lot of new Wii music traded in for that to have occurred.

Benjamin Schachter - UBS

And just one final last question -- does your guidance assume a hardware price cut anytime for the second half of the year?

David W. Carlson

Our guidance continues to assume the hardware price cut we talked about at the very beginning of the year, assuming there is about a $50 price cut on both the Xbox and the PS3 going into the holiday season.

Benjamin Schachter - UBS

Great. Thank you.

Daniel A. DeMatteo

Okay, well, thank you very much for attending this morning. As you can see, we are extremely excited about our past performance in the first half of this year but equally excited about the back half performance and the performance we see next year. The installed base growth, as we predicted -- well, as a matter of fact, we didn’t predict it would be this high but we did predict it would grow over last year, continues to grow and that is setting up a very good 2009. I would not expect that the hardware sales in 2009 actually to decrease that much because most likely what will happen is the manufacturers will begin lowering the price to keep the velocity going.

So this cycle, we have reached a 31 million or 32 million units a year in hardware sales compared to the last cycle of 20 million to 21 million, so almost 50% higher. And we expect that to continue and it’s going to continue to broaden the market and it will continue to therefore create demand for both new and used software.

And lastly, in this economic environment that we are operating in, we are really pleased with the trade program. As I mentioned before, five of our top 10 all-time weeks occurred this summer when we didn’t have a blockbuster blockbuster like Halo 3, and one of them, of course, was last year with Halo 3. But our trades are up significantly and that’s driving our sales and we think that the new/used model in these economic times really is a differentiator between GameStop and other people that sell videogames that will allow us to continue to grow and open new stores.

So thank you very much for attending and we look forward to a great back half.

Operator

That does conclude our conference call today. Thank you all for your participation.

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