GameStop Corp (GME) CEO Shane Kim on Q2 2018 Results - Earnings Call Transcript

|
About: GameStop Corp. (GME)
by: SA Transcripts

GameStop Corp (NYSE:GME) Q2 2018 Earnings Conference Call September 6, 2018 5:00 PM ET

Executives

Shane Kim - Interim CEO & Director

Robert Lloyd - EVP, CFO & COO

Analysts

Seth Sigman - Crédit Suisse

Colin Sebastian - Robert W. Baird & Co.

Benjamin Schachter - Macquarie Research

Jason Haas - Bank of America Merrill Lynch

Operator

Ladies and gentlemen, thank you, and welcome to GameStop's Second Quarter Fiscal 2018 Earnings Conference Call.

This conference call will include forward-looking statements, which are subject to various risks and uncertainties that could cause actual results to differ materially from expectations. Any such statements should be considered in conjunction with cautionary statements and safe harbor statements in the earnings release and risk factors discussed in reports filed with the SEC. GameStop assumes no obligation to update any of these forward-looking statements or information.

A reconciliation and other information regarding non-GAAP financial measures discussed on the call can be found in the company's earnings release issued earlier today as well as in the Investors section of the company's website.

Now I would like to turn the call over to the company's Interim CEO, Shane Kim.

Shane Kim

Thank you. Thank you all for joining us this afternoon. I want to take a minute at the beginning of today's call to especially thank all of our associates around the world for everything they do on a daily basis to make our stores the video gaming, collectibles and wireless services destination for our loyal and passionate customers. Thank you all so much.

Now as we get started, I'd like to share a few initial thoughts and observations from my first three months in the Interim CEO role, address our ongoing strategic and financial review process to the extent that we can share additional information and highlight several opportunities for future value creation we have available to us and how we are positioning the organization to realize them. Following my comments, I'll turn the call over to Rob for a review of financial and operational highlights from the quarter, and then we'll be available to take your questions.

So first, as I told you in May, I stepped into the Interim CEO role with the belief that we have several tangible opportunities to improve the company's performance and drive long-term profitability. I am pleased to say that I have an even stronger belief in those opportunities today. I continue to view my role as one where I can provide strategic leadership and help to set a path for growth-driving initiatives as we position the business for the long term.

Meanwhile, the board is continuing its search for a permanent CEO, and we are working with a leading executive search firm to assist with the process. We are not going to rush this search, and we're committed to finding the best strategic leader for the company. Our shareholders and our associates deserve nothing less than that. To that end, I am committed to remaining in the Interim CEO role until we select the very best candidate who will lead GameStop on a permanent basis.

Second, GameStop's Board of Directors, with support from outside financial and legal advisers, is conducting a broad range review of strategic and financial alternatives to enhance shareholder value. These options include, among others, a potential sale of the company. We also have several strategic and operational levers that we can pull to grow our business, improve financial performance and drive value for our shareholders.

As such, we are reviewing various scenarios and alternatives, and I can assure you, the board is open-minded in considering the best path forward for GameStop and our shareholders. We are the market share leader in the video game industry, we have a strong business model and we generate significant cash flow, all of which makes us a compelling and attractive investment.

It is important to note, however, that this process may not lead to any specific transaction. We look forward to communicating to you at the conclusion of the board's review and appreciate your understanding that we do not intend to comment further regarding the process until that time. Given that activity, we are not likely to name a CEO until these discussions and the process have concluded and we have a clear path forward.

And finally, to the point of growing our revenue, profit and shareholder value, I want to share a few opportunities that I'm very excited about. As I said in May, we have several valuable assets that provide us with significant competitive advantages, including our PowerUp Rewards loyalty program, our pre-owned trade capabilities and the currency that creates for our customers, our expansive global retail footprint and omnichannel capabilities and our strategic partnership with AT&T.

Our team is focused on leveraging our market leadership and competitive advantages to take even greater market share of the physical video game market beginning tomorrow and through the fall with the impressive slate of titles that are launching. We intend to compete even harder than ever before for profitable market share, not just at launch but throughout each individual title's new retail life cycle.

We are confident that gaining more market share of the top titles can also lead to more accessory sales, growth in our PowerUp Rewards membership and even more collectible sales as we broaden our customer reach and drive more traffic in our stores. We also believe that growing our market share of new titles is the best way for us to grow our pre-owned business as we will drive more pre-owned inventory into our system.

With respect to opportunities for future value creation, GameStop is uniquely positioned to satisfy all of the gaming needs of our customers across platforms, across publishers and franchises, across physical and digital formats and across new and pre-owned. We can leverage these advantages to create greater value for our customers and, ultimately, for our shareholders. We are exploring ways that we can connect with gamers beyond our retail store footprint whether that's from a digital perspective or by creating new business models or by actively participating in eSports.

Because we connect gamers with our passion for video gaming like nobody else can, we are exploring ways to participate in other parts of the video game industry value chain.

We're also pursuing the many opportunities available to us in the Collectibles business. Already a $12 billion market in North America alone, we continue to grow that business and take market share in what is a very fragmented market. We see opportunities to invest in and grow that business in our video game stores around the world, in our ThinkGeek and dedicated collectibles stores globally and on our e-commerce platforms.

Beyond driving growth in our core video game business and in our emerging Collectibles business, we're also focused on improving the profitability of our tech brands business. We believe there is ample opportunity to work with AT&T to expand the entertainment and content options available to customers along with their desire for store growth in the dealer network. We will do so strategically and prudently, but we know there's room to grow profitability in this area of the business as the strategic partner of AT&T.

So as I stated at the beginning of the call, and as you can probably tell by my enthusiastic comments, I see great opportunities in all of our businesses to drive growth, profitability and market share, including expanding our leadership position in the video game industry.

I look forward to sharing more details with you in the coming months as we refine the strategic plan to pursue each new opportunity. I also look forward to updating you on the strategic and financial review process as well as our CEO search.

With that, I would like to turn the call over to Rob for a review of the second quarter. Thank you.

Robert Lloyd

Thanks, Shane. Good afternoon, everyone. Looking back at the second quarter, at a very high level, we delivered sales and earnings that were in line with our expectations. We knew the comparisons to last year would be difficult given the overlap of the highly successful Nintendo Switch launch last year and a light title slate within the first half of this year. However, our sales results for the quarter were highlighted by 20.1% growth in new video game hardware driven by the emergence of the Xbox One X and growth in the Nintendo Switch. PS4 continues to exceed expectations and remains the leading hardware seller. As we look toward the second half of the year, we're very encouraged by the upcoming title slate, with some launches starting as soon as tonight, and we anticipate strong software sales across all platforms.

On a reported basis, our second quarter earnings results included a $29.6 million foreign tax charge, which we recognized during the quarter. I'll go into more detail in a minute. However, on an adjusted basis, excluding the tax charge, our operating earnings were $21.6 million and adjusted earnings per diluted share were $0.05. They declined compared to last year but in line with our expectations coming into the quarter.

From a top line perspective, second quarter sales decreased 2.4%, and our comparable store sales declined 0.5%. The decline in comp sales was primarily due to a stronger software lineup last year. In the U.S., comps increased 2.4% while international comps decreased 6.4%, with the contrast in performance driven by our international business outperforming our U.S. video game business last year due to their higher allocations of Switch around its launch.

As I mentioned, our video game hardware business increased 20.1% with nice growth in Xbox One and Switch. New software sales decreased 18.5% in the quarter, in line with our expectations given the lack of title launches to drive sales. God of War, which actually launched at the end of Q1, Detroit: Become Human and Mario Tennis Aces were the largest titles in the quarter. Our pre-owned business declined 9.9% in the quarter with growth in pre-owned hardware. However, this growth was more than offset by a decline in pre-owned software given the weaker new title releases this year and the lack of Nintendo Switch product available in pre-owned inventory.

Our accessories business grew 30% on the strength of headsets and controllers related primarily to the popularity of Fortnite. This continue to be very exciting for our business as we work to meet the consumer demand and benefit from the excitement that Fortnite is bringing to the video game industry.

Digital receipts grew 6% in the quarter. However, excluding the impact of the sale of Kongregate last year, digital receipts increased over 15% on the strength of digital currency and POSA cards sales, much of that attributed to Fortnite. On a reported basis, digital sales declined 13.5% due to the sale of Kongregate in July of last year. Excluding Kongregate from last year's numbers, reported digital sales would have increased over 20%.

We grew the Collectibles business 15.7% for the quarter to $141.7 million with growth driven by new and improved product offerings as well as over 35% growth in apparel. Apparel is a heavy focus area and is now our second largest subcategory inside Collectibles, trailing the toy category. We see continued growth in apparel in the future.

Moving to tech brands. Revenues were down 10.3% to $168.9 million, primarily due to store closures and the sale of Cricket stores, resulting in 173 fewer stores compared to last year. Comp store traffic declined 5.3%, and comp gross margin declined 1.2%. However, operating earnings increased 35.3% from $15 million last year to $20.3 million this year.

Improved operating earnings were primarily driven by better operational execution and improved compensation terms as a result of our continued dialogue with AT&T. To expand on the compensation changes, we've made progress in our discussions with AT&T around our compensation structure as it pertains to increased commissions on mobile transactions, which went into effect on April 1. Enhanced compensation related to our operations in higher cost markets went into effect on July 1. It's important to note that due to these effective dates, the second quarter results include only a partial impact of the improved compensation terms.

Shifting gears to gross margins. Our gross margins declined 80 basis points for the quarter to 36.2%, with increases in hardware, digital and Technology Brands margins more than offset by declines in pre-owned and Collectibles gross margin. Software margins increased slightly for the quarter. Pre-owned margins declined 130 basis points to 43.7% in the quarter, near the high end of our guided range, primarily due to our efforts to drive increased customer engagement in the category such as incremental promotions from both a sales and trade standpoint, incremental marketing activity as well as the shift in mix to a larger percentage of pre-owned hardware.

For Collectibles, the gross margin rate decreased 350 basis points to 31.8% for the quarter. We drove an increase in margin dollars given the solid growth in sales. However, we sacrificed a little on the gross margin rate as we continue to refine and optimize our product mix, pricing strategy and merchandising approach both in store and online. Given the significant growth in this category over the last few years, our Collectibles business at this larger scale is still relatively new to us, and we're continuing to address every aspect of the business as we look to grow it meaningfully beyond where it is today.

Now moving to SG&A. Total SG&A in the second quarter was flat to last year, which included a $7.3 million gain from the sale of Kongregate. Excluding last year's gain, SG&A declined 1.3% or $7.4 million compared to last year.

Total company operating earnings were $21.6 million compared to $43.6 million last year. On an adjusted basis, operating earnings were $21.6 million compared to $36.3 million last year, excluding the gain from Kongregate. The overall decline was largely due to a decline in our software and pre-owned video game categories.

As I mentioned at the beginning of my remarks, and as previously disclosed, we have an ongoing audit with the French tax authorities over certain items impacting our French tax results. In the second quarter, we recorded a $29.6 million nonoperating tax charge or $0.29 per diluted share, which is an estimate covering all periods in question, including the current year.

Excluding the effects of this charge, our year-to-date adjusted effective tax rate is 35.6%. Discrete tax items recognized in the first two quarters of the year have resulted in an adjusted effective tax rate much higher than we expect for the full year. The effect of these items in the second quarter is exacerbated by the lower pretax income.

Reported earnings per diluted share were a loss of $0.24 compared to earnings of $0.22 in the prior year. Second quarter adjusted earnings per diluted share were $0.05 and exclude the impact of the $0.29 nonoperating tax charge. That compares to $0.15 in the prior year period. The second quarter of 2017 included a benefit from the sale of Kongregate of $7.3 million or $0.07 per diluted share.

We made the following changes to our store portfolio during the quarter. We closed a net of 16 video game stores around the world as our overall portfolio remains very healthy, ending with 3,802 video game stores in the U.S. and 1,951 internationally. We closed a net of 8 Technology Brands stores, ending the quarter with 1,289 AT&T stores and 47 Simply Mac stores. We had no net change in Collectibles stores, ending the quarter with 103. Our current average lease life remaining is about two years, which gives us tremendous flexibility related to managing our store base.

Moving to the balance sheet. We ended the quarter with $279.6 million in cash compared to $262.1 million last year. Inventory was up 8.5% or $96.4 million with the increase primarily attributable to hardware, specifically Xbox One X and Nintendo Switch consoles, which have either not launched or were in short supply last year. The impact of FX and higher software levels given the earlier launch of certain titles this year also contributed to the increase.

From a capital allocation perspective, the board declared a quarterly cash dividend of $0.38 per share that is payable on October 2 to shareholders of record on September 18.

Shifting to our outlook for the remainder of 2018. With the first half of the year coming in line with our expectations, we are maintaining our full year guidance consistent with our original outlook. Fiscal 2018 full year revenues continue to be forecasted in the range of down 6% to down 2%, with the same-store sales ranging from down 5% to flat. Our tax rate for the full year is estimated at between 26% and 27%, and our full year free cash flow is estimated at $300 million. Both are excluding the effects of the ongoing audit of the French tax authorities that drove our nonoperating tax charge in the second quarter. Capital expenditures continue to be estimated between $110 million and $120 million.

As you can tell by our comments, we're very excited about the back half of the year and all the great titles launching, with Marvel's Spider-Man and NBA 2K kicking off tonight. For the back half of the year, and compared to previous years, we have seen some titles shift and other great opportunities with franchises that had taken some years off. Our reservations for upcoming titles are up significantly over last year, and we continue to expect Q3 to see significant new software growth compared to the prior year.

With great franchises like Assassin's Creed, Call of Duty and Battlefield all launching new games ahead of holiday season and new titles from Nintendo and Super Mario Party, Pokémon: Let's Go and Super Smash Bros and, of course, the highly anticipated launches of Red Dead Redemption 2 and Fallout 76, our stores and our associates around the world are working towards driving more market share and software growth this holiday season that should benefit our pre-owned business next year.

Having just met with the thousands of store leaders last week at our annual conference, I can tell you that our teams are beyond excited about the titles launching and eager to leverage GameStop's industry-leading position to drive what we think can be one of the best holiday seasons we've seen in quite some time.

It goes beyond simply the software title launches. We're focused on giving our customers what they want. They aren't just passionate about the game, they're passionate about the entire franchise, including our Collectibles offerings. Look for our GameStop stores and ThinkGeek stores to have officially licensed Fortnite product available this fall as well as exclusive collectibles for NBA 2K19, Red Dead Redemption 2 and our largest Collectibles offering from the Fallout franchise this year. Our entire organization is focused on making holiday 2018 successful, and the excitement and enthusiasm is contagious.

In closing, we're very focused on improving our operations, gaining market share and driving profitability across our core businesses. We have a long track record of being a shareholder-friendly company, and we'll continue to be. We appreciate the support of our long-term shareholders as we navigate the changes in our organization and our ongoing strategic review and focus our operations to continue to generate strong cash flows and improve our profitability.

I'll now turn it back over to Shane before we go to the moderator for questions.

Shane Kim

Thank you, Rob. Before turning to Q&A, I'd like to remind everybody that the purpose of today's call is to discuss our second quarter results and outlook for the remainder of the year, and we ask you to limit your questions to those topics. I thank you all in advance for your consideration and cooperation. Go ahead, operator.

Question-and-Answer Session

Operator

[Operator Instructions]. And we will take our first question from Seth Sigman with Credit Suisse.

Seth Sigman

I wanted to talk a little about the strategic and operational levers to improve performance and drive value. I know there's not much you can really talk about at this point, but some of the levers that you are focused on or have identified, and I'm thinking specifically where there may be some low-hanging fruit maybe on the cost side, can you speak a little bit about that opportunity? And is that something that you're looking to execute in the short term? Or is that more of a long-term opportunity? Just help us better understand some of the things that are within your immediate control that you can sort of effect some change.

Robert Lloyd

Seth, this is Rob. One of the things that we've talked about in some of the opportunities we've had to get in front of large groups of investors at Internet casts and conferences and things is the fact that our stores can improve in terms of the look and feel and the shopability for the customer. And so what you'll see as you shop our stores across the next month is a relay of the store layout. And we're going to give much greater prominence to the new video game merchandise as well as make sure that we're displaying pre-owned in a way that is really more attractive to the consumer. So it takes a little bit to relay the stores, but that's a lever that we can pull that we think is going to get after what Shane was talking about in terms of market share as well as drive software growth. And then we're going to continue to remain focused on the new titles after they launch. And we've had a bit of a launch and lead mentality in the past, but we think that we can move beyond that and continue to focus on selling those hot games after their launch week and launch month.

Seth Sigman

Okay. I guess, a follow-up question would be on the guidance for the second half of the year, which implies a pretty significant improvement in operating profit. My math is that it sort of implies operating profit flat to up as much as 14%, excluding the extra week last year. So can you just help us bridge to that, how much of that is driven by Tech Brands and some of the compensation changes you talked about versus the actual core business?

Robert Lloyd

Well, I'm not going to get into specific numbers, but increasing the tech brands' profitability is something we've talked about for 2 or 3 quarters in a row now. It's a priority for the team. The compensation helps with that. But the other side of that is that we see a lot of opportunity in terms of the software growth that we think we can drive in the third quarter and fourth quarter with these titles that are launching.

Operator

We will take our next question from Colin Sebastian with Baird.

Colin Sebastian

I know there may not be many changes to all those strategic reviews underway, but beyond the process of upgrading stores, I'm wondering how much flexibility there is to generate additional efficiencies over SG&A spend since that's relatively flat despite the decline in revenues. And then I have a couple of follow-ups.

Robert Lloyd

We're always focused on how we can improve the productivity of our distribution systems and improve productivity and labor allocation inside of our stores. So those will continue to remain a focus for us as we move through the third, fourth quarter and into next year. Beyond those couple of significant areas, we continue to watch costs across our back office support and the rest of the cost in the store base as well. Nothing in particular that I would note though in terms of huge opportunity.

Colin Sebastian

Okay. Rob, you also mentioned returning to growth in the pre-owned segment at some point. Is that -- was that a comment related to later this year? Or -- I think you also mentioned next year as a sort of echo or follow-on effect from the stronger software releases this year.

Robert Lloyd

Well, clearly what we've seen in terms of hardware is -- you've seen the results on the new hardware side, that drives trading activity on the pre-owned hardware side. And as I mentioned, we've seen growth in pre-owned hardware. We haven't been operating with a title slate that's allowed us to get those trade in on the software side. So we're really excited about these titles that are launching in the next 3 or 4 months that can generate trade on the part of customers. We're very actively marketing to customers around bringing back the games that they bought through this cycle, bring them back and trade in 30 days and you give a certain price, all those kinds of things to make sure that we're driving trade on those games. And we think that will help us as we get into next year. I wouldn't say that I'm expecting a lot of that increase to be seen in 2018, but it should benefit us with better inventory heading into next year.

Colin Sebastian

Okay. And then lastly, with this holiday in mind, wondering what your expectations are for the promotional environment given the strength of the slate. But it's also quite crowded, so what are you hearing from the publisher in terms of promotions? And what -- and then what do you have embedded in your expectations for this year?

Robert Lloyd

Well, we're working with the publishers around that. I can't get into specifics in terms of how we're planning for Black Friday or what activities we would expect to see on the part of the publishers as we move through December. But I can tell you that part of the reason the slate lays out in the way that it does is to allow the publishers the opportunity to take advantage of that preholiday time frame to sell games at full price before we get into the kinds of discounting that we've seen the publishers support during Black Friday and the holiday period. It is a -- it can be a category that sees a lot of promotional activity by competitors in the holiday time frame, and we're planning for that so that we have the offerings that will keep us competitive and help us to go after that share.

Operator

We will take our next question from Ben Schachter with Macquarie.

Benjamin Schachter

A few questions. On the pre-owned, can you just talk about the weakness that you're seeing this year? How much of it is specifically related to Nintendo? For example, you were able to just say Sony and Xbox, what would those comps look like? And the second question, on the relationship with AT&T, thanks for the update on the comp structure, what are the other big sticking points that you're still working on with them? And then I have a couple of follow-ups. Thanks.

Robert Lloyd

Yes, on the pre-owned side of the equation, we've -- as I said, we saw growth in hardware and there's not much of that, that's coming from pre-owned Switch. Frankly, people are holding on to their units. It's coming from the other platforms. We're pleased with what we've seen there. There's not much that's coming in the way of pre-owned Switch software either. We do expect, with three big titles coming this fall, that we'll start to see some more activity in trade around older Switch titles, which we think will benefit us going into next year as well. We typically don't disclose the makeup of how much of the pre-owned business Switch is versus the other platforms. But again, we're just not seeing much yet in pre-owned Switch activity.

Shane Kim

I'll answer the AT&T question. I'm really encouraged by the direction our relationship with AT&T is moving. I mean, obviously, the compensation changes help, but more importantly to me is that we have a closer and tighter working relationship with AT&T than we ever have. I think they continue to view us as a very strategic partner. We are their largest authorized reseller, and we continue to partner on ways that we can go after greater market share with them as they expand their wireless and their content offerings. And so I think we're very well positioned as a long-term partner with AT&T, and we expect to see that business continue to grow both from a revenue and profitability standpoint.

Benjamin Schachter

So just on a few key titles like Call of Duty, Red Dead and Battlefield, those specific titles, what do expectations look like versus where they were say, 3 or 4 months ago?

Robert Lloyd

I'm not sure how to answer that question, Ben, actually. The way that we typically look at these titles as they're developing is -- and particularly with a title like Call of Duty, to a degree with Battlefield, you have a historical reservation ramp that you would expect to see. That reservation ramp can be impacted by things like the beta for Battlefield that's going on right now, promotional activities on the part of the publishers to drive awareness of the titles, so they move around from time to time. In terms of Red Dead, it's been a long time since we've had a Red Dead. So I can say that, as I said earlier in the remarks, our overall reservations against the titles are up significantly, and we're pleased with what we're seeing inside those three titles you called out in particular and, again, overall.

Operator

[Operator Instructions]. Our next question is from Curtis Nagle with Bank of America Merrill Lynch.

Jason Haas

This is Jason Haas on for Curt Nagle. Could you size up the impact that Fortnite had on the results? And has this gotten better or worse relative to 1Q?

Robert Lloyd

The impact that we're principally saying, as I said in the remarks, it really comes inside headsets, which is inside the accessory category. Our headset sales were up over 80%. Gamers want that better headset in order to play Fortnite. It's driving hardware sales as well. It's driving controller sales. And it's driving the digital currency, people coming in to get the VBucks. What we're really excited about as Fortnite continues to have momentum is that we're finally in a position with Epic to have the licensed Fortnite merchandise coming in. Stuff that you've seen out there haven't necessarily been licensed. We don't play in that space. We buy the licensed stuff. So we're really excited about how we're going to be able to get apparel and other products into the hands of our Collectibles customers.

Jason Haas

Great. And then as a follow-up, in the prepared remarks, you mentioned that you're looking, I guess, at other business areas or parts of the gaming industry. I know you mentioned eSports, for example. Can you just provide some more color on what that might look like?

Shane Kim

Yes, I mean, it's still early in that process, Jason. But one thing we know is that everybody who watches an eSports tournament in person or watches a stream of a competition on Twitch or YouTube or Facebook is a gamer and is likely a customer of GameStop. And we have a level of authenticity with that gamer that we think we can leverage to play in that space. Where exactly that's going to be, we're not prepared to announce yet, but we think that there's a really great opportunity for us because we connect with those people. And so the great thing about the people who are so interested in eSports is that their actual customers are real gamers. And we serve them the best, and that's what we're going to be able to leverage as we go into that space.

Operator

And there are no further questions. I would now like to turn the call back over to Interim CEO, Shane Kim, for any additional or closing remarks.

Shane Kim

Okay, thank you. Thank you again for your time today, everybody. We look forward to continuing to update you on our progress in the future, including our next earnings call in November. Thank you very much.

Operator

Ladies and gentlemen, this concludes today's call, and we thank you for your participation. You may now disconnect.