Earnings Call: Q3 2018

Nov 29, 2018

Thank you, and welcome to GameStop's Third 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 statement 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 company's Interim CEO, Shane Kim. Please go ahead, sir. Thank you, everyone, for joining us this afternoon. Before we discuss our Q3 results, I want to take some time to share a few thoughts on our holiday business and several initiatives that we are working on. And then I'll turn it over to Rob for a more detailed review of the quarter and outlook for the remainder of the year. Following Rob's comments, we will be available to answer any questions you may have. So first, as we discussed in September, our Board of Directors has undertaken a broad range review of strategic and financial alternatives to enhance shareholder value and best position GameStop for success. This thorough and comprehensive process remains ongoing. While we understand the high level of interest in announcing a conclusion to that process, we are focused on ensuring the best possible outcome for our company, our shareholders, our associates and our other stakeholders. We feel good about the options available to us and we'll continue to be deliberate in choosing the best path forward. As such and as I have said previously, we will provide you with a further update upon completion of the Board's review. As a part of the ongoing review, we took an important step last week in signing a definitive agreement to divest our Spring Mobile business and its roughly 1300 AT and T wireless stores to Prime Communications, the largest privately held AT and T authorized retailer in the United States. This transaction, which attractively values the Spring Mobile business at $700,000,000 and is expected to close in January, will generate significant cash proceeds and equally importantly, will enable us to increase our focus on serving our customers' entertainment needs across video games and collectibles. We are excited about this transaction and view it to be an enabling one for GameStop. While we are still evaluating the specific use of the proceeds as part of the Board's ongoing strategic review, we expect the transaction to facilitate investment in our core businesses to drive growth and transform GameStop for the future, repayment of debt, return of capital to shareholders or most likely some combination of these opportunities. 2nd, with respect to the Board search for a permanent CEO, that process also remains ongoing. With the help of a leading executive search firm, we are having productive conversations with promising candidates and we are determined to find the best strategic leader for the company. However, as I discussed on our last call, we are unlikely to name a new CEO until the Board's review process has concluded. As I also said in September, I am committed to remaining in the interim CEO role until we select the very best person to lead GameStop on a permanent basis. Now moving on to our core video game entertainment business. As you know, we are the market share leader in the video game industry and we have increased our focus on leveraging that position and our many competitive advantages to further grow our market share. We are very proud that the increased focus has paid off. In October, the U. S. Physical video game industry saw several major title launches and according to the NPD Group experienced almost 50% year over year growth, while GameStop grew its revenue by a significantly greater amount at 63%. We were able to grow our share of physical video games by 4% year over year with 5% share growth in software and 4% share growth in hardware during a huge month. This reflects the value that we offer to customers as well as our ability to drive our business to rigorous focus and discipline. In addition to taking more share at launch of key titles, we are focused on developing plans and implementing strategies across all levels of our business to enable us to compete even harder than we have before for profitable market share throughout each title's lifecycle. For example, you have seen us begin to position our stores to not only highlight specific weekly title launches, but all recent title launches during key periods. This will reinforce with our customers that we are the destination for all things video games. We have learned that dominating market share of top titles leads to growth in other categories, including accessories and collectibles. And as we saw over the Black Friday weekend, the increased foot traffic in our stores and strong e commerce sales helped us to grow our PowerUp Rewards membership, customers who engage with us more deeply and spend the most money with us. And leading with new video game market share is critical for us as we believe it will ultimately lead to an increase in pre owned video game inventory, enabling us to broaden our customer reach and drive more traffic to our stores. In the collectibles business, we are continuing to see strong growth and great resonance with our core demographic as well as expansion into new demographics. We believe the opportunity for continued growth in this business is tremendous as we seek to leverage our expansive global footprint, including our video game stores around the world, ThinkGeek and Xyng stores and importantly our e commerce platforms. Even as we continue to execute on our business objectives in the near term, we have been working hard on shaping GameStop for the future. The sale of Spring Mobile will create tremendous optionality for us in this regard. In addition to monetizing that asset, the team along with our Board is looking hard at how we can improve and evolve all aspects of our company. Representative opportunities include identifying ways to reduce our costs further, improving our technology and data analytics capabilities, optimizing our store experience and store fleet, evaluating strategic and economic partnerships with our publishing and platform partners and evaluating our relationships with customers and the services that we offer to them. In short, we are evaluating everything. Despite our optimism about the future, we continue to face challenges in our traditional physical video game retail business model. As you'll hear from Rob, we are lowering our fiscal 2018 earnings expectations in light of these headwinds. While this is disappointing, we understand we need to adapt our business model and find additional ways to leverage our customer relationships and competitive advantages. Importantly, the team here is optimistic about the future and already hard at work. In fact, we are very excited about what lies ahead for GameStop. We have the unique and exciting opportunity to become the gaming and entertainment lifestyle brand for everybody. We can satisfy all of the gaming needs for our customers across platforms, across publishers and franchises, across physical and digital formats and across new and pre owned. In addition, we are progressing several other strategies that push us into new and different areas of gaming while evolving our current business model and capitalizing on our expertise in small format retail. As we continue to solidify and develop tactical plans to support these strategies, we look forward to sharing more details with you. With that, I'd like to turn it over to Rob for a review of the quarter and our outlook. Before doing so though, I also want to take a moment to thank our associates all over the world for everything you have done so far in executing holiday 2018 and positioning GameStop for the future. We could not do this without you. Thank you very much. Thank you, Shane. Good afternoon, everyone. I'll take this time to walk you through our Q3 results and then share with you our thoughts on the remainder of the year. As you know, we've been looking forward to the back half of twenty eighteen given the strong title lineup and the anticipation around marquee launches across several franchises. For the Q3, the October title launches drove double digit growth in software and we also delivered double digit growth in hardware, accessories, collectibles and digital. Overall for the quarter, we delivered a sales increase of nearly 5%, a strong performance across key categories that demonstrates position as the leading authority in video games. From an earnings perspective, on an adjusted basis, we delivered operating earnings that increased 16% to $94,000,000 from $80,800,000 in the Q3 of fiscal 2017. And adjusted EPS is $0.67 per diluted share compared to $0.54 per diluted share last year. I'll go into more detail shortly, but during the quarter, we incurred a 587,500,000 dollars nonoperating, noncash intangible asset impairment charge primarily related to goodwill, which was triggered by the sustained decline in the company's share price and market value. While we were pleased with our share gains in the Q3, not every title met our expected performance. And while we're also pleased with our sales performance over the Black Friday weekend and Cyber Monday, our overall Q3 and forecasted Q4 profitability is below our expectations. And as a result, we're revising our outlook for the fiscal year. I'll go into more detail about the drivers behind reducing our earnings outlook in a moment, but I want to first discuss the 3rd quarter. From a top line perspective, 3rd quarter sales increased 4.8% and our comparable store sales increased 2.1%. The increase in comp sales was driven by a stronger software lineup this quarter, including several marquee titles that released earlier in the calendar compared to last year. In the U. S, comps increased 3.4%, while international comps decreased 0.5 percent, with our domestic video game business outperforming our international video game business primarily due to stronger software performance and collectibles growth. Our Video Game Hardware business increased 12.8%, primarily due to sales growth in PlayStation 4 and Xbox 1, which was partially offset by a decrease in Nintendo Switch as we anniversary last year's launch. This represents consecutive quarters of double digit increases in hardware sales as a result of the PS4 and Xbox 1 consoles. New software sales increased 10.9% in the quarter given the launch of several highly anticipated titles. Contributors to the increase include Red Dead Redemption 2, Spider Man and the October release of Call of Duty: Black Ops 4. The PlayStation 4 platform was the primary driver behind the growth with the successful launch of the exclusive Spider Man title. Red Dead Redemption 2 was the top selling title despite only a few sales days being captured in our fiscal quarter. Black Ops 4 and the sports titles were not as successful as we had hoped. Our accessories business grew 32.6% on the strength of headsets and controllers as we continue to be a destination for high end ancillary products related primarily to the popularity of Battle Royale games such as Fortnite. Digital receipts grew 29.5% in the quarter, primarily due to strength in digital currency with a large impact from Fortnite. Our pre owned business declined 13.4% in the quarter. We continued to see declines in pre owned software reflective of fewer title launches and a decline in physical software sales earlier in 2018, which affect inventory levels, weakening demand in the face of digital adoption, including digital access to older titles and fewer promotions offered to our customers in the quarter. We experienced growth in the pre owned hardware category. Switch pre owned hardware and software grew meaningfully year over year, although Switch continues to make up a smaller portion of the overall pre owned sales. We grew the collectibles business by 11% for the quarter to $154,600,000 with growth driven by toys, including Pop! Vinyls and apparel. Moving to the Tech Brands segment, revenues were down 11.9 percent to 171,100,000 dollars primarily due to the decrease in store count, while the gross margin rate increased to 80.4% compared to 72.8% last year as a result of a higher mix of commissioned device sales. Comp store traffic declined 7.5% and comp gross margin increased 5.1%. Reported operating earnings increased from $18,000,000 last year to $23,300,000 this year. The prior year operating earnings included a one time gain of $5,700,000 related to the finalization of the Cellular World acquisition payments. On an adjusted basis, operating earnings increased by 108%. The improved operating earnings were primarily due to improvements in compensation terms, better operational execution and the closure of underperforming stores. Shifting gears to gross margins. Our gross margins declined 160 basis points for the quarter to 33.1%, primarily due to the growth in sales of lower margin categories. Gross margin as a percentage of sales increased in accessories, digital and technology brands, while margin rate declined in new hardware, new software and collectibles. For collectibles, we increased both sales and gross profit dollars. However, gross margin rate declined 70 basis points to 37.4 percent for the quarter due to the mix of products sold. Now moving to SG and A. Total SG and A in the 3rd quarter was 566 point $6,000,000 comparable to $565,100,000 last year. As a percentage of sales, SG and A decreased 130 basis points on a nearly 5% increase in sales. We reported a total company operating loss of $493,500,000 reflecting the impact of the impairment of our intangible assets compared to operating earnings of $87,600,000 last year. On an adjusted basis, operating earnings were 94 $100,000 compared to $80,800,000 last year, an increase of 13.2%. Our effective tax rate on adjusted pretax earnings was 15.7% for the quarter. During the quarter, we recorded an approximately $7,000,000 benefit related to an adjustment to our transition tax liability and other discrete items, which caused our tax rate to be abnormally low. The reported loss was $4.78 per diluted share compared to earnings of $0.59 per diluted share in the prior year. 3rd quarter adjusted earnings per diluted share excluding the impact of impairment charges were $0.67 compared to $0.54 in the prior year period. We made the following changes to our store portfolio during the quarter. We closed a net of 15 video game stores around the world as our overall portfolio remains very healthy, ending with 3,798 video game stores in the U. S. And 1940 internationally. We closed a net of 5 AT and T stores ending the quarter with 12.84 and we closed 1 Simply Mac store ending the quarter with 46. We opened 2 collectible stores in the quarter with 105. Our current average lease life remaining for our video game stores is less than 2 years, which gives us tremendous flexibility related to managing our store base. Moving to the balance sheet. We ended the quarter with $454,500,000 in cash, in line with last year. Inventory was up 11% or $204,900,000 with the increase primarily attributable to hardware, specifically Xbox One X and Nintendo Switch consoles, which had either not launched or in short supply last year. We also accelerated some purchases this year compared to prior years as a result of the earlier launch of some of the bigger titles this year and expected shortages of hardware as we get further into the holiday season. From a capital allocation perspective, the Board declared a quarterly cash dividend of $0.38 per share that's payable on December 21 to shareholders of record on December 11. Shifting to our outlook for the remainder of fiscal 2018. As I mentioned earlier, our Q3 performance was better than last year and we drove strong sales performance over Black Friday weekend and Cyber Monday. However, the overall sales and margin performance are not as strong as we had expected, and we're reducing our full year outlook given our expectation that 4th quarter sales will skew more towards hardware than initially planned given what we saw in November. Additionally, underperformance of certain new software titles, including some November launches, weakness in pre owned and recent sales promotions are all contributing to our expectation that 4th quarter earnings will be below what we anticipated coming into the back half of the year. Fiscal 2018 full year revenues continue to be forecast in the range of down 6% to down 2% with same store sales ranging from down 5% to flat. Promotions and category mix of sales are pressuring gross margin and profitability, but driving sales and store traffic. We believe that increased traffic and customer acquisition will benefit us in the long run. Our tax rate for the full year is now estimated at between 23% 24% driven by the 3rd quarter transition tax adjustments and other discrete items as well as the mix of earnings in the countries in which we operate. We now expect earnings per diluted share in the range of $2.55 to $2.75 Given our lower earnings expectations for the year, combined with the resolution and payment of flow is now estimated to be closer to $200,000,000 compared to the $300,000,000 we anticipated earlier. Capital expenditures are now estimated to be between $100,000,000 $110,000,000 As we move further into the holiday season, our stores and our associates around the world continue driving great customer service to keep us as the destination for gaming and collectibles. We remain very focused on improving our operations, gaining market share and driving profitability across our core businesses. We appreciate the support of our shareholders as we navigate our ongoing strategic review and changing video game market. I'll now turn it back over to the moderator for questions. Thank you. We'll take our first question from Curtis Nagle with Bank of America. Great. Thanks very much for taking the question. So, I guess the first one is, why are you guys, I guess not in the market in terms of buying back stock? Look, you guys have a pretty big cash position now. You're theoretically probably getting 700,000,000 sometime this quarter. I guess is there anything preventing you from buying back stock, let's say maybe the selling of spring not being completed? Yes, Curtis, this is Rob. Given that we're in the middle of a strategic review, given that we were in the discussions surrounding the sale of the AT and T business and all of those kinds of factors, obviously, we're in possession of information that would prevent us from being able to buy stock at this time. When spring is completed, are you still prevented or because you're still technically in strategic view, would you still stay out of the market? We would stay out of the market until the strategic review process is complete, at which point, we'll be able to report the results of that and that would then change our possession of material inside information. Do you have any timeline on when that could be? No. Okay. And then on my next question, just maybe walking through the puts and takes of guidance. So top line not really changed. It looks like mix is worse with used weak and hardware stronger. You'll see a little bit of upside from tax. So I guess what else is driving what looks like, I don't know, maybe a $60,000,000 or $70,000,000 take down of EBIT? Is that just on promotions? Or is there something else we should be thinking of? Well, I would say that the biggest drivers are the software performance, the pre owned performance and then to a lesser degree, the promotional activity that we had. And then as I outlined in the script, yes, the shift towards hardware and what that does to margin. Okay. Thank you very much. Thank you. We'll take our next question from Cristina Fernandez with Telsey Advisory Group. Yes. Hi, guys. It's actually Joe Feldman on. I wanted to ask, first about PowerUp Rewards. I know you guys are doing some work to revamp the membership program a little bit. I was hoping you could give a little update on that. And also, are you seeing any changes in the membership levels? Is it going up still? Is it going to come down a little bit? Maybe you could talk about that. Yes. We have a lot of activity going on, not just around PowerUp Rewards, but overall in the marketing space. And it's as we talked a lot about back in the springtime, in the June timeframe when we were on the road, it has to do with the overall customer experience in our stores, understanding customer behaviors, what our customers expect out of a shopping experience at GameStop. We've done a lot of customer segmentation studies. We've done a lot of market research. And we've got firms now that are working very hard on helping us to re envision that customer experience as we go forward. Inside of all of that activity would be an analysis of the PowerUp Rewards program and how we can drive better value for customers inside that. Overall, the program has grown this year. Got it. Thanks. And then, I wanted to ask about pre owned. Obviously, I know it was a little weaker. You did explain, I think, pretty well as to why software was down. I guess, should we think about, is it, I don't know, Q1, Q2 next year, where we should expect to turn because it's finally kind of that 6 month lag, I guess, where you'd finally start to see the games? Or is it a little sooner than that where the Well, it takes Well, it takes a while for those newer release products to come back in trade. And obviously, the phenomenon we've seen there over the last few years is that the online play has the customers holding on to the games for a longer period of time. We do expect that will continue to grow. As I mentioned, the growth there was pretty dramatic, but it is not yet a large enough part of the overall mix to make much of a difference on the rate. And we continue to see demand around the hardware side of the pre owned business. Okay. Got it. Thanks. And then, I guess, I could just sneak one more in. Just to be clear, which games were you guys surprised by? I think you called out Black Ops maybe and I thought I heard Sporting Goods or was it Madden or something that was a little weaker than normal or basketball? I'd say, as I said in the comments, Black Ops and the sports titles that launched in the August, September timeframe, were not up to our expectations, as well as a couple of November titles. Got it. Which is why the Q4 has changed. Okay. Thank you. And I'll pass it to somebody else. Good luck with the holiday season. Thank you. Thank you. We'll take our next question from Stephanie Wissink with Jefferies. Hi, this is Ashley on for Seth. Thanks for taking our question. So regarding the collectibles business and your eSports merch, we wanted to know how should we think about the growth sustainability and what about and the penetration of mix over time? So the collectibles business continues to grow for us and we're excited about the future prospects of being able to grow that business. They're not sure what you mean by the esports merch. We've done some testing with respect to some of that. But really, overall, collectibles, we think, has a long runway. It's a growing business. More of our competitors have increased their positions in that business. As we said in the past, the thing that we see that drives growth and differentiation for us is when we can get those unique and exclusive products or in the case where we don't get exclusive products, how we can be first to market for those things. Great. Thank you. And then, any feedback or initial takes from the eSport test? I'm sorry, from what? From testing the e sports in the e sports. Okay, test the e sports. Not much to report yet. Okay, great. Thank you. Thank you. We'll take our next question from Anthony Chukumba with Loop Capital Markets. Thanks for taking my question. So I had my primary I had one question and one follow-up. In terms of my primary question, I thought you said something interesting in terms of the weakness in use and that you specifically mentioned that digital access to older titles is hurting pre owned software sales growth. Is that a more recent phenomenon? Because I know if I recall historically, new sales is really tied to the inventory. In other words, if you had the inventory, you could sell it. And so I'm just wondering how recent of a phenomenon this is? We are seeing more of the impact of that in recent months. And it does have to do with how customers can get some of those older titles, the very inexpensive titles that you can get through either subscription memberships or online in a pretty heavily discounted mode. Got it. Okay. And then my just quick follow-up. I didn't know if you had any and apologies if you talked about this in the first few minutes of the call. Unfortunately, I had some technical difficulties and called in a few minutes after I had begun. But any update in terms of your CEO search? No, you did miss that and I talked about that. I mean, the search is still ongoing. We're working with a leading executive search firm, but we are unlikely to name a new CEO until the Board's review strategic review process has concluded. Okay. Apologies. I missed that. Thanks for taking my questions. Thank We'll take our next question from Ben Satcher with Macquarie. Hey guys, a few questions. So when you're looking at the strategic options, you didn't sell the whole company just to Tech Brands. Did you have offers for the whole business? Have you had any offers for the video game business and there are sticking points around valuation or other areas or just no offers yet on the video game business? And then I have a couple of follow ups. Yes. Sorry, we're not commenting on the process. So I can't really answer your questions. All right. On the CEO, when you're looking for a CEO, I mean, how do you interview anyone right now if you don't really know the outcome of the strategic review? Like what actually would you be looking for at the moment? Well, I think as I've said all along, we're looking for the best strategic leader for the business. Look, we're as part of the strategic review, we have a very clear understanding of how we see the company evolving moving forward. And so we're we are anticipating that we are going to while we not just anticipate, but we are operating the company as we need to as we move forward. So we are undertaking lots of steps as clearly the sale of Spring Mobile is the best example of some of the outcomes of that strategic review. So I think we have a pretty clear sense of how we need to evolve the company and we're going to dovetail that with the search for the new CEO in terms of his or her vision for what they think the company can and should do moving forward. But we have to continue to operate the company and move the company forward as well. Okay. And then Rob, just a couple of quick ones for you. So what titles actually underperformed in November? And on Red Dead, did that outperform your launch expectations? And how is it doing post launch? We're very pleased with Red Dead. So that wasn't one of the ones. Obviously, you can see in the market what the Metacritic scores are around fallout and that's impacted its sell through. I'll probably just leave it at that. Okay. And just last one, can you remind me the difference between margins for used hardware and versus new hardware? They're within a handful of points of each other, very close. Thanks. Thank you. At this time, there are no further questions in the queue. I would like to turn the call over back to Interim CEO, Shane Kim for closing remarks. I'd like to thank everybody again for your time today and we look forward to continuing to update you on our progress in the future. Thank you very much. Thank you. Ladies and gentlemen, this concludes today's teleconference. You may now disconnect.