Before You Play Bottom-Feeder With GameStop

This is when the game gets hard.

Shares of GameStop (NYSE: GME  ) opened 12% lower this morning, after the video-game retailer spooked investors with less-than-stellar guidance for the current quarter. If you can get past that, the rest of the year should get better, but Mr. Market doesn't have any cheat codes to get that far.

The company's first-quarter results were in line with expectations. Earnings rose 13%, to $0.42 a share, or $0.43 a share before costs related to retiring $50 million of the company's senior notes. Sales were up 9% to $1.98 billion, as expansion helped offset a 1.5% drop in comps. Analysts were targeting $0.42 a share in profits on $2 billion in sales, so they pretty much nailed GameStop's results for a change.

The eye-squinting moment comes with the company's second-quarter outlook. Comps are projected to fall a thunderous 8% to 11%. Earnings are projected at $0.28 to $0.33 a share, short of both the $0.34 a share GameStop earned a year ago and the $0.40 a share that Wall Street was expecting.

GameStop has bucked the retail malaise until now, delivering healthy comps, with the sale and resale of video games thriving in this crummy climate. It's the resales that have really been rocking, with sales of used games and gear growing 31.9% in the quarter and offsetting a 2.8% decrease in new software sales.

Unfortunately for GameStop, its success in buying back used wares and reselling them at juicier profit margins than new games is no longer a monopoly. Amazon.com (Nasdaq: AMZN  ) , Toys "R" Us, Best Buy (NYSE: BBY  ) , and third-party kiosks in some Wal-Mart (NYSE: WMT  ) locations are now angling for that lucrative market, with new initiatives since March.

GameStop isn't worried, but it should be. It is clinging to a strong recovery in the second half of the year. Its management sees flat to slightly positive same-store sales for all of fiscal 2009, but that's hard to swallow after comps fell during the first quarter and might fall even more during the current quarter. GameStop is sticking to its full-year guidance, calling for 18% to 22% in bottom-line growth. The problem there is that earnings growth for the first half of the year will come in flat to up just 4%, according to GameStop's own metrics.

Sure, GameStop was coming up against some fierce same-store-sales comparisons with the first half of fiscal 2008 because of monster hits such as Super Smash Bros. Brawl and Take-Two Interactive's (Nasdaq: TTWO  ) Grand Theft Auto IV. And the second half of the year offers a favorable pipeline, but I'm not convinced.

  • Can console makers offer deeper price cuts to reinvigorate interest in their systems?
  • If it has to offer trade-in customers more for their games and/or charge less for its used inventory, won't the emergence of resale competition squeeze margins at GameStop?
  • At what point will the evolution toward digital delivery of games cut out the middlemen specialty retailers?

If you buy GameStop's rosy second-half thesis, you can buy GameStop today at a huge bargain. It is trading at a single-digit earnings multiple, based on the $2.83 a share to $2.93 a share it expects to earn this year. However, I've been concerned about the chain's prospects since last year, when things were still going well. My skepticism isn't about to fade now that things are coming undone, even if the stock is trading substantially lower.

For more Foolishness:

GameStop, Amazon.com, and Best Buy are Motley Fool Stock Advisor picks. Take-Two Interactive is a Rule Breakers selection. Best Buy and Wal-Mart are Inside Value selections, and the Fool owns shares of Best Buy. Try any of our Foolish newsletters today, free for 30 days.

Longtime Fool contributor Rick Munarriz loves playing video games but he doesn't own shares in any of the companies mentioned in this story. He is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 21, 2009, at 4:02 PM, SteveTheInvestor wrote:

    Two words.... no moat. If GameStop's business becomes profitable enough, The Walmarts of the world will chew them up and spit them out. Gamestop can make money as long they don't make too much and attract the big boys. I view it as a trading stock.

  • Report this Comment On May 21, 2009, at 4:09 PM, EggplantWizard wrote:

    I'm doing a short gamestop long consumer electronic discretionary basket play, intending to short gamestop to zero (or until I get a margin call because someone sells the shares I'm borrowing)

    This has worked out well for the last couple of days -- I expect the trend to continue.

  • Report this Comment On May 21, 2009, at 8:31 PM, SekouMurphy wrote:

    @SteveTheInvestor,

    People said the EXACT same thing about Netflix, when Wal-Mart introduced rental DVDs and there was that Amazon would do the same. The moat? Netflix has both expertise and infrastructure that was not properly appreciated. That's why Wal-Mart bailed out of the rental DVD game.

    In this way, the used video game model is the exact same. Wal-Mart is simply NOT set up for used video games...no expertise and infrastructure for inventory management and pricing.

    I'm much more concerned with new sales. Used games is a finicky business, so not everyone can jump in and make a profit.

  • Report this Comment On May 21, 2009, at 8:32 PM, SekouMurphy wrote:

    1

  • Report this Comment On May 21, 2009, at 9:02 PM, Knifecatcher1 wrote:

    "No moat". Well, slim, anyway.

    Don't misunderestimate (favorite term) walmart. I'm not personally a fan of the company that spreads like fungus, but: they operate the most sophisticated logistics system in the retail world. If they determine it's worth it to them, they'll be able to handle inventory management and pricing.

  • Report this Comment On May 22, 2009, at 1:22 AM, Har1en wrote:

    I believe that the Netflix comparison is apt. GME's moat is in the personnel in their store. You've got to be kidding me if you think any other retailer will attract the right kind of sales staff, other than perhaps Best Buy. Go into a Gamestop. Ask questions about games. You will see why they are tops at what they do. Walmart won't be able to copy, their culture is not right for it.

    I also believe that Rick is wrong about the reason why GME predicts a better 2nd half. From things I read not in his article, it looks like they're expecting further price reductions for the consoles based on hints in the sales plans from the makers. This bodes well for true mass market adoption.

    The PS3 particularly could use a price cut. Apparently, the $200 level is important and the Xbox already has an entry level box there. I also believe this will drive traffic to their store when (note I say WHEN) it happens. It will happen eventually, because that is what happens in consumer electronics.

    This is why it is foolish to buy equipment manufacturers (except perhaps a marketing juggernaut like Apple). On the other hand, GME takes a cut off the top and has no skin in the game from a production standpoint. They just buy and sell games, and that's where all the profit is. I respect Rick's views, but I think GME is nearing a bottom.

  • Report this Comment On May 22, 2009, at 9:27 AM, SekouMurphy wrote:

    One quick follow up...

    The customer base of GameStop v Wal-Mart and others tends to be a little different. GME has more hard core gamers, while WMT is more casual.

    Intuitively, I would think casual gamers would NOT be as apt to trade-in games. I also think that there's a recessionary reason to trade in games and there's a functional reason (b/c you're tired of the existing game and want something new). I would think that casual gamers would have more recessionary reasons than functional, and thus trade in games for non-games (like paper towels), which are offered by AMZN and WMT.

    There's also a regulatory component to trading games. I went into a GameStop and chatted with the sales clerk. She told me that GME does run a customer through the police database. I don't know how AMZN (via norAm International) or WMT (via ePlay) will do it, but I'm curious how they will balance customer satisfaction (immediacy) with regulatory requirements given their put it in the mail (versus in-store) model.

    I wrote a blog about it http://phrenzie.com/2009/05/04/gamestop-v-amazon-bestbuy-toy...

    PLEASE let me know how on (or off) point I am on how to think about this.

  • Report this Comment On May 31, 2009, at 2:18 PM, avgwhiteman wrote:

    Running my name through a police database? What if I pay cash? Do they also profit from taking in criminals and selling them to the police for reward money? America's Most Wanted? Do they kick convicted pedophiles out of the store? LOL

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