CAPS' Weekly Top Stock Idea

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Company

GameStop (NYSE: GME  )

Submitted by

mghaynes1

Member Rating

90.57

Submitted on

5/8/2010

Stock Price at Recommendation

$24.40

GameStop profile

Star Rating

***

Headquarters

Grapevine, Texas

Industry

Electronics Retail

Market Cap

$3.4 billion

Cash / Debt

$431.9 million / $447.6 million

P/E

9.8

Management

CEO J. Paul Raines (since June 2010)
CFO Robert A. Lloyd (since June 2010)

Sources: Capital IQ (a division of Standard & Poor's), Yahoo! Finance, and Motley Fool CAPS.

This Week's Pitch
GME sells new and used games, software, and accessories. Their hook is the used game trade-ins. You go in to trade a game and leave the store with some combination of new games, accessories, or other used games. GME is the clear leader in used video game sales, and they also focus on providing a "gamer" environment in their stores. Other, bigger competitors have tried to enter the used game space with no success. GME has a small moat. It generates tons of free cash flow. I calculate about $550M free cash flow last year with total capital at $2.65B. This is a cash yield of over 20%! So, it [raises] the question, why is GME selling so cheaply? The culprit is everyone's favorite business killer, the internet.

I have counted five ways the Internet threatens GME:

1. Direct download of entire games to consoles
2. Downloadable content for video gamers (mainly in the form of add-ons)
3. On-line gaming (i.e., World of Warcraft, etc.)
4. Next-generation gaming systems (i.e. Onlive)
5. Increasing use of mobile devices for gaming (i.e., iPhone, etc.)

Let's consider each on its merits.

1. Direct download of games. This is the biggest threat to GME. The typical (and faulty) analogy commonly used is Netflix (Nasdaq: NFLX  ) vs Blockbuster (Nasdaq: BBI  ) . This analogy is incorrect because Netflix derives its income from actually sending you shiny little discs through the mail. Its streaming feature (roughly equivalent to direct download) is a value-added service. Ironically, it is the very fact that Netflix has thrived despite the availability of video on-demand services from your cable or satellite provide that augers well for GME.

In the video game market, direct download suffers from two additional handicaps. First, games are getting bigger and bigger, and there is limited storage capacity on the console hard drives. 100 GB seems like a lot until you start storing movies, videos, pictures, and video games. Sure, hard drives can keep getting bigger, but so will the games and the stuff we want to store. Likewise, bandwith is limited. Why wait five hours to download a game when I can go to the conveniently located GameStop down the street and buy the new game and start playing all in about 45 minutes or less. 

The obvious argument is Moore's law. Bandwith will increase. There are plans to create 1 gbps download times, etc. I won't argue with Moore's law. But I remember when we thought 56kbps was blazing fast. As a result, we wanted our stuff to do more. And then 128 kbps was blazing fast. And we wanted more stuff. The same holds true with hard drives and processing power. While they all increase over time, so do our demands. I'm sure in 20 years, a typical game will be a terrabyte in size, and we will all bemoan the glitchy, 1-gbps bandwith that the average person can afford.

Finally, I submit there is no rush to seriously upgrade our internet infrastructure. Personally, I think the average person is actually fine with current upload and download speeds. Mostly we surf websites, stream applications, and download music. Current bandwith is capable of handling these activities. I would not be surprised if major upgrades in infrastructure don't occur until 2015-2020.

I don't want to imply all is rosy. Downloadable games could very well signal the end of GME just as downloadable music did to music stores. But, it is a threat that I believe is 10 years distant at a minimum. Count on inertia. America, the No. 1 buyer of video games, is now the No. 22 country in terms of average broadband speeds. And the games we play aren't getting any smaller.

GME is attempting to stay relevant through its website where you can download PC games. However, this is obviously an insignificant [contributor] to revenues. Quite frankly, if or when the predominate form of acquiring games comes from download, GME is doomed.

2. Downloadable add-on content for games. This is basically the same threat as downloadable games. GME is now selling DLC [activation] codes from its stores. Again, if people switch wholesale to downloadable content, GME is doomed.

3. On-line gaming is nothing new. It's already factored into the equation. These games tend to be far more popular in other countries than [in] the U.S. for whatever reason. GME is attempting to jump into this market via its acquisition of Jolt. While it will be interesting to see what happens with the venture, I don't expect it to contribute significantly to GME. This does not fit into their core concept.

4. Onlive is interesting. However, it will suffer from typical network issues, which means most gamers will consider it as an add-on service, not a replacement service. In the long run, this is possibly the appropriate Netflix analogy (i.e., unlimited choice for a flat fee).

5. Mobile apps basically cut into the market share held by portable devices such as PSP and DX. An increase in the use of such [devices] will/does hurt GME revenues to some extent, but the mobile devices are a much smaller percentage of GME sales. The hard-core gamer is still playing Playstation, X-Box, and Wii.

So, I believe GME is an undervalued company that has at least five years of steady revenue left in front of it. If or when the switch to [downloadable] comes it will be a gradual decline as legacy systems remain in place. So, another five years of declining revenue (hey, I'm still buying games for my PS2). And, even with the switch, it is not clear that GME won't still have a market. Even with Netflix and Streaming Video, DVDs are still brought and sold. I would expect a similar market in games even after the switch (albeit a vastly smaller market).

I analyzed GME using two different cases. The first case assumes that GME continues along as it has been. In this case, I value GME at $45-$50. The second case assumes free cash flow increase slows down gradually for the next five years before turning negative years five to 10. In this case, I value GME at $35-$40. In either case, in my mind, the stock is undervalued between 25%-50%. With the added, speculative possibility of a buyout, I rate GME a solid buy.

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The Motley Fool is investors writing for investors. The Motley Fool staff involved in choosing the top pick did not have a position in any of the companies mentioned in this article. Pitches must be compelling, made in the past 30 days, and be at least 400 words. Netflix is a Motley Fool Stock Advisor recommendation. Motley Fool Options has recommended writing covered calls on GameStop. The Motley Fool has a disclosure policy.


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