GameStop Purchases Its Shares Again. Should You?

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I last asked this question in September, when GameStop (NYSE: GME  ) announced that it would allocate $300 million toward buybacks, plus another $200 million to repurchase senior notes. That's on top of the $300 million buyback announced in January 2010. On Friday, the company announced that its board authorized yet another $500 million share- and debt-repurchasing program, replacing September's $300 million plan, which still had $138.4 million left to spend.

Few investors may be fans of GameStop, given its high short interest. But as my Foolish colleague and noted GameStop bear Rick Munarriz said, the company certainly has a fan in itself.

Predictions of the brick-and-mortar game seller's imminent demise sound familiar by now. Admittedly, the company faces much tougher sledding ahead, and I don't consider myself a raging GameStop bull, either. But the company is cheap, and it has an improving balance sheet and a savvy bench, which I believe prove that the company's ready to take on the digital storm now enveloping the industry.

The storm
If Electronic Arts' (Nasdaq: ERTS  ) recent quarterly report is any indication, this storm is gaining momentum fast. The company's recently reported third-quarter spotlighted a 47% increase in digital sales, while sales of physical games dropped 9%. In addition, EA eliminated any distribution deals it had for other game makers' products.

Competitors and important suppliers for GameStop are also reporting large revenue increases in digitally distributed games. Activision Blizzard (Nasdaq: ATVI  ) is now generating about 50% of its revenue from digital sales, and just about the only positive investors could take from THQ's (Nasdaq: THQI  ) quarterly report last week was management's claim that its revenue from digital distribution will double in its next fiscal year.

While digital gaming is certainly on the rise, let's not forget that GameStop is still a leader in the physical gaming space. While that space may continue to lose share to digital over time, it's not going away overnight. In particular, GameStop is the cream of the crop when it comes to reselling higher-margin used games. The likes of Best Buy (NYSE: BBY  ) and Wal-Mart (NYSE: WMT  ) have challenged its niche as the leading game reseller with little success.

Broadband speed is still a significant issue for the gaming experience, and gamers are unlikely to buy popular games from, or play them via, any digital system that's slow and difficult to use. This is less of problem for the digital delivery of movies, where brief pauses in action won't ruin a game or score. GameStop's core business will serve as an important buffer as the company further develops its digital strategy. It's also a strong brand with a loyal following of gamers from which to continue to develop its digital initiatives, as well as its online gaming hub Kongregate. Ideally, management can transform its physical distribution business in the same way that Netflix (Nasdaq: NFLX  ) is moving away from the red envelopes. Its strong brand will help, but GameStop will also have to create value as a gaming hub, enticing game makers to distribute their content through its online gaming shop.

Better use of cash?
Many have criticized the company's seemingly excessive share and debt repurchases during the last year. I don't disagree that some of this money could have been funneled into greater development of GameStop's digital platform. However, the company has successfully managed its balance sheet, drawing down its debt from $976 million in January 2006 to $249 million today.

GameStop's abundant free cash flow has helped the company clean up its balance sheet and reward shareholders through buybacks. That's quite remarkable for any retailer, let alone one in this space. GameStop boasts a free cash flow margin or "cash king margin" of 4.8% over the last year. In contrast, Best Buy and Wal-Mart sport margins of only 2.8% and 3.2%, respectively.

GameStop certainly faces significant headwinds as it attempts to beef up its digital distribution business to accommodate the changing industry landscape.  However, the company has a great opportunity to leverage its brand name as it transitions to this new business model. GameStop is still generating a lot of cash; it has a clean balance sheet, and its cheap shares have priced in a lot of potential downside. This isn't a stock on the top of my wish list, but it's nonetheless priced like it might never grow again. The business is changing, but so is GameStop.

Andrew Bond owns no shares in the companies listed. Best Buy and Wal-Mart are Motley Fool Inside Value recommendations. Wal-Mart is a Motley Fool Global Gains pick. Activision Blizzard and Best Buy are Motley Fool Stock Advisor picks. Motley Fool Options has recommended a synthetic long position on Activision Blizzard. Motley Fool Options has recommended writing covered calls on GameStop. The Fool owns shares of Activision Blizzard, Best Buy, GameStop and Wal-Mart. You can follow Andrew on Twitter @Bond0 or on his RSS feed. Try any of our Foolish newsletter services free for 30 days. The Fool has a disclosure policy.

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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 February 07, 2011, at 9:32 PM, Humanwrites wrote:

    While the company might be buying back some of their shares, the insiders are dumping like the doors are going to be closed next week. Over three million dollars worth sold just one day before the announced new buyback plans. Hmmm...

  • Report this Comment On February 07, 2011, at 9:46 PM, Humanwrites wrote:

    Correction to above comment:

    Make that "thirty" million dollars sold.

  • Report this Comment On February 08, 2011, at 7:00 AM, BioBat wrote:

    Gamestop's brand name? Seriously? I understand they're the place to go to for games but that's because they're the only place to go for games, much like Blockbuster (for a long time) was the only place to go for movies.

    Everytime I can avoid Gamestop, I do. I can't stand the snot nosed brats working at most of the stores who think because they work at "Gamestop" know everything there is to know about the gaming world and treat customers like they're stupid if they ask a question. That's Gamestop's brand right there.

    All I've read from MF over the past two years was how they were beaten down by the economy and turning around and doing everything right. That's fine but they've dropped 40% in that time and look to have a bare bones positioning for the digital transition. They're doing something but they're late to the game. Terrible business to invest in until they start shutting down a lot of stores and really show they can compete with other digital retailers.

  • Report this Comment On February 09, 2011, at 11:05 AM, georgetag wrote:

    I hate them kids too!

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