Rising Star Buy: Game On for GameStop

This article is part of our Rising Star portfolio series.

Last November, I purchased an initial, small position in GameStop (NYSE: GME  ) for my Messed-Up Expectations portfolio. At the time, I pointed out two concerns. First was Best Buy (NYSE: BBY  ) and others entering the preowned game market, putting pressure on one of GameStop's revenue streams. Second was deteriorating margins at GameStop.

Over the two quarters since I purchased those shares, I feel that GameStop has shown that it's moving in the right direction to increase sales and margins, and to fend off what competition there is from Best Buy and others.

Loyalty programs can be good for business
Last October, GameStop expanded its loyalty program, PowerUp Rewards, nationwide. Since then, it's grown to have 10 million members. GameStop is learning more about its customers -- they "shop in a lot more locations than we thought ... [and] they are far more hybrid than we thought," shopping at several different store locations, online, and buy both physical and digital products, as CEO Paul Raines noted in last quarter's earnings conference call.

That knowledge is letting GameStop track its customers, noting what they buy, and offering small promotions targeted specifically to individual customers, driving sales.

The program really drives sales, too. Members of PowerUp Rewards tend to spend three times as much as nonmembers, and they spent $65 more per person in the holiday shopping month of December than nonmembers. Management is very focused on growing the program and exploring how it can benefit both members and the company.

It's "preowned," not "used"
The preowned market is a big part of GameStop's business -- generating 45% of the company's profit in 2010. This last quarter, preowned sales grew by 9.5%, helped by the loyalty program with members purchasing a higher mix of preowned products than nonmembers.

Part of what's driving this increase is digital content. Customers are buying a preowned game and then downloading digital content that enhances it.

GameStop is integrating its preowned business with its growing digital business -- which itself enjoyed 53% growth in sales last quarter -- and using PowerUp Rewards to drive both. Making purchasing and enjoying games convenient for the customer, in my opinion, increases the competitive advantage of its preowned business and GameStop as a whole.

Checking in with Best Buy and its preowned business, CEO Brian Dunn said in its first-quarter conference call earlier this month, "Trade-ins and preowned sales are still relatively new, but we are making good progress." Best Buy's efforts may be relatively new, but it began testing the idea nearly six years ago. Not exactly the execution speed one would expect from a serious competitor.

Another sign of improvement
The growth of PowerUp Rewards and GameStop's digital business is bearing fruit for the company. Year-over-year revenue growth has increased, and both operating and net income have changed from shrinking to growing again, as the table below illustrates.

TTM Period Ending

Revenue Growth

Operating Income Growth

Net Income Growth

July 31, 2010 3.7% (5.6%) (1.1%)
Oct. 30, 2010 2.9% (3.5%) (1.9%)
Jan. 29, 2011 4.4% 4.0% 8.1%
April 30, 2011 5.4% 5.7% 8.1%

Source: Capital IQ, a division of Standard & Poor's; TTM = trailing 12 months.

Not out of the woods
Not all is rosy for GameStop yet, however. Electronic Arts (Nasdaq: ERTS  ) recently announced that it will launch a digital download service for its own games, which would in principle let it bypass GameStop. Activision Blizzard (Nasdaq: ATVI  ) is also growing its own online presence with the Battle.net service. However, being an aggregator of content is a great business model, as Netflix is proving, giving customers a single place to go to in order to purchase their gaming needs.

In addition, while same-store sales growth (comps) was good for GameStop at its U.S. stores -- 9.1%, a fifth straight quarter of positive comps -- international locations experienced negative 4% comps last quarter. This is a point of worry, but if the world economy continues to recover, as I expect, this problem should diminish over time.

Today's move
Despite those concerns, I believe that GameStop is turning a corner and will improve from here. The market isn't convinced, however, as priced-in expectations for free cash flow growth are only 1.7% a year for five years before flat-lining forever after that (using my usual 15% hurdle rate to discount). If GameStop can actually manage to grow FCF at the same rate that analysts are expecting net income to grow over the next five years -- 7% -- and then half that for another five before flat-lining, then a share price of $34 would be expected, instead of the current $26 price.

Tomorrow, the MUE port will increase its position in GameStop by another 2% of initial funds, about $340. This will put GameStop into the "middle" tier of confidence, a place I believe it's earned by the improvements show over the past two quarters.

After you add GameStop to My Watchlist by clicking here, come discuss the decision on my Messed-Up Expectations discussion board or follow me on Twitter.

This article is part of our Rising Star portfolio series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios).

Fool analyst Jim Mueller owns shares of Netflix and Activision Blizzard, and has an option position on both. He's an analyst for the Motley Fool Stock Advisor newsletter service.

The Motley Fool owns shares of Activision Blizzard, GameStop, and Best Buy. Motley Fool newsletter services have recommended buying shares of Netflix, Best Buy, and Activision Blizzard, creating a synthetic long position in Activision, writing covered calls in GameStop, and buying puts in Netflix. Motley Fool newsletter services formerly recommended Best Buy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool's disclosure policy is never messed up.


Read/Post Comments (3) | Recommend This Article (7)

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  • Report this Comment On June 28, 2011, at 8:23 PM, caballote77 wrote:

    I thought about GME also, BUT i'm afraid Best Buy, Amazon will heavily discount games this coming holiday season and really hurt GME.

    The future for GME does NOT look bright. Rumor is the next xbox will be announced in 2012... My belief is that next generation consoles will have cloud computing capabilities and GME will become blockbuster at some point.

    Everyone (except retailers) will make more money by eliminating the traditional store distribution system.

    I'm thinking (at the right time), GME will be an amazing short.

  • Report this Comment On June 29, 2011, at 7:34 AM, dbtheonly wrote:

    Please don't forget the rather serious problem of "bootlegged" games.

  • Report this Comment On June 29, 2011, at 3:06 PM, MonkeyFish912 wrote:

    No, forget the small problem of "bootlegged" games. It is not widespread, and companies want to inflate the number of sales they lose due to pirates. In reality, the pirates are broke or didn't want the game enough to pay for it in the first place.

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