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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
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.
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.
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