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This article is part of our Rising Star Portfolios series.
With my Messed-Up Expectations portfolio, my goal is to beat the market by buying good companies when the market undervalues their future prospects and selling when the market overvalues that potential. My edge lies in recognizing these situations generated by fear, disfavor, euphoria, or other messed-up expectations. One example of this is my purchases of video game retailer GameStop (NYSE: GME), which I've purchased twice: once at about $20 per share and again at about $26 per share.
Today, I believe two reasons are still causing some messed-up expectations and that this situation is still holding GameStop's shares below where they should be trading.
"The report of my death was an exaggeration."
Mark Twain had to set the record straight. For the gaming industry, that hasn't happened yet.
A closely watched report by Wall Street is NPD Group's analysis of video game sales. As recently reported by The Wall Street Journal, December's retail sales as measured by NPD fell 21% from the previous year. Calamity for industry players like GameStop, you'd think. Yet it's been pointed out, even by NPD, that the reported numbers are inaccurate because it misses digital sales, which generally don't flow through traditional retail channels.
For instance, Electronic Arts' (Nasdaq: ERTS) Star Wars: The Old Republic sold 600,000 copies in December according to NPD. However, EA reports there are over a million players, each of which has to have a copy to play. The difference, presumably, were sold through digital download sites such as EA's Origin.
In other words, predictions about the gaming industry's demise based on declining retail sales are overblown, especially when those predictions appear to be based on incomplete data.
"No, Mr. Bond. I expect you to die."
The other point to consider is what digital downloads are supposed to do to traditional retailers like GameStop: Kill them. Yet GameStop, like James Bond, has refused to die.
Instead, GameStop is embracing the digital revolution in several ways. First is its member rewards program, PowerUp. This grew from about 4.5 million people during the 2010 holiday season to 15.5 million this past season. Members account for 60% of the company's transactions and the program represents over 30% of all video game consumption in the U.S. GameStop is using PowerUp to cross-sell digital content with physical games, help guide its decisions on closing stores, and to microtarget promotions to individual members based on their tracked gaming preferences.
Second, it's in the digital space already with its downloading site, Impulse, its casual gaming site, Kongregate, and its cloud gaming subsidiary, Spawn Labs, which will soon be in advanced beta testing. Its digital business was up 59% in the last quarter, up 69% the quarter before that, and is expected to bring in more than $450 million in revenue this year.
Third, it has the support of publishers and console makers in its digital endeavors. For example, President Tony Bartel said in the third-quarter's conference call, "In the case of Call of Duty: Modern Warfare 3, we worked closely with Activision [Blizzard] (Nasdaq: ATVI), Sony (NYSE: SNE), and Microsoft (Nasdaq: MSFT) to pre-order and deliver nearly 600,000 instances of the Modern Warfare 3 Elite" downloadable content. These relationships help all four of the companies involved deliver more content more efficiently. It's truly a win-win for all parties.
"You miss 100% of the shots you never take."
Take these two expectations and you've got a company that many believe is in trouble. The current price reflects that. Based on last night's close of $24.76 per share and using trailing-12-month free cash flow of $703 million, my model says that the market is expecting GameStop will actually shrink FCF over the next 10 years before flatlining (using my usual 15% hurdle rate to discount).
If, however, GameStop manages to execute its new initiatives well and manages to hold FCF steady going forward, I model a $34 share price. And if it actually manages to grow FCF year over year -- which it has for the past three TTM periods and nine of the last 12 -- shares would be worth even more.
As Wayne Gretzky implied, letting market pessimism hold you back is not a winning strategy. Tomorrow, the Messed-Up Expectation portfolio will add to its GameStop holdings.
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This article is part of our Rising Star Portfolios 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).