GameStop Just Won’t Quit

Don't write off the console video gaming sector just yet. After tanking by more than 30% in the first half of the year, shares of GameStop (GME 6.16%) have been given new life. They even pulled ahead of the market this week, bringing the year-to-date return to about 12%.

Since hitting a low in July, shares are up by almost 70%. That is a remarkable sprint for a retailer that hasn't seen quarterly sales growth in almost two years.

Why are investors suddenly so game to own this stock? And, more important, is the new optimism warranted?

The early rounds
After all, GameStop's business is under siege from just about every angle. For one, casual gaming is here to stay. Apple (AAPL -0.35%) has paid out more than $6 billion in royalties to iOS app developers as it floods the market with tablets and iPhones that are as much about entertainment as anything else. And Google's (GOOGL 10.22%) Android store is humming along too, powered by more than 1 million daily activations of Android devices. This surge in mobile electronics has stuffed gaming devices into people's pockets, drawing attention from their TVs -- where GameStop's business is still centered.

Next, the rise in digital downloading is hacking away at the company's addressable market too. According to industry watcher NPD, spending on digital content was $1.4 billion last quarter, well ahead of the $1.07 billion spent on physical gaming purchases. And digital spending remains one of the industry's bright spots, growing by more than 20% in the third quarter. That's more bad news for GameStop, as the more game shopping moves online, the less traffic the company will see in its stores.

And finally, there's the slowdown in console innovation that has really hurt GameStop's sales. Video game sales are driven by innovation in both the hardware and the software. And the major players just haven't upgraded their hardware in years. Sony's and Microsoft's (MSFT 1.82%) consoles are more than seven years into their life cycles, and Nintendo finally got around to refreshing its hardware last month, after an even longer break.

These factors combined to send GameStop's sales plunging. Here's a look at the company's comparable sales since it last reported growth by this metric in the first quarter of 2011.

Source: GameStop financial filings.

Hitting Restart
But things are starting to look brighter for this specialty retailer. New video game releases this month were met with healthy demand, showing that console gaming can still be an entertainment powerhouse. Microsoft's latest installment of the Halo franchise had a better rollout than any of its predecessors. And Activision Blizzard's (NASDAQ: ATVI) new Call of Duty game reached over $1 billion in revenue in just its first 15 days. That's more revenue than even the blockbuster movie Avatar could notch in that amount of time.

And it's not just software that's flying off the shelves this holiday season. Nintendo's new Wii U system had a solid holiday launch, moving more than 400,000 units. And Microsoft's Xbox 360 was no slouch either. The company sold over 750,000 consoles over the Black Friday week. Even GameStop's digital business is seeing encouraging traction, up nearly 50% to $454 million. As the leading specialty retailer in the video game space, GameStop is well situated to capture the benefits from any recovery in the industry.

Looking ahead
All of that good news adds weight to the company's cautious projection that this quarter could spell the end to its declining sales. And that's probably sparked more interest in the stock. But it's just as likely that the rally in shares is a consequence of the ridiculously low valuation GameStop was trading at earlier in the year. Despite it having no debt and producing annual free cash flow of almost $500 million, investors were valuing the company at less than nine times earnings this past summer.

Still, GameStop has gotten more expensive since then. You can't snap shares up at less than 0.25 times sales anymore. But the stock is still yielding almost 4%. And the company remains an aggressive buyer of its own shares, passing the $1 billion mark in buybacks in the third quarter. With a strong commitment to keep returning cash to shareholders and an industry that's finally showing signs of life, GameStop isn't done yet.