Is GameStop Destined for Greatness?

Investors love stocks that consistently beat the Street without getting ahead of their fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with robust and improving financial metrics that support strong price growth. Does GameStop (NYSE: GME  ) fit the bill? Let's look at what its recent results tell us about its potential for future gains.

What we're looking for
The graphs you're about to see tell GameStop's story, and we'll be grading the quality of that story in several ways:

  • Growth: Are profits, margins, and free cash flow all increasing?
  • Valuation: Is share price growing in line with earnings per share?
  • Opportunities: Is return on equity increasing while debt to equity declines?
  • Dividends: Are dividends consistently growing in a sustainable way?

What the numbers tell you
Now, let's take a look at GameStop's key statistics:

GME Total Return Price Chart

GME Total Return Price data by YCharts

Passing Criteria

3-Year* Change

Grade

Revenue growth > 30%

(7.1%)

Fail

Improving profit margin

(183.6%)

Fail

Free cash flow growth > Net income growth

(18.4%) vs. (177.7%)

Pass

Improving EPS

(200.7%)

Fail

Stock growth (+ 15%) < EPS growth

189.7% vs. (200.7%)

Fail

Source: YCharts.
*Period begins at end of Q2 2010.

GME Return on Equity Chart

GME Return on Equity data by YCharts

Passing Criteria

3-Year* Change

Grade

Improving return on equity

(188.4%)

Fail

Declining debt to equity

(86.3%)

Pass

Dividend growth > 25%

Initiated in 2012

Pass

Free cash flow payout ratio < 50%

35.6%

Pass

Source: YCharts.
*Period begins at end of Q2 2010.

How we got here and where we're going
GameStop doesn't come through with flying colors, as it earned four out of nine possible passing grades, and two of those passing grades were granted on the track record of a recently initiated dividend. Over the past two years, GameStop's free cash flow has weakened, but hardly to the degree as its net income, which had been falling away from free cash flow even before its crash in 2012. Despite this weakness, GameStop's shareholders have enjoyed significant gains, nearly all of which have come in the past 12 months. How might GameStop sustain this rebound? Let's dig a little deeper to find out.

My fellow Fool Sean Williams notes that GameStop has been looking to leverage the hotly anticipated next-gen consoles from Microsoft (NASDAQ: MSFT  )  and Sony (NYSE: SNE  ) , which are expected to launch in November. However, GameStop might have to confront several difficulties in the used games market, which has been roiled by proposals to restrict game licenses to the original purchaser. The two console makers have since backed off of this strategy, but over the long run, a shift to digital gaming will destroy GameStop's bricks-and mortar used-game retailers, since there's really no need to go to a store when everything is contained in the cloud. It's worth mentioning that GameStop made more than 21% of its total revenue from used games last year. GameStop's reliance on used games pose a potential threat on its growth prospects, regardless of console resale policies.

However, GameStop's new-game segment has a few rays of sunshine to look forward to. My Foolish colleague Rick Munarriz notes that the launch of a few major new games could boost GameStop's sales growth in the next few quarters. Activision Blizzard's (NASDAQ: ATVI  ) newest shooter, Call of Duty: Ghosts, will hit stores alongside the new consoles, and if the series continues its trend of record-breaking sales, it could produce notable results on GameStop's fourth-quarter earnings. Take-Two Interactive's (NASDAQ: TTWO  ) long-awaited Grand Theft Auto V will also hit the shelves any day now, and that's another record-breaking series to pad GameStop's bottom line.

GameStop has also seen an overwhelming response for upcoming gaming consoles. The company reported one million pre-orders for Sony's PS4, while Microsoft's Xbox One preorders totaled 700,000 at last count. Fool contributor Demitrios Kalogeropoulos notes that GameStop has diversified into new business areas (digital sales and electronics device resale) as its traditional business has been in continuous decline over the past few quarters. The company now accepts trade-ins of smartphones and tablets to resell them as pre-owned merchandise to customers. GameStop's mobile sales revenue has soared by almost 300% in the latest quarter, while digital sales were up 47% for the same period. GameStop's acquisition of Kongregate, an online gaming portal, has brought intriguing new opportunities for GameStop to capitalize on growing potential in the digital space.

Putting the pieces together
Today, GameStop has some of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.

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