GameStop: This Game Isn’t Worth Playing

GameStop faces strong competition from the likes of Amazon.com, Wal-Mart, and Target, along with new entrants such as app makers.

Apr 12, 2014 at 11:00AM

GameStop (NYSE:GME)has not been a growth story for quite a while. It used to attract hordes of customers, and did not need a new video game cycle since it minted cash by buying and selling used games. However, it now faces stiff competition that includes Amazon.com (NASDAQ: AMZN), Wal-Mart (NYSE: WMT), and Target (NYSE: TGT). In addition, there is an ever-increasing amount of offerings from digital companies that allow consumers the ability to download apps on mobile devices.

Can the company return to its glory days, or is time no longer on this retailer's side? 

Top line growth leaves much to be desired
GameStop's sales for fiscal year 2013 rose 1.7% to $9.04 billion. However, the retailer's domestic store count fell about 4%, and 2012 had an extra week due to the nature of the retail calendar. Comparable-store sales, which remove these factors, rose 3.8%. Worldwide, the company owned 6,675 stores as of February 1, 145 fewer stores than it had in the year-ago period.

This seems like a respectable performance. Nonetheless, this performance stemmed from the launch of new video game systems, an event that does not happen every year. Both the Xbox One from Microsoft and the PlayStation 4 from Sony hit the shelves last year, which was largely responsible for the 29.7% jump in sales GameStop saw in its new video game hardware category.

Granted, the company had an extra week a year ago and this increased its sales in the period, but most of its other product categories had less-than-stellar performances. New video game software, which comprised 38.5% of this year's top-line, declined 2.8% to about $3.5 billion. Pre-owned and value video game products, its next-biggest category which represents 25.8% of sales, saw a 4.1% fall to $2.3 billion. Meanwhile, these categories face competition from an ever-increasing amount of apps such as Candy Crush from King Digital.

Mobile and consumer electronics was a bright spot, with more than a 50% increase. However, it makes up a small part of GameStop's business at $303.7 million in sales, which accounts for just 3.4% of GameStop's total sales. This unit sells wireless services and new and pre-owned mobile devices.

Bottom line could use a boost
The new additions of the aforementioned game systems did not help the retailer's bottom line. Although diluted earnings per share was $2.99 versus a loss of $2.13 in the year-ago period, both periods include charges, including a large one in 2012 for goodwill. Excluding these charges, as well as a gain that resulted from a change in customer liabilities in 2013, earnings per share actually dropped. It fell 5% to $3.01 even though the share count dropped by 8 million.

Management's guidance for this year looks ambitious. They call for a comparable-store sales increase of 6% to 12% and the expansion of the operating margin to 6.5%-7%, from last year's 6.3%. The company currently expects diluted earnings per share of $3.40 to $3.70.

Of course, GameStop does generate a nice amount of free cash flow for now, so the company can sustain itself for some time. The retailer's free cash flow, or FCF, was $637.1 million last year as its operating cash flow grew by more than $150 million. Still, this received help from the roll-outs of the two new video game systems. FCF was about $470 million in 2012 and 2011.

Sizing up the competition
GameStop faces stiff competition from well-established players, aside from a constant stream of new entrants that provide apps on mobile devices. For instance, Amazon, an online retailer that sells many competing products with just a click of the mouse, had $74.5 billion in sales in 2013 for a 21.9% increase from the prior year. Its income from operations rose 10.2% to $745 million.

No doubt, Amazon has been a revolutionary company. However, the stock might be due for a pullback since it trades at 550 times trailing  earnings and the price has run-up 280% over the past five years.

GameStop also competes against megaretailers such as Wal-Mart and Target. Each promised a price-matching guarantee this past holiday season, indicating a tough competitive environment and companies' willingness to sacrifice margins to win market share.

None had a stellar year. Wal-Mart had a 1.6% increase in sales to $476.3 billion, but most of the increase came from membership fees for its Sam's Club. Its operating income fell 3.1% to $26.9 billion. Meanwhile, Target, which was plagued by a data breach in which customers' debit and credit card information was compromised, saw revenue decline 1% to $72.6 billion and earnings before interest and taxes, or EBIT, fall 21.3% to $4.2 billion. .

Final Foolish thoughts
Investors who seek a high-growth story might be better served to look elsewhere in light of the tough competitive environment. GameStop is returning some of its cash stockpile to investors. Last month, it raised its quarterly dividend payout by 20% to $1.32 per share. The company is also repurchasing its shares as it shelled out $258.3 million to buy back 6.3 million shares last year. However, the shares have a 3% dividend, which might not be enough for income-oriented investors. GameStop also paid out more than half of its free cash on share repurchases and dividends when investors might be better served if the retailer plowed this cash into future growth initiatives.

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Lawrence Rothman has no position in any stocks mentioned. The Motley Fool recommends Amazon.com. The Motley Fool owns shares of Amazon.com, GameStop, and Microsoft. 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 has a disclosure policy.

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