3 Reasons Why GameStop Won’t Stop

Eight years of pent-up demand is a huge force driving GameStop's future earnings.

May 29, 2014 at 5:15PM

Just a year ago, many investors were actively betting against GameStop (NYSE:GME), and there was significant short interest in the stock. Seemingly every report about the gaming industry suggests that digital sales are the future and that traditional gaming is in decline. Though there was initially skepticism about how popular the Xbox One and PlayStation 4 would be, the results argue that GameStop's recent surge may just be getting started.

Eight years of pent-up demand
It took eight years for both Microsoft and Sony to step up to the plate with new gaming consoles, and apparently gamers were waiting with bated breath. It was recently reported that the Xbox One sold 5 million units since the launch, and PlayStation 4 sold about 7 million units.

This helped GameStop to report an 81% increase in new video game hardware sales. While GameStop grew revenue by 7% annually, competitors like Best Buy(NYSE:BBY) and Wal-Mart Stores(NYSE:WMT) have reported overall sales declines.

Best Buy had the opportunity to capitalize on new hardware sales, but entertainment sales only represent about 8% of the company's domestic sales. Wal-Mart and other retailers like Target carry game consoles, but these items are just a small part of their sales. While Wal-Mart has begun selling pre-owned games, the company doesn't have the experience or the manpower to help gamers like GameStop can.

The first reason GameStop's run could just be getting started is that millions of new Xbox One and PlayStation 4 consoles mean gamers will be looking forward to the best games of the year. Though it will be another quarter or two before the top titles of 2014 are released, GameStop is in the perfect position.

Best Buy better watch its back
For investors who believe that GameStop is just a bunch of gaming stores, they may have missed two of the company's nascent businesses. One of Best Buy's biggest businesses is its mobile division. The company has consistently seen strong comparable-store sales in mobile, and this is partly why the company has moved away from big-box locations and increased its Best Buy Mobile presence.

Wal-Mart not only provides multiple options for customers looking to buy a cell phone, but the company also offers service through T-Mobile called Family Mobile. Apparently GameStop decided what's good for the goose is good for the gander. The company's Spring Mobile stores are dedicated AT&T product and service stores.

The second reason is GameStop's mobile and consumer-electronics business should continue to report strong sales growth. Partially due to Spring Mobile and partially due to Simply Mac stores (Apple authorized stores), GameStop reported 100% revenue growth in its mobile and consumer-electronics business.

While it's true that this division only represents about 5% of sales, GameStop plans to nearly triple its Simply Mac locations over the next two years. If mobile is Best Buy's bread and butter, GameStop represents a competitor in this space that Best Buy probably never saw coming.

Let the cash flow
The third reason GameStop won't be stopped is its peer-leading free cash flow. In fact, in the last year, GameStop produced core free cash flow of nearly $0.05 for every dollar of sales; the hyper-efficient Wal-Mart produced about $0.03, and Best Buy only managed about $0.02. Despite the differences among these retailers, the fact that that GameStop generated these results last year when the newest consoles were only available for a short time is a testament to how profitable this retailer can become.

Final thoughts
GameStop seems to be perfectly positioned to benefit from continued upgrades to the newest gaming consoles. When the top software releases of the year begin to hit in the fall, the company will benefit from its experienced staff advising gamers on what titles to buy.

The company generates more relative core free cash flow than its larger peers, and at present offers a yield that is nearly a percentage point higher than that of Best Buy or Wal-Mart. GameStop also sells for the lowest forward P/E ratio of its peers.

Investors looking for growth and income from an innovating retailer should consider adding GameStop to their watchlist today.

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Chad Henage has no position in any stocks mentioned. The Motley Fool owns shares of GameStop. 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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