Rising Star Buy: GameStop

This article is part of our Rising Star Portfolios series.

On the Messed-Up Expectations (MUE) Portfolio discussion board, we've been discussing different stocks that might or might not fit the MUE criteria. For instance, I laid out part of my research that led to the decision to buy Power-One a couple of weeks ago. So far, the outcome is good as the stock is up 5.2% since I bought it, but it's still too soon to tell. I'm looking for a longer-term win based on the company's ability to sell inverters into the green energy market.

I'm also open to stocks that other people like which might qualify as a MUE pick. For instance, poster VTDave suggested GameStop (NYSE: GME  ) as a potential MUE. And he could be right.

GameStop sells new and used video games and the units to play them on, such as Sony's PS3 and Microsoft's Xbox 360. It is agnostic as to what games it sells, happily selling Call of Duty: Black Ops, which launched early this month, alongside Epic Mickey, which launches tomorrow. It also sells via digital download, allowing gamers to download games straight to their PC, Playstation, Xbox, or Wii.

The Street's sentiment for this company is that it won't do well, as it will suffer from poor same-store sales, competitors, and growth in digital game downloads direct from publishers, which will replace everything.

Is that sentiment justified?

What I'm looking for are situations when everyone else has panicked, when they conclude that the company is not going to be able to do anything (or very much) going forward. For-ever. And that's the time to buy. Take advantage of everyone else's freaked-out psychology.

I wrote that in another post on the MUE Port discussion board and I think that might be the situation today with GameStop. While I'm not saying that the Street is panicked or freaking out, I do think they are too pessimistic about the company right now. Using the last available trailing-12-month (TTM) free cash flow number of $447 million, the market is currently pricing GameStop as if it will only be able to grow that by 1.1% annually for the next five years, then no more for the rest of time (at a 15% discount rate).

Now, the company hasn't yet filed the 10-Q for its latest quarter, so that FCF number is probably a bit low, which means that the expectations are a bit high. But it reported a pretty good third quarter, reporting a 5.3% same-store sales increase here in the U.S. and a bump up of 4.8% to net income -- both higher than analyst expectations. And, it increased its full-year guidance.

Plus, it has rolled out a pretty successful rewards program, generating loyal customers who spend more. Finally, during the conference call for last quarter, management said they see "no impact" from competitors such as Best Buy (NYSE: BBY  ) and Wal-Mart Stores (NYSE: WMT  ) on sales of used games.

What to watch
Two things. First, even though GameStop hasn't seen significant competition in its high-margin used game business, yet, that doesn't mean it won't. Wal-Mart and Best Buy could prove to be formidable competitors, though it could be argued that they are playing outside their areas of expertise. After all, Wal-Mart was supposed to crush Netflix back in the day, too.

Second, I'm keeping an eye on margins. In the last quarter, sales grew by 3.5%, but operating earnings increased only 2.8%. Further, for the last eight TTM periods, going back through the period ending Jan. 31, 2009, while gross margin has increased steadily from 25.8% to 27%, operating margin has actually fallen from 7.7% to 6.8%. This could certainly be contributing to the pessimism on this company. If this trend continues over the next two or three quarters, then I'd have to reconsider my decision.

Buy, but watch
The market is currently expecting very, very little out of GameStop. To a certain extent, that is justified given the recent recession, current unemployment situation, and the margin issue, but I think the market's overshot the mark on this one by expecting just 1.1% annual growth for only five years before grinding to a complete halt in growth. Add in the company's initiative to generate loyal, higher-spending customers, its digital sales ability, and a lack (so far) of significant used game competition, and I believe the market is handing us a MUE opportunity.

Therefore, the MUE Port will purchase about $340 worth of shares tomorrow, an initial 2% position. Depending on what happens with margins over the next couple of quarters, that position could either be increased to 4% or closed.

Would you buy GameStop today? Come tell me why or why not over on the MUE Port discussion board.

Best Buy, Microsoft, and Wal-Mart are Motley Fool Inside Value recommendations. Best Buy and Netflix are Stock Advisor picks. Wal-Mart is a Global Gains choice. Motley Fool Options has recommended buying calls on Best Buy, writing covered calls on GameStop, and a diagonal call position on Microsoft. The Fool owns shares of Best Buy, Microsoft, Power-One, and Wal-Mart. Try any of our Foolish newsletter services free for 30 days.

Fool analyst Jim Mueller owns shares of and is short puts on Netflix, owns shares of Power-One, and is a beneficial owner of Microsoft shares. He works for the Stock Advisor newsletter service. 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 Fool's disclosure policy woke up this morning with messed-up hair, but it's working on that.


Read/Post Comments (12) | Recommend This Article (22)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 29, 2010, at 11:55 AM, rockbox64 wrote:

    Are you aware that we will be able to by any game we want and download it onto our own discs within the next year or so?

  • Report this Comment On November 29, 2010, at 11:58 AM, TMFTortoise wrote:

    Actually, I'd be surprised if it happened that soon. GameStop is moving aggressively into the download space, as well. Makes it convenient for customers who don't want to visit several different publisher websites to purchase and download all their games at a single location.

    Thanks for reading!

    Jim

  • Report this Comment On November 29, 2010, at 2:50 PM, BioBat wrote:

    TMFGebinr,

    rockbox64 is bang on.

    Downloading is here already and Gamestop is severely lagging. You might want to read up on Steam. It has games available from all the major publishers already. Steam had a locked Black Ops available for PC download weeks before it was officially released. Gamers were given an activation code upon release and could start playing right away without worrying about download times, waiting in line, etc. Steam owns the PC space for digital downloads controlling up to 70% of the market and over 25m users. This is a market (PC gamers) that Gamestop largely ignored for a long time and has only recently jumped back in bed with in an attempt to grab some of the digital market. Steam's also added Macintosh support in the past year and has announced that it's going to be offering downloads for the PS3 next year and are actively looking to get the Xbox on board as well.

    Steam is far and away the digital leader right now. Gamestop will be lucky to eat crumbs.

  • Report this Comment On November 29, 2010, at 3:05 PM, TMFMoby wrote:

    BioBat - where do you get your data? I'm not doubting it, but I'd like to read more with context at the source. Thanks.

    Jeremy

  • Report this Comment On November 29, 2010, at 3:49 PM, BioBat wrote:

    TMFMoby,

    The 30m registered users comes from their own press release:

    http://store.steampowered.com/news/4502/

    The PS3 announcement came during E3 this year. Right now Steam's only scheduled to release Portal 2 but it's a start that has them in the lead in terms of real downloadable games in the PS3 download space (outside of the smaller games and add ons released through the Playstation Network).

    Last year Stardock, which runs Impusle, a competitor to Steam estimated that Steam had 70% of the digital market (in terms of revenue). Impulse had 10% and everyone else made up the other 20. That report was widely broadcast on multiple gaming blog sites (Kokatu, NG4, Gamasutra, etc) last year.

    That's about it. Being privately run, Steam is extremely protective of how much they're actually generating in terms of dollars and cents but they're clearly the one that people in the space are looking at as the leader.

  • Report this Comment On November 29, 2010, at 6:25 PM, wrongnumber wrote:

    I am one of the disillusioned former shareholders. I sold my GME shares last week for a small gain. At $20/share, I just do not see the magnitude of the potential upside compensating for the risk of the downside. When I bought, my IV was $27. It is now at approximately $24. They have not met my expectations over the past year and I would prefer an investment that either has more upside potential (such as GOOG or ISRG) or has less risk (such as KO or PG).

  • Report this Comment On November 29, 2010, at 11:45 PM, gdf55 wrote:

    I think the market was interested in GME as a growth stock, Now its high-percentage growth days are behind it, but the value/cash flow investors haven't moved in.

    But a couple of concrete observations. First: if you were into quantitative analysis, which you're not, you'd note that the chart looks like a classic boom/bust stock with a converging pattern in the past couple of years, and you'd argue that no one should be making moves into GME unless it breaks out on the upside of that convergence. Otherwise your money's better used elsewhere. And there's no guarantee the breakout won't be to the downside, either.

    Second, cash flow. Obviously I'm still not on the CF bandwagon, but regardless, the company's cash flow seems to be hegative except in 4th quarters. What's to love here? One amazing quarter a year during the holiday season isn't exactly inspiring and it happens to be a quarter that sees a lot of competition on price points from every other game/console marketer.

    Third, the rationale for paying attention to cash flow. You CF guys really hammered home the point that you need CF analysis when a company has a lot of deferred revenue. Well, GME doesn't have *any* deferred revenue that I can see. Its customers walk in to the store, buy stuff, and leave, and GME has no further responsibility after the sale.

    What you're left with is a company that is growing the top line ~12%/year and the bottom line a smidge better - in an industry where all the other issues we've talked about on the ATVI board still apply.

  • Report this Comment On November 30, 2010, at 11:25 AM, nonzerosum wrote:

    Good analysis Jim, I agree.

    @gdf55: I don't follow why seasonality somehow detracts from GME's valuation? The cash flows are consistently better than net income. There are short term catalysts too, see http://www.fool.com/investing/general/2010/11/24/is-gamestop...

    tj

  • Report this Comment On November 30, 2010, at 12:57 PM, shaileshnita wrote:

    I see at Yahoo Finance that the insiders are persistently selling this stock. I wonder why?

  • Report this Comment On December 01, 2010, at 11:14 AM, CarolinaMatt wrote:

    While the future for video game sales and GME is very hazy right now, I mostly lean toward the "buy when everyone else is panicking" opinion.

    Basic math says:

    --CY PE is about 7.5 right now for a company in a growing/healthy industry.

    --Cash flow is slightly better.

    Even if this company just treads water, uses cash intelligently (buybacks, etc.) and rises with the industry tide without excelling, it is undervalued at 7.5X earnings. The stock is priced for a decline to death scenario right now.

    If they actual get things right (fending off the big retailers and transitioning to online sales), then the upside is HUGE.

    I also think there are 2 big differences versus Blockbuster:

    1) The sale size is much greater ($2-4 versus $30+).

    2) The pricing is similar for the new model. Blockbuster was getting undercut on price, convenience and cost structure all at the same time. GME's business model/cost structure is not nearly as broken.

    Do they need to evolve? Yes. Is the environment competitive and changing? Yes. But is GME's business model just flat broken and doomed? No.

  • Report this Comment On December 06, 2010, at 6:07 PM, countsmol wrote:

    OK guys and girls,

    What is the Symbol for Steam please?

    Sam in VA

  • Report this Comment On December 06, 2010, at 8:45 PM, popatop100 wrote:

    From a late comer, how about that debt/equity ratio? If things don't develop as expected and cash flow deteriorates, the stock price will drop like a rock when they can't make their interest payment.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1382759, ~/Articles/ArticleHandler.aspx, 11/26/2014 10:00:52 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement