Peter Lynch taught that everything you come across is a potential investment, and since I started writing for the Fool, I've paid attention to every store I visit. Following Lynch's example helped me put GameStop (NYSE: GME) on my investing radar.
My kids wanted new games for their handheld system. I thought prices might be cheaper online, but they weren't. Even Wal-Mart (NYSE: WMT), with its relentless focus on low prices, didn't offer online discounts -- suggesting that demand for games allowed sellers across the board to keep prices high. Such a strong seller's market could give GameStop serious pricing power.
"Kids, let's go to GameStop!"
The offerings in GameStop's very busy store seemed to exemplify the explosive growth in gaming. Limited only by designers' imagination (which is theoretically boundless) and consoles' technology (which is constantly getting faster and cheaper), video games will keep pushing the envelope, and luring new audiences away from TV and movies. To me, that's a huge secular growth opportunity.
Even in a recession, that powerful growth fuel meant GameStop had to be doing well, I thought. A check of the financials revealed that the company posted almost 40% earnings growth for FY 2008. However, in 2009 earnings contracted 5%. Still, the company saw a combined profit of more than $1 billion over the past three fiscal years.
Free cash flow was fantastic during 2007, 2008, and 2009, at $325 million, $366 million, and $481 million, respectively. GameStop also commands $460 million in net cash. It's trading at nine times this year's expected earnings, but boasts 16% expected growth this year, and 11% over the next five years. Based on this year's earnings, GameStop could be a value play.
Overall, the numbers looked good -- until fellow Fool Rick Aristotle Munarriz's report on the company's first-quarter earnings showed the cracks in GameStop's armor. Same-store sales fell 1.6% in Q1, while big share repurchases inflated earnings per share.
Faced with a mixed outlook, I asked myself what Peter Lynch would do. For one thing, he'd say the story looked good: The recession hurt sales, but the company's hanging tough, and it'll likely pick up when the economy improves.
But what about the future? That's where my thesis lost steam. I pondered whether GameStop's sales might correlate with the performance of dominant game producers Electronic Arts (Nasdaq: ERTS) or Activision Blizzard (Nasdaq: ATVI). If so, their sales outlook might help me predict GameStop's fortunes going forward. Nonetheless, as Rick pointed out, who knows how the retailer will fare three years from now?
I realized that while GameStop was not a buy, it was a perfect candidate to sell covered calls against: a stable company I wouldn't mind owning, which tends not to make big sudden price moves. Best of all, the premiums for June 22 calls were 3% above my target price. Done.
In short, Lynch's model has its limits. Walking into a store and liking what it does just isn't enough. Read the financials carefully, and beware of value traps. When confronting GameStop's foggy future, you'll have to make like Mario or Luigi facing a big jump: Weigh the risks carefully, and decide which strategy best fits your investing skills and your comfort zone.
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