GameStop's (NYSE: GME) earnings report and conference call remind me of why I bought Netflix (Nasdaq: NFLX) in the midsummer of 2007. Back then, analysts hated Netflix for two seemingly valid reasons: First, it was fighting a bruising price war with Blockbuster, and its margins were suffering. Blockbuster was bigger and had the advantage of bricks-and-mortar stores for immediate store pickup and drop-off. (Advantage bricks? Can you believe that?) Second, Netflix was in the antiquated business of moving DVDs by snail mail. Analysts scoffed at the Netflix model because they knew the future belonged to digital downloads.
GameStop is similarly despised in the investing community today. Analysts still know that the future belongs to digital downloads, and they see margin erosion from competition in the used-game market from retailers such as Wal-Mart (NYSE: WMT).
But I liked Netflix in 2007 because the management team was financially prudent, aware of the threats, and patiently evolving the company's strategic response. Netflix's financials showed healthy cash-flow metrics that were usually better than reported net income. Moreover, management was looking to the future and experimenting with instant viewing. Do you remember how clunky those first viewers were, with stuttering video and frequent crashes? But each iteration got better, and customer usage was steadily climbing.
GameStop's management today is demonstrating a similarly prudent execution plan. The company's financials are excellent -- free cash flow exceeded net income by 21% in 2009 and is on the same track for 2010. Management is incrementally improving digital downloads, which grew by 9.9% in the most recent quarter.
"We continue to be the fastest-growing website in the gaming space as we became the No. 2 largest online game retailer behind Amazon (Nasdaq: AMZN)," said GameStop President Tony Bartel this week.
In addition, the company is leveraging its physical locations with its PickUp@Store program to provide immediate gratification for customers who like to browse before buying.
Moreover, GameStop has several immediate catalysts that make me bullish about the stock. Demand for Microsoft's (Nasdaq: MSFT) Kinect and Sony's Move platforms are driving a new demographic to the stores and keeping supplies tight. Meanwhile, more traditional gamers are buying Activision Blizzard's (Nasdaq: ATVI) Call of Duty: Black Ops at record levels. Those sales and the upcoming World of Warcraft: Cataclysm release, also from Activision, should boost earnings nicely. No wonder management raised guidance for the year!
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