Rising Star Buy: GameStop

Gaming and retail? Am I crazy or am I taking advantage of messed-up expectations?

Jim Mueller, CFA
Jim Mueller, CFA
Nov 29, 2010 at 12:00AM
Other

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.


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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.