GameStop Has Received an Undeserved Beating

By Derek Stevens

The Holiday Season is upon us, and while it is normally a time of family bonding and relaxation, the equities market isn’t taking time off for a break. On the contrary, most investors are afraid of what’s in store for this year’s holiday season. (Although I’m sure they’re also pretty worried about what’s left in stores at the end of the season). Undoubtedly, consumer spending will take a dive given the financial instability of the economy, and the 14-year high unemployment rate at 6.5%, but as risk-averse investors, all that we need to do is to take a look at the fundamentals of the economy and consumer sentiment to find out which companies are the safest plays this holiday season.

Play By the Rules of the Recession’s Game

In 2001, consumer spending had increased by the smallest amount in over a decade, at less than 2%. Economists believe spending will be slightly higher than the 2001 low, around 1.9%, smaller than the average growth of 4.4%. One of the largest percentages of consumer spending for the holidays went into the purchases of video games and related hardware in 2001. With new systems being released the last few years, the video game industry will fair better than most this holiday season.

GameStop Inc. (GME), the industry-leading seller in video games, will benefit from their business model: Sell new games (make profit), buy them back for quarters on the dollar, and sell them as used (make higher profit margins). GameStop has recently been crushed and is over 60% off of its 52-week high, but is unfairly so. Their diluted earnings per share this quarter has increased to $0.31 per diluted share, up from last year’s $0.13.

GameStop is virtually the only player in the used video game sales category. This being said, consumers have nowhere else to turn to feed their gaming addictions at a discount. GameStop offers over 3,000 different used products at extreme discounts compared to new ones. One of their key business strategies is to continually make aware the availability of used games when a customer attempts to purchase a new one. With an average used price of $16 dollars (compared to an average new price of $42), consumers will, without a doubt, be more willing to purchase guaranteed-to-work used video games over their new counterparts.

Microsoft’s (MSFT) Xbox 360 hardware and software make up a large portion of GameStop’s sales and this holiday Xbox 360 prices have dropped to $199 from last years price of $350. Microsoft considers this price the “sweet spot” that will optimize the sale of hardware and software units. This is a significant move that will benefit GameStop because it will motivate parents to finally buy a current-generation system for their kids. Microsoft is pushing to attract this lower-budgeted customer base even further by throwing in a couple family games like Kung Fu Panda and Lego Indiana Jones to kick-start the gaming addiction. GameStop will clearly benefit from the new customer base by selling more products, but it also might increase profit margins by selling more used games due to families’ lower budgets.

Foreign Frenzy

In the early years, GameStop has survived tough times through key acquisitions like EB Games. The video game giant is now looking to continue expansion on a more international level, and most recently acquired Micromania, Europe’s second largest video retailer which operates 332 stores in France. Although the deal is still pending with the European Commission, GameStop would increase it’s presence in Europe by close to 45%, bringing the total number of international stores from the current 1,200 to over 1,500.

GameStop is trading at an extreme discount compared to the historical P/E multiples of the stock. I believe the gaming industry is not nearly done growing, and therefore, I feel GameStop is still a growth company. The price to earnings ratio has been significantly higher in the past during economic boom times, with ratios of 30.19, 34.17, and 62.12 in 2005 through 2007 respectively. This year, the trailing twelve months P/E has been 10.50, with a forward P/E of 8.08. When the industry bounces back, GameStop should see an increase in P/E to reflect the high growth potential that is yet to be tapped. I do not believe that the multiple will return to the 60’s range but it could easily double from these depressed levels.

While I believe that GameStop will perform well this holiday season, the long-term outlook on the video game industry remains as promising as ever. As the leading retailer of video game products, GameStop’s proven business model and key acquisitions will continue propel profitability and earnings in the future. The brutal blow GameStop has been dealt during this recessionary period is undeserving. I believe that since 97% of the equity is in the possession of large institutions, GameStop’s beating has occurred because of a sector-wide scare in consumer discretionary. With one look at GameStop’s nearly-perfect record and continuing potential for expansion, I believe GameStop will come close to, if not top, the stock’s record-high price of $63.77 in the next few years. Predicting the market’s bottom is difficult, but as soon as the big institutions become bullish, GameStop will soar once again. I recommend to take the current price as a relative bottom and to get in for the long-term.

Comments

[Gaucho420:]

What about the fact that downloading games will become the norm and that many new games offer free additional downloads to buy them new (hence, taking away from GME's used game biz) as opposed to used?

Personally, I see the industry turning and quickly on Gamestop, because anyone who goes in their knows 1) the salesclerks almost unanimously prefer to recommend used games over new ones, which is why companies are offering freebees for 1st time buyers of new games and 2) Gamestop does an awful job of promoting the Wii, almost ragging on it and its customers as it sees fit. Anyone who shops at Gamestop regularly knows that your treatment will depend on whether or not the minimum wage clerk approves of your purchase.

I beleive in the short term their maybe a bounce in this stock, BUT, long term it is doomed as we approach fully downloadable games and with the industry finally paying attention and fighting back GME's blattant used car sales tactics.

GME is not the friend of the companies...at all and I beleive that will cost them in the long run.

2008 Dec 10 05:04 PM

[TheDragonclaw:]

Digital downloading will never replace owning the hard copy of a game. Hardware crashes happen (especially with the 360...) and no one wants to risk losing hundreds, if not thousands of dollars in games to a crash or the ir kid hitting 'the wrong button'. On the other hand I do think game companies offering free downloadable content to first time buyers and then selling that content to late adopters and used buyers is a possitive move that benefits the developers and if done right can even help Gamestop and it's relationship with their suppliers.

2008 Dec 10 09:15 PM