GameStop’s Recent Sell-Off Breeds Opportunity

GameStop Corp. (NYSE:GME) May 25, 2009: $22.55
52-week range: $16.91 (Nov. 21, 2008) - $50.67 (May 29, 2008)

GameStop is the world's largest retailer of video game products, including hardware, software, and accessories. In addition to selling new products, GameStop makes a market in used video game products by allowing gamers to trade-in used games for credit toward purchases. The company also publishes the Game Informer magazine, which has more than 3 million subscribers.

• Company profile by Morningstar

Video games and hardware platforms such as X-Box 360, WII, GameCube and PlayStation 3 have remained strong despite the poor economy. Fiscal 2008 (ended Jan. 31, 2009) marked the seventh straight year of improved sales and earnings for GameStop and the April first quarter of FY 2009 showed EPS of $0.42 versus $0.38 year-over-year.

When announcing those good numbers, GME management pre-announced that the next quarter would be under expectations as they saw $0.28 - $0.33 versus last year’s $0.34 and the consensus view for $0.40.

The market reaction was a swift share price drop from about $30 to today’s $22.55.

Management now sees full FY earnings of $2.83 - $2.93 which would still be well above FY 2008’s $2.40. Zacks now sees $2.84 and $3.13 for FY’s 2009 and 2010. That puts GME’s multiple at < 8x this year’s and 7.2x next year’s numbers.

That's the lowest multiple on GME since its IPO in 2002.

Morningstar assigns GME 4-stars (out of 5) and figures 'fair value' as $32.

Here are the per share figures from continuing operations as reported by Value Line:

FY …….. Sales …... C/F .... EPS ….. B/V ….. Avg. P/E
2002 ..... 11.85 ….. 0.66 … 0.44 …. 4.81 ……. 20.1x
2003 ..... 13.92 ….. 0.82 … 0.53 …. 5.24 ……. 13.4x
2004 ..... 18.13 ….. 1.03 … 0.59 …. 5.34 ……. 15.4x
2005 ..... 21.24 ….. 1.24 … 0.92 …. 7.66 ……. 16.5x
2006 ..... 34.92 ….. 1.76 … 1.00 …. 9.03 ……. 23.4x
2007 ..... 44.06 ….. 2.60 … 1.75 ….11.57 …… 25.2x
2008 ..... 53.75 ….. 3.34 … 2.40 ….14.04 …… 16.5x

One long-term cloud on the horizon is the possible spread of OnLive, a web-based gaming system that allows users to play video games without the need for hardware or physical software products. Should this develop into the industry standard for gaming it would seriously impact GameStop’s business model. That threat may or may not occur and its effects appear to be well into the future regardless.

The installed customer base for the multiple hardware platforms and the extent of gamers’ investment in software for those systems makes it unlikely that any new technology will cause obsolescence anytime soon.

Here’s a nice eight-month play with GameStop that look appealing right now…

Buy 1000 GME @$22.55 …...... $22,550
Sell 10 Jan. $22.50 calls @$3.80 ……...$3,800
Sell 10 Jan. $22.50 puts @$3.70 …......$3,700

Net Cash Out-of-Pocket …….... $15,050

If GameStop shares remain over $22.50 on Jan. 16, 2010:

The $22.50 calls will be exercised.
You will sell your shares for $22,500.
The $22.50 puts will expire worthless.
You will have no further options obligations.

In this best-case scenario you will hold no shares and $22,500 for your original $15,050 cash outlay.

That’s a net profit of $7,450 / $15,040 = + 49.5%

… achieved in under 8 months on shares that did not need to go up at all from the trade’s inception price.

What’s the risk?

If GameStop shares are below $22.50 on January 16, 2010:

The $22.50 calls will expire worthless.
The $22.50 puts will be exercised.
You will be forced to buy an additional 1000 shares of GME and to lay out another $22,500 in cash.
You will end up with 2000 shares of GME.

What’s the break-even point on the whole trade?

On the first 1000 shares it’s the $22.55 purchase price less the $3.80 /share call premium = $18.75 /share.

On the ‘put’ shares it’s the $22.50 strike price less
the $3.70 /share put premium = $18.80 /share.

Your overall break even is thus $18.78 /share.

GameStop shares could fall by as much as $3.67 /share or
(-16.2%) from the original $22.55 price without causing a loss on this trade.

Disclosure: Author is long GME shares and short GME options.

Comments

[Cem Unal:]

Sorry but why would you bother buying video games retailer ? There are so many other opportunities out there and that are more "useful" to everyday's economy that I am not putting a penny in a video game retailer or producer stock... and I am a big video game player ;)

May 26 08:26 AM

[ChipsAhoya:]

Paul, I think you underestimate the threat of digital game distribution to GME's business model. OnLive is not the only thing that will eventually kill GME, the console and game makers will continue developing and expanding downloadable content until you can purchase all of your games online and store them on your hard drive. Not only do they want a bigger piece of the pie, but it will prevent them from missing revenue from the sale and trading of used games, as well. In addition, other retailers are getting into the game trading business, and while they won't be as successful at is as GME, it will be a loss of revenue / growth.

GME has little tangible book value and their future earnings potential has a clear limit to it. I would avoid this stock.

May 26 11:11 PM