GameStop: Margin of Safety Is Attractive at Current Prices

The purpose of this report is to illustrate why GameStop (GME) is at an attractive value with an adequate margin of safety at current levels. In this report, I will conclude that GME has a company value of $32.70. Let me just round it to $33.

Company Overview:

GameStop was born from Barnes and Noble (BKS). When it later acquired Electronic Boutique in October 2005, it entered the video game retailing business. At that time, GME acquired 2,300 stores. The company makes most of its money re-selling used games (software) and hardware.

Sector Overview:

GME is a retailer. It trades at P/E levels that are about half that of such competitors as Walmart (WMT), Best Buy (BBY) or Radio Shack (RSH). At the time of this writing, retail stocks should not be trading at any premium relative to the overall major indexes. Consumers are de-leveraging. In short, they are now saving more than they consume. The consumption era is over, and therefore consumer stocks ought to be trading at more distressed levels.

I determined that GME is trading at closer to distressed levels as compared to its competitors. It is also a “recession-proof stock" in that the product it is selling will appeal to consumers who want to have their cake and eat it too…that is, save money and still enjoy the entertainment of console games.

Let me get on with my report to illustrate why GME should be trading at almost 50% from current levels.

Reasons for for GME Valuation @ $33.

1) Corporate strategy
2) Geographic diversification
3) Recent Quarterly Earnings
4) Conservative Forecast
5) Risks exists but the market is punishing the stock anyway
6) Valuation/Margin of Safety

1) Corporate Strategy

The company stated in its recent 10-Q filing a strategy that it would:

- Increase comparable store sales and operating earnings by capitalizing on industry growth and increasing sales of used video game products

- Open new stores in our domestic and international target markets

The first point is standard for a retail industry: a company will want to grow sales from its existing infrastructure. The question is if GME will be able to pull this off. I believe the “home run” event for GME achieving this may be done if any of the following events occurs: release of a “hit” game later on this year by software developers will benefit the resale market. A price decrease of consoles (namely the Sony (SNE) PS3) will help improve GME profit margins. The latter is of minor benefit despite management’s claim that this is important in its strategy. Still, a cheaper console will draw in more buyers for games, especially for used games at a time of recession.

2) Geographic diversification

Let’s face it. Diversification in earnings no longer comes from product diversification. It comes from geographic diversification. The reason is that currency fluctuations and end-user demands will vary by geography. Let me illustrate my point with GameStop’s sales:

- Europe experienced an increase of 300% sales in the last 3 years

- Canada experienced an increase of 200% sales in the last 3 years

- The US experienced an almost 133% increase in sales (the US still represented the bulk of revenue @ $6.5B of $8.8B in its most recent year).

Risks:

Something came up in my research of GME. GME has the most number of stores in the States facing the greatest rate of foreclosure:

US State | # Stores | Foreclosure Rate (as of Mar/09)

Florida - 318 - 5% foreclosure
Illinois – 190 – n/a
California - 479 - 1.8% foreclosure
NY - 237 – n/a
Ohio - 184 - 1.5% foreclosure

Foreclosure figures' Source

3) Recent Quarterly Earnings

Here were its reported results:

- Used game sales grew 32%

- New hardware sales were 17% (note these figures are strong from Nintendo (NTDOY.PK) DSi launch and Xbox 360 @$199)

- Comparable store sales grew 20% with EPS growing 162%

Here are revenue allocation figures by product type:

Gross profit – 6.1% @24.1M
New video game hardware - 21.5% @ 165.5M
New video game software - 48.1% @263.6M
Used video game products – 33.4% @88.9M

On the conference call, GME stated the following:

- Quarterly earnings per share to range from $0.28 to $0.33

- EPS guidance remains unchanged at $2.83 to $2.93 as we continue to expect US software industry sales to increase between 5% and 10% in 2009 due to a strong back half title lineup and growth in our used business.

- Forecasts negative comparable sales for the current quarter due to unusually strong previous quarter driven by a strong title lineup, strong console sales, and government stimulus checks.

It remains to be seen whether any “home run” titles will succeed in the second half of this year. The important thing for investors is that this “premium” is not being priced in the stock price. The hot titles to watch out for are: Guitar Hero 5, Halo 3, Batman, Tekken 6, BioShock 2, Call of Duty: Modern Warfare 2, and Assassin’s Creed 2.

If investors accumulate GME now and play on the stock for the seasonal strength moving into the Christmas period, there is still a “timing” opportunity for profits.

5) Risks exist but the market is punishing the stock anyway

Wal-Mart (WMT) entered the used-game industry but GameStop executives are skeptical. GME has an advantage over Wal-Mart and the other competitors threatening to enter this market. Its employees are specialized, knowledgeable, and most importantly, have understanding of its consumers. The entire buy/sell dynamic of used games cannot simply be mimicked quickly.

Management stated the following:

GameStop has invested heavily in training, systems, in personnel, to be compliant with those literally thousands of regulations across the country. To give you a feel for that level of compliance requirements; over 50% of our stores require some type of a license to buy and sell used merchandize, about 25% of our stores have fingerprinting requirements, and about a third have product hold requirements.

Source: conference call

Amazon (AMZN) recently announced it would enter this space as well, and GME was punished. Note that I entered a position at that time and sold for a profit on the kaChing portfolio.

A greater threat for GME in the longer term is the ability for consumers to buy games online/downloading. This threat will need to be monitored closely.

6) Valuation/Margin of Safety

Below are the EPS figures for GME over the past 6 years. Electronic boutique was not acquired until late-2005.

2008 2007
$1.75 $1.00

2006 ... 2005 ... 2004
$1.61 $1.05 $1.06

2004 ... 2003 ... 2002
$1.06 $0.87 $0.18

The average EPS for GME is $1.22 excluding the 2002 year. I have excluded this because of usual items, etc. that will not make overall comparisons accurate.

The average growth rate over this period is 22.27%. I excluded 2003 since the year-over-year comparison would skew my comparisons.

I have halved the growth rate to 11.1% to provide a 50% margin of safety in my forecast. Applying Graham’s original formula for valuation of a business, I therefore arrive at a price target of $32.72.

Recall that management provided a 2009 Forecast of $2.83 to $2.93. The forward P/E is 11.6, which is almost an 1:1 PEG (P/E to Growth) ratio.

Other Financial Figures:

P/B = 1.61
Debt/Eq = 0.20
P/S = 0.42
Source: finwiz.com

Additional figures:
Goodwill, net = $1,877,832 vs $1,415,509
Total assets including good will = $4,255,482
Total liabilities = $1,833,697

Therefore, Asset (excluding goodwill)/Liabilities = 1.30

The asset/liabilities is somewhat lower than I would like. Goodwill due to acquisitions reduces this ratio and therefore this figure will need to be monitored.

Conclusion:

Although GME is a retail play, the company benefits from specializing in selling games regardless of the console platform. Its margins are very high, and the market for used games is perfect for “recession-proof... a portfolio. I would hold no more than 5-10% of this company.

Disclosure: I hold a LONG position in GME on my KaChing Portfolio. This portfolio is followed by over 330 users.

Comments

[Cheshire Cat:]

Very well researched and thought out. The company clearly deserves a higher multiple than single digits. The current valuation has a very significant margin of safety. This is a busted growth story that is a true value play.

May 28 03:25 PM

[matttz:]

ummm what about onlive.com

May 28 03:40 PM

[matttz:]

Have you ever actually bought or entered one of these stores , esp in the last 6 months ?
They no longer are taking Used games, I would Value this stock at 12.00 - 17.00 in the next 5 months with the release of Onlive.com . Dozens of game makers like EA sports have already signed on with Onlive ( The Same Guy when Invented WebTv)

May 28 03:44 PM

[Chris Lau:]

matttz, could you elaborate on your claim GME does not take used game? This is completely incorrect: it's the cornerstone of its business and a reason why it is so attractive during "recessionary" times.

Used-game sales were up 32%, with sales at $549 million. This is +19%, +31% on a quarter to quarter comparison.

May 30 05:35 PM

[matttz:]

A few stores here in Connecticut have signs on the front stating : Please we are not accepting any used games at this time.
My Concern about GME is they wont keep up with online technology and that the demand for consoles has peaked.
Later this year onlive.com will come online allowing anyone to play rent or just try new games all with out the need of a console.

Why would someone go and buy a used game when they can get it instant with no lag and no console all online.

GME is going to go the way Blockbuster has gone competing with online retailers like Netflix.

Have to believe GME has peaked and that ploy of the company CFO, David Carlson purchasing 25,000 GameStop shares , thats because he owns almost 200,000 shares and was losing his shirt if he didnt stop the down word spiral of this stock as it was heading to the 19.00 dollar range last week or maybe even lower.

Even in Video games one thing stays constant, Gravity.
Better get a parachute for this game stock, looks like a hard landing for GME.

Jun 02 06:36 PM

[borisb:]

GME makes little on world of warcraft or other online games.

Jun 08 08:14 AM