GameStop Keeps Going, And Going...

Includes: BBY, GME
by: Saj Karsan

Yesterday, GameStop (NYSE:GME) shares fell more than 8% after the company missed expectations by a penny and guided earnings estimates lower for its 3rd quarter. A variety of factors appear to be coalescing in the short-term to push the stock close to its 52-week low. But longer term investors should actually be encouraged by the company's results, as the company appears set to generate years of strong free cash flow relative to its current market cap.

First of all, a retailer like GameStop makes most of its money during the Christmas quarter, so a few cents here and there during the summer quarters says nothing about the health of the overall business. But still, how can one get excited by the company's long term outlook when short-term expectations are being lowered? Well, because of the reason for those lowered near-term expectations: namely, increased expenses associated with the national roll-out of initiatives that were very successful in their test locations.

First, the company's loyalty program appears to have generated excellent returns in the test locations, causing management to want to take this program national immediately. Participation rates are high, and customers enrolled in the program have increased their transactions at GameStop, both as buyers and as used-game traders. The company is also going national this quarter with its in-store download kiosks. Customers appear to have taken to this new form of distribution, as 5% of the company's transactions now take place through these kiosks, which is up 80% year-over-year.

But some skeptics no doubt wonder what good a couple of years of cash flow are worth, when the business model is out of date. Digital distribution is the way of the future; but the company is also focused on being the leader in this space. Its acquisitions show that the company will be a significant player when the market shifts from bricks-and-mortar to digital distribution. NPD reports that GameStop's online market share has grown 50% in the last year, and its online business was the fastest growing "dot com" in the gaming industry.

In this quarter, the company plans to continue to improve its online offerings. It will add "buy online, pickup in-store" e-commerce capabilities, fully extend the royalty program (described above) to the web, and offer full-game downloads. GameStop will be well-positioned to handle the transition to digital distribution as it occurs over the next several years.

In the meantime, the company appears to have a license to print cash. While the company trades for just $2.9 billion, it generates operating cash flow of over $600 million per year. It has a P/E (based on current year earnings estimates) of just 7, which doesn't take into account the fact that the company expects to finish the year with a cash position of $1 billion, representing one-third of the company's market cap!

Furthermore, management has not been shy about returning cash to shareholders. The company has purchased $300 million worth of stock in the last few months, and hinted on yesterday's conference call that it is developing a plan to return more cash to shareholders in the form of annual buybacks.

Of course, seeing how successful GameStop has been, the competition is trying to grab some of those profits. BestBuy's (NYSE:BBY) recent announcement that it will enter the used game space took some air out of the stock. (To see why the used game business is so important to GameStop, see this article.) But GameStop management is watching the situation closely, and is so far not seeing any impact. From the company's conference call:

"There have been several big-box competitors who have launched "used" business. And we measure the run rates and impacts of used sales of all the stores adjacent to them, and we simply have not seen an impact. Now, some of the big-box competitors have not really even begun yet. They've announced that they've started, but we haven't seen that.

And then another of the big-box competitors began with a small amount of stores. We haven't seen any expansion there. So on the competitor side, we just don't see the impact yet in our stores, but of course we take them seriously, we watch them closely. Believe us, a lot of the traffic in those competitor stores are our guys testing the process etcetera. So we're all over that."

While the competition attempts to steal share, however, GameStop is not standing still. In addition to the loyalty and kiosk programs (described above) that it plans to roll out before the holiday season, the company actually has some further retail opportunities. With Blockbuster's store closures (and the likelihood of continued closures, as it nears bankruptcy), GameStop is able to place locations in desirable areas that it was not able to before:

"Blockbuster has closed a lot of stores, so has Hollywood. And that has given us real estate opportunities into centers that heretofore we could not get into because they had exclusives...[A]s they continue to close stores, again, it gives us opportunities, especially into highly dense urban areas. If you take like the LA area etcetera, for example, which is a very difficult real estate market, it gives us opportunities to get into centers that we've not gotten into."

Is GameStop the next Blockbuster? Unlikely. But Blockbuster's former locations can help add to GameStop's profits.
When a stock is beaten down over short-term earnings, or even over long-term fears (that humans are very poor at predicting successfully, yet are very confident about), investors are often offered excellent companies at great discounts to their intrinsic values. GameStop appears to be one such company.

Disclosure: Author has a long position in shares of GME