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, DerekCapo.com (102 clicks)
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Summary

  • GME will continue to raise revenue and EPS guidance in 2014 and 2015.
  • GameStop’s “Tech brands” is under appreciated and will provide meaningful revenue and EPS growth.
  • Management has been executing well for years and will continue to do so.
  • Too many bears are an indicator that there is more upside to the stock price.

Since 2010, I have owned stock in GameStop GME on the thesis that the company would not be destroyed by digital distribution or larger electronic retailers entering the used game business. For years, I looked like a fool holding as the rest of the market was heading higher while GameStop floundered until 2013 when GME experienced a massive run. GameStop's run is far from over and I believe it may be worth more than $70 a share and will highlight the reasons why below.

GameStop isn't a gaming retailer….WHAT?

The main misconception is that investors see GameStop as a consumer electronics retailer heavily concentrated in the gaming industry when in reality GameStop is a refurbishment retailer that relies on intelligent marketing and loyalty program that is catered to educated and cost conscious consumers that so happens to be in the gaming industry. Proof to this is that they are now entering Apple and other eco-systems and will soon generate over $1 billion USD in revenue in this new business segment.

Here are some simple facts to prove my statement above:

1. GameStop 182,000 square foot refurbishment center refurbishes games as well as other electronics via GameStop, buymytronics.com and Simply Mac.

2. GameStop PowerUp rewards program is at 37 million members and in 1 out of 4 American households. On August 18th, GameStop will begin offering Pro members 20% more credit with their trade-ins which will be a further boon for all of the segments of the business. For example, if all of the PowerUp rewards members convert to PRO (cost of $15 a year), it would yield more than $550 million in high margin revenues. The consumer would need to execute about seven trade-in transactions to "break even" yet the overall goal would be to take away market share from people selling their "inventory" via Amazon (NASDAQ:AMZN) or Ebay (NASDAQ:EBAY).

GameStop knows what customers want and has consistently delivered. GameStop's system fosters loyalty, motivates customers to return, lowers acquisition costs and for shareholders produce an excellent return on invesment. PowerUp rewards is head over heels better than any loyalty program Blockbuster ever attempted in the history of the company. In fact, looking back I don't think I ever got a free rental from renting so many movies maybe I got a free popcorn once.

3. If you look at the breakdown below of revenues you can clearly see that most of revenues and profits is the used game business which shows no signs of slowing down in this console cycle.

Category

2014 Sales

6 months

2013 vs. 2014 % growth 6 Months

% of Sales

Gross Margin %

Gross Margin % of Business

New video game hardware

$438

81.1%

21.94%

10.2%

7.13%

New video game software

$559

-20.3%

28.00%

22.7%

20.30%

Pre-owned and value video game products

$602

5.29%

30.15%

49.5%

47.64%

Video game accessories

$145.1

14.80%

7.26%

37.9%

8.78%

Digital

$56.1

0%

2.81%

62.8%

5.72%

Mobile and consumer electronics

$102.2

100%

5.12%

36.2%

5.91%

Other

$92.1

-19%

4.6%

30.7%

4.52%

Total

$1,996.3

7%

100%

31.4%

Although, it would love to have all customers buy new software and consoles through their stores it knows it has multiple chances to get those consumers via enticing PowerUp rewards. Also, the trade in business essentially fuels all of the segments of the business. Just consider all of the possible transactions that you can do with a trade-in.

1. New Game $60 - Trade In is $35 credit - Buys Digital Product =Cycle Ends company has to spend money to entice them to do more "trading" via more marketing or via Power Up rewards.

2. New Game $60 - Trade in is $35 - Buys new console, old/new game = Cycle continues (does not stop until consumer no longer sees value or finds better deals worth the time and effort).

3. New Game $60 - Trade in is $35 - Buys electronics such as phone,iPad, etc. =Cycle may or may not continue depending if consumer is in PowerUp Rewards.

4. You could replace the "New Game $60" with other products or services and as long as the consumer gets into the PowerUp marketing flywheel the company will continue to succeed.

Again, GameStop isn't a gaming retailer it is so much more than that.

Digital download threat is seriously overblown

Yes, it would be foolish for me to ignore the threat of consumers purchasing games directly vs. through retailers. GameStop was not stubborn about the possibility, in fact; bears were expecting that it would happen in the current cycle when Microsoft announced that it wouldn't support GameStop's business model sending shares down more than 20%. Then, Sony announced hours later that it would support the used game market because that is what consumers still want, sending shares higher.

Did Microsoft stick to its guns and maintain its no used game policy? No, it fired the executive in charge of the launch and caved to consumers because pre-orders for Sony's console, at one point, outselling Microsoft by a factor of 20 to 1. Also, this year Microsoft lowered their Xbox price by $100 to spur demand given Sony is still outselling Microsoft.

Did Blockbuster ever have a powerful and influential community as GameStop does? No.

I would like to illustrate a few contrarian points about the threat of digital downloads.

1. GameStop would not be the only retailer affected if 50% or more of games were purchased digitally as Wal-Mart, Amazon and others would also experience a large decline in revenues.

2. Telco and Cable companies are now moving towards charging consumers for every gigabyte consumed just like wireless companies have done for years with cell phone users. This move would increase the cost of digital purchases because games are about 30 gigs or more and require continuous updates and streaming to perform well.

3. Teens don't know how to manage money, and no parent will link their credit card to an online store. Teens want control of what they buy, trade and sell and parents prefer this than the possibility of their kid one day buying hundreds of dollars of games online. In fact, Apple got sued by parents for this when kids bought Apps without their approval.

4. Prices must come down for digital downloads (like Amazon.com is doing with Kindle) before digital downloads becomes a serious threat to all of the retailers selling games. I will illustrate below why:

Current situation and why GameStop continues to succeed:

Transaction costs

GameStop scenario

Online version

New Game ASP

$60.00

$60.00

Tax

$4.20

$0.00

Transportation costs

$1.00

$0.00

Time value of money

$4.00

$0.00

Download cost

$0.00

$7.20*

Total Cost of New game

$69.20

$67.20

Trade-in Value

$30.00 to $40.00

$0.00

Net cost of the game

$39.20 to $49.20

$60 to $67.20

Winner

Yes

No

Below is a scenario showing what it would take for game developer to hurt GameStop.

Transaction costs

GameStop scenario

Online version

New Game ASP

$60.00

$40.00

Tax

$4.20

$0.00

Transportation costs

$1.00

$0.00

Time value of money

$4.00

$0.00

Download cost

$0.00

$7.20*

Total Cost of New game

$69.20

$47.20

Trade-in Value

$30.00 to $40.00

$0.00

Net cost of the game

$39.20 to $49.20

$40 to $47.20

Winner

Maybe

Yes

Digital versions of the game have to drop more than 30% to make it financially viable to eliminate GameStop. Some companies are offering monthly subscriptions to old games yet it has to be determined if consumers are willing to pay the $30 to $100 USD a year for this service.

Notes: on the scenarios:

-Tax, I used 7% given some states are higher, and some are lower and felt this was an average.

-Time value of money was calculating that it cost an average consumer 30 minutes of their time to go visit a store and given that the hourly rate of a teen is about $8 an hour. We all know that teens don't think this way, but investors should.

-Download cost: is assuming that households are being capped at 250 GB a month (Comcast does this). Downloading a game will "cost" 30 to 50 GB of bandwidth and an internet the monthly bill on average is about $60 a month which would equal to 12% of the bandwidth or $7.20. Let's consider the fact that some media companies are thinking of paying the Telco and Cable companies directly for this cost.

GameStop is executing on their PLAN B and provides further upside to revenues and earnings

GameStop did investment in online gaming and experienced some wins (Kongregrate) and losses (Spawn) and prudently decided to be a part of another strong and loyal Apple community via the acquisition of Simply Mac and AT and T/DirecTV via Cricket Wireless.

If you look at the Gross Margins and % of margins, the "Tech Brands" business is growing 100% a year and slowly becoming a major profit contribution. At its current run rate, the company estimates this segment to be a $1 billion revenue business by 2016 and at the margin of 30% could be more than 30% of the total profits. This potential market for the "Tech Brands" is larger than that of GameStop. Perhaps in the future the name of the company will change.

Capital Allocation Plan = Private Equity returns for shareholders

Since 2010 the company has done the following:

1. Buyback more than 35% of shares (inflates EPS but also stock price)

2. Issue dividends (increasing every year since initiated)

3. Purchased stock or issued dividends of more than $2.1 billion.

In 2010, GameStop's enterprise value was about $1.8 Billion USD and given its 4 year capital allocation to shareholders of more than $2 billion would imply a more than 21% annual return. Essentially, GameStop acted like a private equity firm and produced enviable returns for its shareholders. I would rather enjoy these returns than handing over GameStop to a private equity firm filled with overpaid Ivy League MBA's that would destroy GameStop's business model and incredible eco-system. A good example of this is how Sun Capital is currently doing with Gordman's Department Stores which I wrote about.

Valuation

The company is trading at a current P/E of 10.8x or 10x cash adjusted. 2015 shows no signs of slowing down given projected revenue growth of 8% and an EPS increase of more than 20% which would yield a 2015 P/E of about 9x (8x cash adjusted).

I predict that the 2014 and 2015 revenues and earnings will exceed current estimates given the strength of the cycle and growth of the company's other business segments. I also think the company should be trading at 17x current earnings and 15x next year.

My projections:

2014

2015

Revenue Growth

13% vs. estimates of 10.5%

11% vs. estimates of 8%

EPS

$4.00 vs. estimates of $3.68

$4.75 vs. estimates of $4.33

P/E (17x and 15x)

$68

$71.25

Conclusion

Investors who are negative or short GameStop, will lose out as GME continues to outperform. Investors that compare the company to Blockbuster are ignorant and most likely have never shopped or talked to at Gamestop customer. GameStop's business segments (new and old) are close to running on all cylinders and this run has just begun.

Disclosure: The author is long GME. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: GameStop Is A Strong Buy: Blockbuster Comparison Shows Ignorance