Why BestBuy Should Buy GameStop

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 |  Includes: BBY, BLOAQ, GME, MSFT
by: Adam Muller

GameStop

GameStop (NYSE:GME) is a retailer of video game products and PC entertainment software. The company sells new and used video game hardware, video game software and accessories, as well as PC entertainment software and other merchandise at 6,573 stores in the United States, Australia, Canada and Europe.

While currently trading at approximately $27/share GME once traded as high as $62/share before on-line gaming threatened its bricks and mortar business model and investors questioned whether or not GameStop would become the next Blockbuster (OTC:BLOAQ). With a current market capitalization of $3.8 billion and an enterprise value of $3.7 billion GME trades at 4.3x trailing EBITDA and 9x forward earnings. Based on these multiple GME appears inexpensive. Nonetheless the short interest remains high with approximately 25% of the float sold short. GME's strategy is to focus on selling pre-owned games and develop an on-line strategy. In addition, the company is attempting to growing share in mature markets while controlling costs in smaller less profitable markets.

BestBuy

BestBuy (NYSE:BBY) is a retailer of consumer electronics, home office products, entertainment products, appliances and related services. The company operates retail stores, call centers, and conducts on-line retail operations.

BestBuy has been hurt as the sales of large consumer electronics such as televisions has declined and moved on-line. The idea that BestBuy has become the electronics show-room for Amazon.com illustrates the problems that BestBuy faces.

Brian J. Dunn, BestBuy's CEO, on the first quarter conference call on June 14 articulated BestBuy's current strategy:

"Our multi-channel strategy clearly differentiates us from competitors and gives us unique opportunities to grow. We are optimizing our scale for growth in the key areas we've previously discussed, new products and services like tablets and connections, categories where we have a competitive advantage and significant upside such as appliances and gaming and formats and new locations like Five Star in China and Best Buy Mobile standalone stores throughout the U.S."

The smaller mobile stores may help the company capitalize on the growth of smart phones and tablets.

I can recall a time when I went to BestBuy to browse row after row of DVDs. It was a large section and seemed to have every movie I would ever conceive of buying. Now, with services available such as Netflix and movies on-demand, DVD sales have materially decreased and the DVD section at BestBuy is sparse. To some degree what replaced DVDs as sales began to fall was gaming as the gaming industry exploded with the introduction of Sony's Playstation, Microsoft's Xbox, Nintendo's Wii, etc. One could argue that effectively there was a GameStop store inside of every BestBuy store.

Should BBY acquire GME?

So should BestBuy buy GameStop?

Arbitrarily assuming a purchase price of 8x trailing EBITDA of $850mm places an enterprise value on the business of $6.8 billion and implies a per share purchase price of $49, an 80% premium to the price today. In 2010 GME has $1.7 billion of SG&A costs. If 25% of these costs could be removed in the context of a deal (again an arbitrary assumption) the 8x times multiple would be reduced to 5.3x from BBY's perspective. Would investors accept an 80% premium for GME today? More importantly, would this make strategic sense for BestBuy. If on-line gaming is going to destroy the bricks and mortar gaming business in the short-term this deal may not make sense. But, if it's going to take time and be an evolution rather than a revolution perhaps it does make sense. Recent reports suggest that a new version of the Xbox is on the way and other consoles refreshes are also likely. Further, Microsoft's (NASDAQ:MSFT) Kinnect has been an enormous success and requires the purchase of the device. BestBuy could rationalize GME's store locations and use the remaining footprint to sell other non-gaming consumer electronics as well – perhaps a gaming and mobile store profile would be successful.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.