Most of its stores are located in strip malls, with the remaining stores located in shopping malls. GameStop Corp. also offers strategy guides, action figures, as well as other computer and video game magazines to its customers. The company's strategy is to grow through store expansions in favorable localities, by providing the largest title collection of used and new video games, and by leveraging its first-to-market distribution network to offer the latest hardware and software releases.
On October 10, 2005, GameStop and Electronics Boutique completed their merger. The combined company instantly became the leading global video game retailer. Under the terms of the agreement, Electronics Boutique shareholders received $38.15 in cash, plus the equivalent of 0.78795 shares of GameStop Class A common stock for each share of Electronics Boutique.
We continue to expect the company to benefit from the current video game cycle, which is still in the early stages, and gains from the merger with Electronics Boutique. We believe GameStop is wellpositioned to take advantage of this video game cycle that is being driven by next-generation video game consoles. The cycle was kicked off in November 2005 with the Xbox 360 from Microsoft (MSFT). The Xbox 360 is essentially a high-end PC gaming machine complete with digital media and networking capabilities housed in a sleek package. This new console takes gaming to the next level of entertainment and interactivity.
During the 2006 holiday shopping season, Sony (SNE) rolled out the PlayStation 3 and Nintendo (OTCPK:NTDOY) began selling its Wii. These two consoles (especially the Wii) are also popular with gamers and should continue to help boost GameStop's sales for the next few quarters, as consumers upgrade their game systems. We estimate that this video game cycle will last three to four years as new software titles are designed for the Xbox 360, PlayStation 3, and Nintendo Wii, and that bodes well for GameStop's earnings growth over the next few years. The company believes that this cycle will be deeper, wider, and longer than any previous period of new console introductions.
These next-generation systems have spurred numerous new video games that were available for the spring of 2007. Games such as Pokemon Diamond, God of War II, Guitar Hero II, and Ghost Recon: Advanced Warfighter 2 were among the most popular software titles. To be sure, this new video game cycle will shake out winners and losers as consumers decide which system and games they like the most. From GameStop's perspective, however, it doesn't matter which game console wins or which video game makers win.
The company's results will flourish as long as demand for the video games remains strong. Instead of picking the winners, GameStop closely monitors the pulse of the video game world and lets its customers tell them which games to stock in stores. We are confident that GameStop will continue executing this part of its business model.
In addition to the next generation video game cycle, GameStop will also continue to benefit from its merger with Electronics Boutique. Before merging, GameStop and EB Games followed similar strategies. Both companies aggressively opened new stores, favored strip mall locations, offered superior customer service, and focused on trade-ins and the sale of used games.
Going forward, we expect GameStop to continue pursuing these strategies that made both companies successful. After the merger, GameStop has over 4,800 stores, making it the largest video game retailer in the world. This size will afford the company many competitive advantages and cost savings that should help drive solid sales growth and profit margin expansion in the years ahead. The competitive advantages include being the first stop for serious gamers to seek out new and used games and offering a higher level of product knowledge customer service than its competitors.
These advantages should lead to further market share gains domestically and be better equipped to aggressively go after international market share. Moreover, GameStop will be able to achieve cost efficiencies from the merger. For example, previously competing stores will be able to share distribution, advertising, and labor expenses. That should enable the company to achieve significant operating expense leverage in future quarters; the result will be an expanding operating margin and accelerating earnings growth. The long-term outlook for GameStop remains bright.
We reiterate our Buy rating and increase our target price from $40 to $45 on GME shares.
INDUSTRY OUTLOOK INDUSTRY OUTLOOK - NEUTRAL
Our outlook for the non-food retail/wholesale industry is neutral. This industry is contingent on consumer disposable income, which is critically tied to the employment outlook. There is some debate about the extent to which debt has funded consumer spending over the last few years. Though debt reduction through home refinancings has slowed a great deal, consumers will continue to have some additional disposable income from lower payments.
Consumer debt is high by many measures, though including mortgages may be somewhat misleading, as U.S. home ownership is at an historic high. Retailers, in general, should benefit from an improving economy and consumer confidence, along with job growth and lower unemployment. Some retail segments will perform better than others. Merchandising has been and will continue to be very important, as consumers are selective in terms of product and price.
Building traffic is a central theme for all retailers. Target (TGT), Wal-Mart (WMT), and Dollar General (DG) are trying to attract customers by offering both groceries and other items in one place. Radio Shack (RSH) and Circuit City (CC) have focused on reformatting their stores to be more visually appealing. Home Depot (HD) is improving its customers' shopping experience by providing better service and cleaner stores.
Inventory management is the other focus for retailers. Expectations are high for new systems (at chains as diverse as Nordstrom (JWN), Home Depot, and Dollar General) to provide management with faster and better information regarding what is selling. This impacts markdowns, distribution, re-orders, and new inventory purchases. As the economy improves, earnings for these companies will benefit. Overall, we believe retailers will perform in line with the S&P 500.
GameStop is the largest specialty retailer focusing on video game software and hardware sales. The company caters to the hardcore gamer, as well as the casual video game buyer. The retailer has 4,778 stores, sells new and used software and hardware and should generate over $6.3 billion in sales this year. However, competition in this space is fierce and video game shoppers have many alternatives. Bigbox retailers, such Best Buy (BBY), Wal-Mart, and Target look at video games as high margin sales that can help drive store traffic. These companies focus on new hardware and software sales.
There are also video rental chains, such as Blockbuster (BBI) and Hollywood Entertainment that opened video game stores within their current locations to buy and sell new and used games. Another area of increasing competitive pressure comes from numerous websites that buy, sell, and rent new and used video games. Still, GameStop has an advantage over its larger competitors. Video game sales are not just a part of its business; those sales make up all of its business. Whether it is knowing what new titles will be popular, how much inventory to have on hand, or valuing used titles, GameStop has the upper hand in all phases of its core business over other retailers that view video games as just another product.
On May 23, GameStop announced financial results for the first quarter ended May 5, 2007. Total company sales increased 23.0% to $1,279.0 million in comparison to $1,040.0 million in the prior year quarter. Comparable store sales increased 15.3% during the first quarter, also beating previously released guidance of 12.0% to 14.0%. Hardware sales grew 75.1% in the first quarter, driven by overwhelming demand for Nintendo's Wii and DS Lite systems, and strong sales of Microsoft's Xbox 360 and Sony's PS3. GameStop's net earnings were $24.7 million, including debt retirement costs of $6.7 million ($4.2 million, net of tax benefits), an 111% increase over the first quarter of 2006. Diluted earnings per share were $0.15 for the first quarter of 2007, including debt retirement costs of $0.03 per diluted share.
The company also provided financial guidance for the second quarter and full-year 2007. For the second quarter, the company expects comparable-store sales to range from +16.0% to +18.0% and diluted earnings per share of $0.07 to $0.08. For full-year 2007, GameStop expects total revenue growth of 19.0%-21.0%, comparable-store sales of +14.0% to +16.0%, and earnings per share of $1.39 to $1.42 not including debt retirement costs.
On February 12, GameStop announced that its board of directors approved a two-for-one stock split of the company's common stock to be effected in the form of a stock dividend. Each shareholder of record at the close of business on February 20, 2007, will receive one additional share of GameStop common stock for every outstanding share held on the record date. The additional shares will be distributed on March 16, 2007. More importantly, the board also authorized an additional $150 million for the buyback of senior floating rate notes and senior notes. The timing and amount of the repurchases will be determined by the company's management based on their evaluation of market conditions and other factors.
GME shares are trading at 23.9x our 2007 EPS and 18.2x 2008 EPS estimate. We think GameStop's industry-leading footprint, strength in the used video game market, and the early stages of the video game product cycle make GME shares a solid long-term holding. Our target price of $45 may look expensive at 30x our 2007 EPS estimate, but it is supported by our discounted cash flow analysis. Our model assumes that GameStop can increase its sales at 9% and earnings 24% for the next five years. It further assumes that GameStop's earnings growth will eventually decline to a sustainable rate of 3% over the long term. We then discount the cash flows generated by those assumptions at our estimate of GameStop's weighted average cost of capital of 12%. RISKS If software developers produce unpopular games, GameStop's results will suffer. The merger could lead to integration issues that prevent the companies from achieving the forecasted synergies and cost savings. The rapid expansion of company stores could stretch the company's ability to find and hire qualified store managers and employees. This could tarnish the company's brand and reputation with its customers.
GameStop's first quarter results demonstrate that the current video game cycle is going strong. Moreover, we believe that GameStop is well-positioned to take advantage of this product cycle, which should last for the next few years. That s because no matter which game console or software titles eventually win out, GameStop will succeed by selling the most popular consoles and titles in its stores. All told, GameStop remains one of our favorite stocks in the retail sector. We reiterate our Buy rating and increase our target price from $40 to $45, which is 23x our fiscal year.
We think that GameStop has numerous competitive advantages that will enable the video game retailer to deliver strong growth for the next several years. The video game business is still in the early stages of a new video game console cycle that includes the next generation platforms Xbox 360, PlayStation 3, and Nintendo Wii. These next-generation systems will require gamers to upgrade their current systems in order to experience more advanced video games. Longer-term, the video game industry should continue to take entertainment and advertising dollars away from movies and television. For their part, video game companies continue to produce entertaining, challenging, and popular video games that gamers want to play. Most investors underestimate GameStop's used video game business, which produces strong sales with higher profit margins than new video game sales. GameStop reported robust sales and earnings growth for the first quarter. Management also issued strong sales and earnings guidance for the second quarter and full-year 2007.
We reiterate our Buy rating and increase our target price from $40 to $45.
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