GameStop: A Contrarian Investment With Lots Of Upside

| About: GameStop Corp. (GME)

Summary

Continued revenue growth in a shrinking brick and mortar market demonstrates GameStop's resilience.

A niche market for trade-ins and retro gaming will keep GameStop from becoming the next Blockbuster.

Upgraded Sony and Microsoft devices should drive hardware sales and traffic through GameStop over the next few years.

Over the past decade, we have seen the shift from brick-and-mortar sales to downloadable content result in the bankruptcies of former household-name companies like Blockbuster and Borders. These once popular chains were out competed by newer technology and e-commerce. The Street has lined up to name its next victim in this transition, and with almost 40% of the float short, that company is GameStop (NYSE:GME).

GameStop, which offers video game software, hardware, accessories and trade-ins, looks like nothing special and a very natural victim of downloadable content. Essentially everything it sells can be purchased digitally.

But I think the 40% short float, an attractive valuation, and near-term catalysts make this stock an attractive long in an otherwise struggling broad market. It is the most heavily shorted stock in the S&P 500, so investors following me on this will be going against the trend, but that heavy short interest coupled with a 6x 1-year forward P/E multiple and 5.8% dividend yield give the stock a fairly attractive risk-reward profile.

The market in general might be in decline, but the numbers certainly don't show it. After a stark 7% decline in 2013, revenues have grown in the low-single-digit range every year since. Revenues last year were up almost $500 million from where they were 3 years ago. Gross margin is also expanding, and this has led to gross profit growing 10% since 2013 and even being 9% higher than 2012 levels when the company netted nearly $200 million more in revenue.

What is even more shocking is the growth is expected to continue. Analysts see this 0% to 2% revenue growth continuing over the next 2 years, and for that revenue growth to lead to 2.5% earnings growth this year and 6.5% earnings growth next year. Over the next 5 years, analysts expect GME to grow revenues at a 7.6% CAGR. This is more-or-less in-line with analyst estimates for market growth over the next 5 years, and so it makes little sense to me that a company with similar growth projections as the broader market trades at 7x trailing earnings while the market trades at 23x trailing earnings, and that's inclusive of the recent Brexit sell-off.

The forward estimates calling for steady earnings growth also means the stock is trading at 6x Fy18E EPS, and that equates to a 16.7% forward earnings yield. This looks extremely favorable relative to the current 10-Year Treasury yield of 1.4%. Investors should also know that recent share price depreciation has hiked the dividend yield up to almost 6%, and this gives investors an attractive cushion for volatility.

The fundamentals add up here, but what good are they if the analyst forecast for growth is flawed. So is GME a company that actually can grow earnings at a consistent, low-growth rate over the next 5 years? I think the answer to that is yes, as I see a company that is able to drive revenues higher in a shrinking market space. In the near future, I see the GME continuing revenue growth and don't think bankruptcy is in the foreseeable future.

But why do so many people feel that GME is such a great short candidate?

First, you can find all the new games, systems, and electronics at GME or online or through direct downloads on platform servers. That gives the consumer multiple options outside of GME to get what GME sells. While this seems like compelling evidence of a company following in the footsteps of Blockbuster, I think it lacks an understanding of GME's target consumer. A recent survey found that more than 70% of teens aged 13 to 17 play video games, with that number soaring to more than 80% when narrowed to just boys between the ages of 13 and 17. Only 11% of this audience carries a credit card. There exists a substantially sized market for kids who have a $20 bill from this week's allowance, want to buy a new video game, and ask Dad to drive them down to GameStop.

Those kids don't even have to buy the physical game to make GameStop's business not obsolete. According to Joshua Brustein in the article linked above, GameStop is generating significant revenue from selling digitally licensed content. In short, customers enter a GameStop, buy a code to download a game, and go home and download it.

No one would ever schlep to a Barnes & Noble to download an e-book, but GameStop claims a 30 percent to 40 percent market share in the sale of digitally licensed content, such as extra game levels, and a 10 percent to 15 percent share of full-game downloads.... For Microsoft the figure is 40 percent; Sony says one-third of digital sales come from retail locations

So this shows that GME can survive even if the secular shift towards downloadable content continues. In other words, the sale of new physical games is not a necessity for the persistence of GME's business. Moreover, there will never cease to be dedicated fan base for retro games or for buying consoles on release-date in-store.

The Xbox One and PlayStation 4 were rumored to include code that would prevent the use of used games-a potentially devastating blow to GameStop, which gets 27 percent of its revenue from trade-ins. But gamers revolted, and instead of a death sentence GameStop has gotten a lift from the consoles. Its sales of the devices are growing twice as fast as the industry as a whole, and its sales of their games have risen almost four times as fast.

Beyond downloadable content, there will always be a market for new gaming systems and accessories. Later this year, Playstation will release the new and improved PS4 with 4k resolution and virtual reality headsets and other accessories. In the following two years, Xbox is slated to release the new Xbox One S and Project Scorpio. These near term tailwinds in new consoles and expensive new accessories will help drive revenue for GME. Additionally, the release of new consoles will drive demand for new games and more accessories to play in a more involved interactive way. In the same way GME experienced sales growth after the initial release of the PS4 and Xbox One, these new consoles will usher in a new wave of excited gamers on an annual basis who will increase software, hardware and accessory sales.

I believe that the shift towards downloadable content is already maxed out. PwC believes that going into a GME and buying a physical copy of a game will remain the dominant method for purchasing video games in even 5 to 10 years. I agree with this. Physical copies lend themselves to the re-sale market, so when you want a new game, you can trade-in your old one to get credits. There also certain memory and data constraints with downloading content, and consumers like the portability of a disc.

Another thing at play here is the gift under the tree. Holiday sales account for roughly 41% of annual video game sales. In my opinion, it is quite hard to "gift" a downloaded game. There is something to be said for having a physical gift under the tree, whether it be a card with a bar-code or an physical copy of a game, both of which can be purchased at GME.

It's not a growth stock. There are several threats to the company's growth into perpetuity, but I think all of these fears are overly baked into the stock price and I do not think many of them will come to fruition. I like GME in a broader market that is declining because there isn't much valuation risk and a strong dividend yield will support some near-term volatility.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.