Why GameStop's Stock Price Could Double

| About: GameStop Corp. (GME)

GameStop (NYSE:GME) is a leading retailer of used video games and used video game consoles in the U.S., Canada, Australia and the UK. The company's stock has taking a significant beating recently along with many other companies in the video game space. There are many reasons why the sector has been so weak and several other names have been hurt as well.

Electronic Arts (NASDAQ:EA) has nearly been cut in half over the past six months. Another top player Activision (NASDAQ:ATVI) is at the low end of an $11 to $13 six month trading range. However several of the ongoing industry wide factors driving down video game manufacturers and retailers are coming to an end. The end of this cycle and changes in the video game business have created buying opportunity in some of these companies, GameStop specifically has a huge potential upside.

The change in the video game business affecting GameStop the most was the rumor of the Sony (NYSE:SNE) Playstation 4 being released as a fully online console. While game makers could still make physical disks, once the game was put into the console the player would then have to input a code to activate the game. After the code was successfully entered the game disk would only work on that specific console. This would mean gamers could no longer trade games, borrow games from friends and most importantly for GameStop, sell their used games.

Fortunately for GameStop, Sony rejected the idea of an online only console just a few days ago on May 30th. The next incarnation of the Sony Playstation will most likely include an optical disk drive similar to previous video game consoles. Microsoft has also stated it plans a use a disk drive on the next Xbox version. One of the major reasons the companies decided against download only consoles was the inconsistencies in internet connectivity around the world.

Comparisons to historical console launch cycles are difficult to make because the industry is still young and changing rapidly. Remember technology in the 90s? By the time you opened the box of your new computer of video game system, it was already obsolete. Then the sixth generation of game consoles were released around the turn of the century. That launch and the launch of the seventh generation of consoles in 2005 to 2007 are the only two significant product cycles in the past 13 years.

The annual E3 video game exposition was held last week in Los Angeles and it's the event where game and console makers debut their newest products. Gamers and investors were waiting to hear news about the next generation of consoles, rumored to be released next year. Currently we are at the end of the console cycle with the Sony Playstation 3 having been out for six years, the Nintendo (OTCPK:NTDOY) Wii released in 2006 and the Microsoft (NASDAQ:MSFT) Xbox 360 now in its seventh year. This extended part of the product cycle has only enhanced the sluggishness of the video game market, typically the product cycle for consoles has been 3 - 5 years.

Nintendo proudly premiered its Wii U at the Expo on Monday. The system has many technological advancements you might expect, including a GamePad touchscreen controller and enhanced motion controls. Nintendo is also looking to beef up its online presence with Miiverse, a new network communication system that will connect gamers from around the world. The new Nintendo will be backwards compatible, so both the games and the controllers from the original Wii, will also work on the new Wii U.

Both Microsoft and Sony said virtually nothing about their next generation of consoles. Instead both companies opted to emphasize new inter-connectivity features that target mobile devices. Microsoft introduced Microsoft SmartGlass, Xbox Music, and Internet Explorer for Xbox. Some of the features of the SmartGlass app include the ability to watch a movie on a tablet and then transfer it to a television, picking up at the same point you left off. The tablet would then automatically show information and content pertaining to the movie.

For gamers, they could design plays for Madden football on the tablet and run them on their Xbox or target a ship in Halo 4 and gets schematics and data pushed to their tablet. The devices were so interconnected the Trey Parker while introducing his new South Park game joked and asked the audience rhetorically,

How many times have you been watching an episode of South Park and thought, 'I'd like to be able to watch this on my television, while hooked into my mobile device, which is controlled by my tablet device, which is hooked into my oven,' all while sitting in the refrigerator?

Sony took the opportunity to announce its commitment to improving the portable Playstation Vita and like Microsoft, increasing its connectivity with the Playstation 3. With the tone of Sony's and Microsoft's presentations and the willingness of all three companies to move to the online space all the news looked bad for GameStop. The video game industry gets a massive boost from new console releases, now it looks like the new game machines are at least a year away.

The news of waning sales, online only consoles and longer console product cycles has already been priced into the stock and the future looks better than the stock price would suggest. Leading me to believe GameStop may have hit a bottom and is ready to go higher.

There are many bright spots in the company's business. GameStop knew the switch to online games and mobile devices was coming and is preparing for it. The company plans to grow its online download business by over 50% this year. While the video game business is expected to continue its slowdown into next year, the online digital business is a higher margin business and the company hopes it will offset losses from slowing hardware and video game sales. Some digital products are yielding 100% profit margins. The company also started buying, selling and refurbishing tablets and smart phones in an effort to break into the mobile markets.

To further the company's online efforts, in 2010 it purchased Kongregate Inc., which offers free video games online and has a virtual currency called Kreds. The company earns revenue from in-game advertising and gamers purchasing Kreds to advance themselves in games. In 2011 GME purchased Spawn Labs, a streaming technology company and in the same year purchased Impulse which allows users to download games directly to internet connected devices.

Digital sales at GameStop were $457 million last year and are expected to top $675 million this year. In 2013 the company expects digital sales to reach $1.5 billion. Its mobile business is expected to have sales of $175 million this year and increase to $575 million in 2013.

The stock has been gradually declining since 2008 when it was trading at its highs of $62 per share. This was 1-2 years after the release of the latest generation of gaming consoles, which is the time when GME says its sales are the greatest. Now the stock is poised to run up again in anticipation of the new console launches and since 2008 the company has bought back several hundred million worth of stock and paid down virtually all of its debt. GME is now trading at a P/E of around 8, which is only slightly pricier than some of its peers like RadioShack (NYSE:RSH) at 4.7 and hhgregg (NYSE:HGG) at 6.1. The premium is well deserved considering GME's low debt in comparison to other electronic retailers.

Despite all the bad news, GameStop is transforming its business and it still expects sales to increase 1 to 5 percent this year. It is only one of 22 companies in the S & P 500 that is debt free. Historically, in the 52 weeks after new video game consoles are released, GameStop has experienced more than a 20% increase in software and hardware sales.

Assuming new video game consoles are released early to mid 2013 and that GameStop made relatively accurate predications of its business, I estimate it could make upwards of $5.20 per share on revenues of over $12 billion for the full year of 2013. For the stock to have a projected P/E of around eight it will have to double before 2014. A bad second half of 2012 and a poor holiday season should have already been priced into the stock, so it may only be a matter of time before GME starts its climb higher.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in GME over the next 72 hours.