BACKGROUND (Source)
GameStop Corp. (GME), headquartered in Grapevine, Texas, is the world's largest multichannel video game retailer. GameStop's retail network includes 6,627 company-operated stores in 17 countries worldwide and online at GameStop.com . The network also includes: Kongregate.com , a leading browser-based game site; Game Informer® magazine, the leading multi-platform video game publication; Spawn Labs, a streaming technology company; and a digital PC game distribution platform available at www.GameStop.com/PC .
History:
Below are some possible concerns creating headwinds for GME. (Source 10-K)
The electronic game industry is cyclical, which could cause significant fluctuation in earnings.
The electronic game industry has been cyclical in nature in response to the introduction and maturation of new technology. Following the introduction of new video game platforms, sales of these platforms and related software and accessories generally increase due to initial demand, while sales of older platforms and related products generally decrease as customers migrate toward the new platforms. New video game platforms have historically been introduced approximately every five years. The current generation of video game consoles were introduced in 2005 and 2006. If video game platform manufacturers fail to develop new hardware platforms, our sales of video game products could decline.
This console cycle is already 2 years longer than the last console cycle so management is in uncharted territory as far as forecasting sales. Near term until there is a refresh it's not unreasonable to expect weak sales. The longer term opportunity is a new video game cycle that the market appears to be ignoring.
Technological advances in the delivery and types of video games and PC entertainment software, as well as changes in consumer behavior related to these new technologies, could lower sales.
While it is currently only possible to download a limited amount of video game content to the current generation video game systems and downloading is constrained by bandwidth capacity, this technology is becoming more prevalent and continues to evolve rapidly.
There is probably more hype than substance to this threat. For example Gamezone reports Sony's 2013 release for PS4 will not be "digital only" for the following reasons:
Sony (SNE) decided against a download-only model largely because Internet connections are too inconsistent around the world," one of the WSJ sources said. "Because game files are large, customers in countries where Internet connections are relatively slow would be hobbled by a requirement to download games.
In the meantime the company is not resting on their laurels. From the May conference call:
Our digital businesses grew at 23%, continuing strong growth around the world... Our PC download business grew 172%... Kongregate continues its transformation, growing in-game transaction revenue by 144% during the quarter, and growing total revenue by 50%. Traffic, as measured by Google Analytics, increased 22% on Kongregate.com during the quarter.
Spawn Labs achieving all of its objectives and demonstrating its ability to execute ultra low-latency cloud gaming through 6 data centers to our associates throughout the nation. We continue to work with our publishing partners to bring a console-based service to market. We've also begun development of a PC-based solution to augment our PC digital service, as well as to provide an expanded cloud gaming offering that takes advantage of our patented virtualization process.
Economic uncertainty in the US and Europe: This is probably the greatest threat in the near term, not just for GME but any company that depends on its customer's discretionary income.
FINANCIALS:
We'll examine trends based on management's financial track record using GAAP results to highlight longer term trends. The annual data used in this article can be found here.
EPS TRENDS: The following graph for EPS and cash trends are arrived at by calculating the statistics for a trend line using the "least squares" method. This determines the line that best fits the historical data and consensus estimates.
The above represents the following trends:
Analysis Period | EPS Growth Trend |
3 year | 4.0% |
5 year | 6.3% |
10 year | 10.4% |
Model trend | 6.9% |
CASH TRENDS:
The above represents the following trends:
Analysis Period | EPS Growth Trend |
3 year | 3.7% |
5 year | 12.6% |
10 year | 14.9% |
Model trend | 9.4% |
DIVIDEND: On Feb. 8, 2012GME announced its board of directors approved the initiation of a quarterly dividend to its shareholders of $0.15 per share. Dan DeMatteo, executive chairman, said the following:
We have achieved our goal of eliminating debt and are pleased to return excess cash to our shareholders. The board's decision to initiate a dividend reflects GameStop's strong capital position and demonstrates our confidence in the long term viability of our business.
This represents an attractive 3.3% yield at the time of this writing. The following graph shows the dividend is safe and there is room to increase it if the trends continue.
The FCF payout ratio is 18% based on near term projections
VALUATION:
This fair value analysis is based on management's longer term financial performance as measured by the previous data. Fair values are based, in part, on the following: Discounted cash flow, a modified Graham's intrinsic value formula and a P/E analysis. The valuation model consists of two parts.
- The discounted cash flow and the modified Graham's intrinsic value are blended to arrive at a fair value.
- A P/E analysis based on historical adjusted values.
Fair value used is the minimum value of the two parts.
Part 1: Discounted cash flow and the modified Graham's intrinsic value.
An estimated long-term EPS growth rate of 6.9% and a long-term cash per share growth rate of 9.4% were calculated from the data described above. Analysts are projecting a five-year EPS growth rate of 9.25% as of this writing. (Source: Nasdaq.com)
Running these projections through our pricing model, excluding the PE analysis, produces a fair value of $31. Needless to say, the result is sensitive to changes in the growth rates as illustrated below.
Part 2: P/E Analysis
The model looks at current and past periods to calculate a limiting PE value.
The result is a maximum allowable PE of 9 yielding a fair value of $27. The result is sensitive to any earnings revision as illustrated below.
The PE is the controlling factor in this case. Final fair value is the minimum of the two methods or $27.
COMPETITION
Below are some of the competitors listed by GME. The following graph shows the prior year and TTM operating income growth along with current PE ratios:
Considering Amazons (AMZN) tax advantage and the pricing power of Wal-Mart (WMT), Target (TGT) and Best Buy (BBY), GME is doing well alongside these large competitors.
CONCLUSION
Is GME an opportunity or value trap? A PE of 9 is not overly aggressive. The yield is attractive. The discounted cash flow and the modified Graham's intrinsic value analysis support pricing up to a PE of 10.3. The question is, has the market oversold GME creating an opportunity or are some of the risks listed in this article greater than described above? Feel free to comment and share your opinion (opportunity or value trap) in the comment section.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in GME over the next 72 hours.
