GameStop Is A Buyout Candidate With Excellent Underlying Value

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 |  About: GameStop Corp. (GME), Includes: BBY
by: J Mintzmyer

Following Best Buy's (NYSE:BBY) highly publicized buyout offer by founder Richard Schulze, speculation has shifted towards GameStop (NYSE:GME). Although GameStop is more specialized, their plight is similar to Best Buy. Both boast strong revenues, earnings, and operating cash flows in a troubled industry during a poor economy. Both have turned to dividend boosts and share repurchases to buoy their stock valuation. Ultimately, both stocks have tumbled, not necessarily due to current numbers, but as a result of dismal expectations.

Extremely Poor Expectations

GameStop has suffered from poor press, including a recent report that GameStop is the "10th worst place to work in the US." Expectations for the near term are poor, with Q2 2012 earnings expected to drop by 36.4% to 14c per share. Expectations for the long term are even worse, with some analysts even predicting bankruptcy within the next five years. If GameStop is able to deliver on their initial guidance of $3.10 to $3.30 per share, while showcasing strong digital revenue growth, I believe GME stock will trade in a P/E range of 8-10 ($24.80-$33) by 2013.

Massive Short Interest

With a float of 128M shares, and recent short interest at 48.64 M shares, GME is shorted at a ratio of 38%. This is far higher than Best Buy's 15% short interest, and provides a virtual powder keg underneath GME's share price. If a massive surprise happens with GME, whether through a new acquisition, strategic partnership, earnings blowout, or even buyout offers, 48.64M shares will need to be bought back by shorts. This represents 18.9 days to cover based on average volume. In comparison, BBY's days to cover is 3.78. In rough terms, GameStop is shorted 5 times deeper than Best Buy was (short numbers are current as of 31 July).

GameStop has been heavily shorted since 2008, and only one minor short squeeze has occurred. This squeeze was over March-April of 2011 in response to record sales and net earnings, and a digital sales increase of 61%. Read the big-name stories on GameStop and you would think that 2011 was a disaster. In fact, 2011 was the 2nd best year in company history for EPS. If GME hits their target of $3.10-$3.30 for 2012, this will represent an increase of 28.6-36.9% y/y and an increase of 17-24.5% from their all-time record (2010). In the previous short squeeze, GME rocketed 33% in under a month to land at $26.40 in April 2011.

If GME posts an all-time record in EPS, all bets will be off for shorters.

Dividend Payouts

In a bid to increase their stock price, GameStop initiated a dividend on February 8, 2012. At a 60c annual run-rate, GME is paying out approximately 25% based on last year's earnings and as low as 18% from the high end of projections. 60c annual payout represents a current yield of 3.35%. If GameStop makes their guidance, I fully expect a dividend increase, perhaps as much as a 33% increase y/y to 80c annual.

Share Repurchases

In January 2010, GameStop began a massive share and debt repurchase program. GME has since gone from 167.6M shares diluted and $545.7M in debt to 134.8M shares diluted and $0 in debt. This represents a decrease of 19.6% in diluted shares outstanding while also completely deleveraging the company. GameStop has paid an average of $20.38 for all shares repurchased to-date. There is currently $455M remaining under current buyback authorization, which at today's prices, represents another 18.9% reduction in outstanding shares. With OCF close to $600M for the past three years, I expect the complete authorization to be used before 2013.

Solid Cash Flows and Safe Balance Sheet

As mentioned above, GameStop has zero debt and has generated around $600M in Operating (around $400M Free) Cash Flows over the past three years.

GameStop has a Current Ratio of 1.24 and a Quick Ratio of 0.39. The latter number appears worrisome to unfamiliar investors, but almost all A/R and A/P in this retail sector is linked. GamSstop merely "holds" inventory of new games for many publishers, and GME is ultimately only "stuck" with the used game inventory, which has proven to be massively profitable (46.4% gross profit margin last quarter). Retail juggernaut Wal-Mart (NYSE:WMT) has a comparable Current Ratio of 0.83 and a Quick Ratio of 0.23. Best Buy has a Current of 1.15 and a Quick of 0.48.

Pundits who mention future bankruptcy have clearly done little to no due diligence on this stock. Those in major media who use words like 'tail spin' and 'failure' obviously do not realize that GME has posted its two top years of EPS in 2010 and 2011, respectively.

Growth in Digital Sales

While critics bemoan the "death of the brick and mortar store" and make erroneous comparisons to Blockbuster and Borders, GameStop is quietly expanding their digital arsenal. Impulse Driven and Kongregate have been forgotten by most analysts while Spawn Labs has been written-off completely. In the recent quarter, GME posted a 23% y/y growth of digital sales. In Q1 2012 sales reports, the "other" category, which digital sales is a main contributor to, posted a gross margin of 40.5%. This is very impressive, and perhaps the most over looked factor for GameStop. There is nothing but upside here because analysts expect next to zilch in terms of digital revenues and profits.

Buyout Hype

A recent article in Barron's, posted last Saturday, has generated waves in the financial community over the possibility of a GME buyout. In all fairness, in my article posted two days earlier covering the BBY offering, I drew similar comparisons to Best Buy and suggested a buyout possibility in the comments section.

Fellow Seeking Alpha contributor, Todd Sullivan, has weighed in that the buyout is unlikely. I strongly disagree; however, I also believe that GME is a great investment whether or not a private deal ultimately occurs.

At its current price level, assuming the $3.10-$3.30 EPS target is hit for 2012, GME is trading at a forward P/E of only 5.4-5.8. Trailing P/E to what pundits consider a poor 2011 is still a meager 7.42. Best Buy at $20 is trading for 5.3-5.7 forward P/E.

With FCF of $400M (OCF $600M) proven for the past three years, GME is trading at merely 5.8x FCF and 3.88x OCF. In comparison, Best Buy at $20 is trading for a comparable three-year average of 3.1x OCF and 4.14x FCF.

It is easy to draw the direct parallels. Add in the upside that GameStop can be purchased for a much smaller total amount, has nimble leasing terms, and has zero debt, and suddenly this looks like no-brainer for a Bain Capital type company.

Great Investment or Risky Trade?

GameStop's short-term future is all about expectations, namely for full-year 2012. If you believe that GameStop can deliver on the $3.10-$3.30 EPS guidance, than this should be an automatic purchase. I'm slightly skeptical, but even EPS of $3 would be tremendous considering that this debt-free company trades for under $18/share.

I prefer to hold GameStop for the long term, and I would personally shun any takeover offer for less than $35 considering their digital potential. Time will tell, this stock is definitely not for the faint of heart or for those looking for a "quick buck."

Disclosure: I am long GME, BBY.