GameStop: A Great Way to Play

Since it is a relatively slow retail news week, we thought it might be worthwhile to publish a list of our favorite consumer stocks. Given the significant number of headwinds facing consumers (such as record high gas prices, declining home values and the corresponding "wealth effect," and lingering credit concerns), we concede that at this time, this space may not be appropriate for all investor. That being said, we still believe there are a number of compelling investment ideas to be found in this sector.

In this post, we will look at video game retailer, GameStop (NYSE: GME).

Investment Highlights

• Opportune hardware/software cycle timing: Historically speaking, video game retailers are the most profitable during the second and third years following a major hardware platform release. Software presents much higher margin opportunities than the consoles they are played on because they are easier to mass-produce and require fewer input costs. The latest round of consoles were released in late 2005 or early 2006, meaning that we are currently in this "software sweet spot." Coupled with an impressive line-up of already released and upcoming titles, we expect video game retailers to continue to post excellent profitability over the next 12 months.
• Economic stimulus check benefit: In our opinion, the Street is overlooking a key consideration of the economic stimulus payments - the age of potential recipients. Individual taxpayers with an adjusted gross income of less than $75,000 will receive the full $600 rebate (joint taxpayers with less than $150,000 will receive $1,200). Yes, the majority of economic stimulus checks will be sent to lower- and middle-income families who will likely spend excess funds on necessities or service personal debt requirements. However, there is also large number of stimulus check recipients between the key video-game playing ages of 18-35 that don't necessarily have to worry about housing payments or gas price inflation. Coupled with the recent and upcoming release of highly sought titles, strong sales should persist for several quarters to come.
• Leisure activity substitute: Given the recent attention on soaring gas prices, we also expect discretionary spending on travel and other leisure activities to be down substantially this summer (and likely into the back half of the year). As a result, consumers will likely substitute lower-priced leisure activities and we believe video game retailers (especially those with family-friendly titles) could be a key beneficiary.

Investment Risks

• Valuation: Unlike most retailers and other consumer-related stocks, GameStop's stock has held up reasonably well over the past year. At 19x the consensus fiscal 2009 estimate of $2.38, the stock may be too expensive for some investors, even those willing to give the stock a premium valuation. However, the recent pullback presents an opportune entry point and we believe there could be some upside to the full-year numbers due to the reasons we outlined above, meaning the stock would be more attractive using forward multiples.
• Longer-term competitive threats: A few years from now, we are concerned that, like movies and television shows, video game purchases and rentals will be a largely online experience. However, the average consumer does not have the in-home bandwidth or storage capabilities to download large video game files at this time, and we believe GameStop has at least a few years of protection before facing a serious online competition. That being said, we welcome increasing efforts by GameStop to expand its online game sales operations.

For our mock portfolio purposes, we will assume our entry price on GameStop was $44.63 (the closing price as of June 10).

Disclosure: We hold a small long position in GameStop.

Comments

[Dan Jacome:]

GME is a short, too many outperforms, there is the long term downloading threat, and BBI is moving in hard on video games. If the BBI/CC deal fails, one could expect BBI to get into games more aggressively, a net negative for GME.

I'd be careful with GME, even with the stock down 28% YTD.

2008 Jun 11 11:48 AM