GameStop (NYSE:GME) is a retailer which sells new and used video games, including console hardware and related accessories.
The company operates more than 6,500 retail stores, primarily across the US, Canada, Europe, and Australia. GameStop also owns several eCommerce sites in various countries using the GameStop, EB Games, and Micromania brand names. To continue its strategy of digital expansion, the company recently purchased popular video gaming website kongregate.com as well as Impulse and Spawn Labs. The latter two will improve the company's abilities to enter the market for distribution and streaming of popular games online. GameStop competes with other traditional box retailers as well as eCommerce sites, including Wal-Mart (NYSE:WMT), Amazon (NASDAQ:AMZN), and Best Buy (NYSE:BBY).
For some time now, I have been reading articles hearing how GameStop will be "going the way of Blockbuster" in a few years. For those who might not be aware, Blockbuster was a movie rental retail chain that after several years of losing business to digital downloads and new competitors such as Netflix (NASDAQ:NFLX), filed for bankruptcy in September 2010.
As the world of gaming and entertainment has shifted more and more to digital mediums, investors have become concerned that GameStop's business model is dead and the company will not be able to adapt. Similar fears exist for other retailers of games and electronics - two examples are Best Buy and RadioShack (NYSE:RSH).
In this article, I will present my thesis as to why I believe GameStop shares are a great value today. The fears that investors have about the company are simply unwarranted. To make my case, I will first do a comparison of how GameStop has done over the past few years vs. the final years of Blockbuster. I will then summarize the upcoming catalysts for the company and examine the current valuation.
Comparison of Blockbuster and GameStop Financials - Clearly Not the Same Story
I thought it was useful to first look at some financials which clearly show that GameStop is in much better shape than Blockbuster was in its final years.
The following table shows some key metrics for Blockbuster in its final 5 years before bankruptcy.
Long Term Debt
Note: Data in table sourced from 2010 10-K of Blockbuster.
In these 5 consecutive years, revenues decreased every single year. In fact, revenues were down 27% over the 5 year period. Blockbuster lost money with a negative net income in 4 out of the 5 years. Debt also remained high throughout the whole period. Stockholder equity is not shown in the table, but the debt/equity ratio was greater than 1 in all of these years.
So without looking any further into Blockbuster, it is very clear from the numbers that this was a struggling company. There were warning signs in the financials.
This begs the question - if investors think that GameStop will "go the way of Blockbuster," you would expect there are some similar warning signs in the financials - right?
In fact, one glance will tell you that just the opposite is true. Here are the same financial metrics for the past 5 years of GameStop (data sourced from 2012 10-K):
Long Term Debt
*Note: In 2012 the company initiated a healthy dividend, and committed to pay out the majority of earnings to shareholders in the form of share buybacks and dividends. Stock currently yields 4.2%.
In the case of GameStop, revenues have continued to increase. In total they have gone up 35% in 5 years. Net income has also increased overall. Although it should be noted in 2011 the company had a non-cash impairment charge, which is why there was a drop in net income in 2011. However, compared to Blockbuster's last 5 years, this is for sure a much healthier company. Long-term debt has also been paid off completely in 2011.
Risks to GameStop's Business Model
The financials surely look OK for GameStop, so there must be something else going on in the future prospects of the business that has scared investors away. Indeed, there are some risks to consider. The most obvious one is that video gamers will stop buying physical games, and will do all of their gaming online. As GameStop currently only gets less than 13% of revenue from online sources, this would pose a huge problem to the company if they couldn't develop their digital market share quick enough.
Recently I read an article which explains quite well about these risks, and that really boils down to 2 main threats:
- Gamers will convert to digital downloads, and stop going to physical stores to buy their video games.
- The next generation of consoles being released in 2012-2014 will drop backward compatibility, greatly hurting used video games sales (used game sales make up more than 40% of GameStop's profit).
I won't go into detail here on the risks, as this is covered in the referenced article as well as many others on SA. To summarize though, both of these risks are definitely overblown and do not pose a major threat in the coming few years to GameStop. Threat #1 has some technological constraints around file compression, which means basically that the most popular larger games will not be downloadable in a reasonable amount of time even on the fastest broadband connections. It would take many hours to download, which will not be practical for most users.
As for the dropping of backwards compatibility threat, this is unlikely to happen in the near term. The consumer market for used games remains strong, and there is a lot of evidence that this would not be well received. Even though it could be more profitable for video game makers to do this in the short term, they need to be mindful of what their customers are demanding, and also watch closely what their competitors are offering. The risks of customer backlash are too great here, so the chances of all 3 major console makers doing this is very small.
Summary of Upcoming Catalysts for GameStop
Now that we've established that GameStop is not in as much trouble as the pundits think, it's also important to realize that there are several potential positive catalysts happening in the coming year. Here is a short list:
- All three major video game console makers, Nintendo (OTCPK:NTDOY) , Sony (NYSE:SNE), and Microsoft (NASDAQ:MSFT) are preparing to release the next generation of their products. The Nintendo Wii U is coming out at the end of 2012, and the other two are expected either late in 2013 or in 2014. This should improve hardware and new game sales for GameStop in the near term, and should also help to ensure that earnings and FCF numbers remain strong in the next 2-3 years. There is already evidence that the Nintendo Wii U is receiving stronger than expected demand.
- Management has made a strong commitment to shareholders, by instituting a healthy dividend (>4% yield), and a massive share buyback program. This really shows their belief in the company. Continued reduction in outstanding share count will be a positive for the stock price, and minimizes the downside risk considerably.
- Institutional ownership is only 4%, according to Yahoo Finance. Very low institutional ownership means that any positive surprises on the company could cause some of them to buy in, which will help the stock price further.
GameStop's compelling valuation
In case you are still not convinced about the company, I just want to leave you with how compelling the current valuation is. Have a look at these valuation ratios:
Clearly these are quite attractive numbers for a company that has had growing revenues, stable earnings, and no debt.
Conducting a simple DCF exercise, I get an intrinsic value of $33.97/share:
- Discount Rate: 6%
- EPS Growth over 5 years: 3%
- Growth after 5 years: 0%
- Confidence in estimates: 75%
With a current price of $22.86, there is still a margin of safety of more than 30%. This DCF assumes very modest growth in the coming years and reduces the resulting intrinsic value estimate a further 25% by adding the confidence factor variable. By saying I am only 75% confident in my growth estimates, the DCF calculator assigns an intrinsic value of 0 to 25% of the business. Although this is overly simplified, it has the effect of being a very conservative way to try and avoid over estimating the value.
In conclusion, I find GameStop to be a compelling value stock. Clearly the company is priced very cheaply by the market. In addition there are positive catalysts, and the company is out of favor due to several risks which appear to be overblown.
I would therefore ask readers - what is there not to love about GameStop? I welcome your comments below.