When Is It Time To Take Profits On GameStop?

| About: GameStop Corp. (GME)

Last summer I outlined why GameStop (NYSE:GME) would double in 12 months. Finally, when Microsoft (NASDAQ:MSFT) and Sony (NYSE:SNE) announced they would release the new eighth generation gaming consoles this holiday season it propelled GameStop well past my price target. Now with the company beating estimates and hitting new 52-week highs, it's time to figure out when the stock is overpriced and it becomes a sell.

Until last year, investors had been avoiding GameStop stock in part because of rumors that the new consoles would not allow used games to be sold or traded. GameStop's worst fears almost came true a few months ago when Microsoft announced serious restrictions on used games. Just some of the restrictions the company put on its published games were that you could only give Xbox One games to people who have been on your friends list for at least 30 days, each game could only be given once, friends can't borrow games, nor will loaning or renting be available at launch. As soon as Microsoft confirmed Sony would not have any restrictions, the company gave in to fan outrage and removed the stipulations on June 19th.

The news that used games will still play a part with the new consoles gave GameStop an additional boost over the past month, the stock sitting around $38.56 before the announcement and closing just under $43 this past week. The fear that the core business would become obsolete once the eighth-generation systems were released has been weighing on GME for literally the past five years. It could have been especially damning considering that while the seventh-generation product cycle was the longest in the industry's history and an internal document allegedly from Microsoft estimates that the new consoles will have a 15 year product cycle.

In addition to the positive news about used game policies, the other factor that is contributing to GameStop's strong performance, is the anticipation of the massive increase in game sales that occurs during the release of major consoles. The Xbox 360 was introduced in November of 2005 and for the full year the total revenue from console video game sales was $10.5 billion. Almost a year later, the Playstation 3 was released. The console only sold 688K units during the holiday, but it was enough to give the overall video game market a modest boost of 19% to a total revenue of $12.5 billion. In 2007, the first full year of release for all the major consoles, video game sales soared another 43% to $17.94 billion.

It doesn't come as a surprise that GameStop reported record earnings for fiscal 2005, posting a profit of more than $100 million. Then in fiscal 2006 the company blew those numbers away and had net earnings of $158 million. For the fiscal year 2007 (you see why I place so much emphasis on console releases) GameStop had net earnings of $288.3 million. The company should be able to follow the same pattern this time around. The uptrend in earnings that began last year with the release of the Nintendo Wii U, should continue through the fall with the launch of the PS4 and the Xbox One and finally a peak in earnings for the full year 2014.

As you might expect, during the release of the seventh-generation consoles, GameStop's stock followed the same uptrend as its record earnings. GME began 2005 at just $10 per share and by late January 2006, the stock had doubled to $20 per share. Nearly the exact same pattern we have seen over the past year with GME stock going from $20 per share to close at $42.42 on July 10th. The company's shares hit a high of $62.30 on December 28th, 2007, but afterwards it was straight downhill. By November 2008, video game sales had slowed, the luster had worn off the shiny new consoles and GME had fallen below $22 per share. The stock then stayed in a very tight range of $18 to $22 per share for years, that is until this latest surge.

While I haven't personally tested the new hardware, there don't seem to be many differences between the seventh and eighth generation of consoles, at least not as many as there were between the sixth and seventh. For instance, early models of the Playstation 2 needed an adapter to connect to the internet. There were no movie or TV apps like Netflix (NASDAQ:NFLX) or Amazon (NASDAQ:AMZN) Prime, the controllers weren't wireless, there was no Bluetooth connectivity, the list goes on and on. The improvements on the Playstation 3 were light years ahead of its predecessor. So I had some trepidation that customers would be content with their PS3s and Xbox 360s, wouldn't find an upgrade necessary and wouldn't shell out $400 to $600 for the new consoles. As a result, I thought there was a danger that console sales would be weak and end up not helping GameStop as much as they did in the past.

Those fears were assuaged this week while still in the pre-order phase of the console releases. Some of the largest retailers of video games have stopped offering certain systems, and started using a term I'd never heard before "pre-sold out". GameStop said on Tuesday that is was sold out of Playstation 4 consoles and they are no longer available for pre-order. Amazon.com is no longer offering either console by the launch day. Best Buy (NYSE:BBY) is no longer offering the Xbox Day One edition for pre-order. However as of Thursday July 10th, Target (NYSE:TGT) and Wal-Mart (NYSE:WMT) still have launch day units of each console available.

Comparisons to orders and shipments of the last console releases are difficult for several reasons. First of all, Playstation 3 pre-orders did not start until October 10th, 2006 and the console was launched just a month later on November 17, 2006 (in the U.S.). In addition, there were a very small number of units allocated to each store. GameStop locations were getting 8 - 16 units to reserve for pre-sale. Sony also announced it would ship 400,000 PS3 units on launch day, but several reports say the company did not meet that quota. Nevertheless, the console sold out all of its pre-sale allocation on the first day and was completely sold out on launch day.

Flash forward to June 15th of this year, just after the E3 Video Game Expo, and PS4 pre-orders were 75,000, while the Xbox One had 45,000 reservations. Retailers are saying that Xbox One pre-sales have caught up since Microsoft changed its restrictive policies on used games and online connectivity requirements on June 19th. I have no doubt that given the speed of which the consoles are selling out and the amount of time still left before launch, the companies will ship substantially more units with this release than they did the last time.

All this is going to provide a huge boost to GameStop, but earnings over the long term and even the viability of the business model will depend greatly on the company being able to effectively monetize digital sales. While GameStop's global sales dropped 6.8% in the first quarter of 2013, its digital sales increased 47%. The company makes money by selling downloadable content available at a video games launch and works directly with game publishers to offer bonus in-game items. Naturally, this business will also get a boost this fall, with over 40 games launching with the new consoles. Another part of the digital segment of GameStop's business is Kongregate.com. This website allows users to play games online for free, but because the games are not console related it will probably see a drop in traffic over the next 18 months. Overall, the digital business made the company $630 million in 2012.

The next segment of GameStop's business which will help the company offset the market shift away from the used game business, is tablet and smartphone trades and sales. Customers can bring in their mobile devices and receive cash or store credit. GameStop then refurbishes and re-sells them. Sales of mobile devices rose 290% to $46.8 million. A very encouraging sign, but still a very small part of the companies $1.87 billion in revenue for the first quarter of this year.

The effect on earnings from the new console releases will not be seen until the company reports fiscal 2013 results after January of next year. Despite the increase in revenue from higher overall sales of hardware and software, typically during a console release and the first full year afterwards, GameStop's gross margins take a hit. The bread and butter of GME's business is used games, which had a profit margin last quarter of 47.7%. New video game software only had a profit margin of 21.1% and new video game hardware had a gross profit of 8.4%.

After the first full year of a console release, the sales mix moves back toward the higher margin software and accessories sales and gross margins climb back up. For the 13 weeks ending May 4th, 2013, GME's gross profit as a percentage of net sales, was 31%, a 1% increase over the same period last year. GameStop expects to see an overall decline in gross margin percentage beginning in the fourth quarter of 2013.

I am not going to spend a lot of time writing about last quarter's earnings, because like most retailers, the majority of GameStop's yearly earnings are made during the holiday quarter. When Microsoft announced the Xbox One, GameStop raised the lower end of its range for the full year 2013 earnings forecast to $2.90 to $3.15 per share. While the console release is the catalyst for GameStop's increase in earnings, many parts of the business are going to benefit over the next couple years. For instance, the Game Informer website (GameStop's magazines website) saw its traffic nearly double from March to April of this year.

Because of what I have outlined in this article and the way GameStop has managed to beat analysts estimates four times in the last five quarters, the company should not only come in at the high end of the full year 2013 range, but it should beat those estimates as well. I think analysts and GameStop have underestimated the demand for new consoles and the effect the new systems will have on all aspects of GME's business. The company should easily be able to make $3.25 per share for the fiscal year ending January 2014.

Looking out longer term, the consensus estimates for 2014 is $3.76 and the estimate for 2015 is $4.49. In my estimation, those number should almost be reversed. Despite lower gross margins, GameStop should earn more for 2014 than it will in following year. While it's very difficult to get specific that far out, I think GameStop will earn roughly $4.30 for the full year 2014 and $4.20 for 2015. Whether the company will be able to sustain these earnings in the years after that will depend on its ability to grow the digital business.

GameStop lumps its digital business into the "other" category. This category is comprised of downloadable content for third party games, purchases/subscriptions for games on its Kongregate platform, its magazine Game Informer and its mobile device trades and sales. Last quarter, this segment of the business had a gross profit margin of 40%, but only had a gross profit of $139 million. This was $9 million less than new video software and almost half of the profit that used video game products made. Unless the company can increase its gross profits by nearly 100% over the next two and a half years, then GameStop's income will begin to decrease as the consoles age.

So when do you sell GameStop? If you haven't already figured it out from this article, I believe GME will hit a peak in earnings for the full year of 2014. The company will report earnings sometime after January 2015. If my estimates are correct, than $60 per share would be a trailing P/E of just above 14 which is on the low end of the average for the retailing sector. If estimates for 2015 don't come down, then a stock price of $65 to $70 per share would still have a solid PEG ratio that would be below one. So if the company's digital, magazine, and mobile businesses haven't begun making a profit close to what the used video game business is doing than this is the time to say "Game Over".

Disclosure: I am long GME, AMZN, MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Tagged: , , , Electronics Stores
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here