Sunday, April 4, 2010

The Game Is Not Over For GameStop Corp.

Company Profile

GameStop is the world's largest video game retailer. The company operates 6,450 retail stores throughout the United States, Austria, Australia, Canada, Denmark, Finland, France, Germany, Italy, Ireland, New Zealand, Norway, Portugal, Puerto Rico, Spain, Sweden, Switzerland and the United Kingdom. The company also operates an e-commerce site, GameStop.com, and publishes Game Informer(R) magazine, a leading multi-platform video game publication. GameStop Corp. sells new and used video game software, hardware and accessories for video game systems from Sony, Nintendo, and Microsoft. In addition, the company sells PC entertainment software, related accessories, and other merchandise.

Investment Thesis

The big question is whether GameStop is a value trap. The videogame industry suffered through most of 2009. During the first nine months of 2009, sales dropped 8 percent below 2008 levels. The holiday season saw a major uptick in sales and the industry was able to report Y-O-Y sales 4 percent higher than 2008. Hardware sales were particularly strong with revenue growth of 16 percent. The major beneficiary in this category was Nintendo’s Wii. Significantly, Sony’s Playstation outsold Microsoft’s Xbox 360.

GameStop has provided us with guidance for 2010.

For fiscal 2010, based on current market trends, GameStop expects the following:

  • Total sales growth between +4.0% and +6.0%
      • New hardware: -5.0% to -15.0%
      • New software: +2.0% to +5.0%
      • Used products: +5.0% to +10.0%
      • Other: +5.0% to +10.0%
  • Comparable store sales of 0.0% to +2.0%
  • Diluted earnings per share ranging from $2.58 to $2.68, an annual increase of +14% to +18%, based on expected outstanding diluted shares of 155,000,000.

During the year, GameStop intends to execute our previously announced capital allocation plan, which includes the following cash deployment:

  • $75 million in the opening of 400 new stores
  • $125 million in store improvements, information system support, refurbishment upgrades, distribution expansion and loyalty program enhancements
  • $100 million reserved for acquisition and investments
  • $300 million for share repurchases

Based on our current financial projections, the company forecasts it will end fiscal 2010 with $900 million cash on hand.

For the first quarter of fiscal 2010, the company expects comparable store sales to range from -3.0% to 0.0%, driven by reduced hardware price points compared to last year. Diluted earnings per share are expected to range from $0.46 to $0.48, a 7% to 12% increase over the prior year quarter.

Note that guidance does not include debt retirement costs.

The Company also embarked on a $300 million share buyback program. GameStop has already purchased 12,642,200 shares at a cost of $247 million.

By The Numbers

Y-O-Y, sales grew 3.1% from $8,805.9 million to $9,078.0 million. For the quarter ending 1/10, sales reached $3,524.0 million as compared to $3,492.1 million for the quarter ending 1/09. As reported by Thomson Reuters, analysts project FY 11 sales in the range of $9,222.3 million to $9,613.8 million with a mean of $9,431.22 million. Based on our own analysis, Measured Approach estimates FY 11 sales of $10,589.59. Our sales growth estimate reflects a 16.6% growth rate. This compares with a three growth rate of 19.5%, a five year growth rate of 37.6% and a seven year growth rate of 31.3%.

Historically, GameStop’s sales growth rates have outpaced its industry median. The industry median company has grown sales at the rate of 1.2%, 3.7%, 7.5% and 9.4% over the past one year, three year, five year and seven year periods, respectively.

Operating income declined in FY 10 to $631.7 million from $672.8 million in FY 09. Net income also fell. Net income fell from $398.3 million in FY 09 to $377.2 million in FY 10 or 5.3%. The Company reported EPS of $1.29 (MRQ) as compared to $1.39 in the comparable year-ago quarter. This represents a 7.2% decline in quarterly earnings.

Analysts are estimating FY 11 EPS in the range of $2.55 to $2.70 with a consensus estimate of $$2.63. Based on this estimate, the forward-looking PE is approximately 8.5X. Measured Approach’s estimate of FY 11 EPS is consistent with the analysts at $2.69. If Measured Approach is correct, we will see a 17.5% growth in EPS which would be supported by our estimate of sales growth.

With the increase in sales in FY 10, we were pleased to see that inventory to sales decreased to 11.16% from the FY 09 level of 12.22%. This is an indication that the Company is not expanding its inventory beyond what is necessary to maintain product in its stores.

GameStop reported a dramatic increase in cash and short-term investments in FY 10. Cash and short-term investments grew to $905.4 million in FY 10 as compared to $578.1 million in FY 09. As stated above, the Company is using this cash to buy back stock which increases shareholder value. The company is also paying down long-term debt. The long-term debt to capital ratio has declined to 14.1% as reported for the quarter ending 1/10 in comparison to 19.4% as reported in the quarter ending 1/09. These are good uses the excess cash. Long-term debt decreased to $447.3 million from $545.7 million. Overall, the balance sheet is solid.

Valuation

GME is currently trading at about 8X projected earnings, a significant discount to the S&P 500. The current multiple of 10X is below the industry median. GME has historically traded at a premium to its industry median. If we applied the industry median of 13.8X to GME’s TTM’s EPS of $2.29, we get a value of $31.60.

On a price to book basis, again GME is selling at a discount to the industry median. If we apply the industry median PB to the Company’s book value for the MRQ, we get a value of $29.85. Historically, GME has a PB ratio in line with the industry median.

GME has a current price to sales ratio of 0.4X. The current industry median PSR is 0.7X. Applying this metric to GME, we get a value of $38.68.

Conclusion

We need to answer the question asked earlier. Is GameStop a value trap? We do not think so. We think the huge installed base of video games provides a foundation for continued growth for GME. We also think that as long as Nintendo, Microsoft, Sony and the other major players continue to introduce new hardware with more features, the base will continue to expand. Online gaming is a danger going forward that dampers our enthusiasm. Our target price of $31.35 is about 11.65X our FY 11 EPS estimate and about 10.X our estimate of free cash flow.

Disclosure: At the time this article is written, the author has no position in GME.

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