Strong Fundamentals
The stock market game has been one that GameStop has seemed unable to win since 2008. More recently though, things appear to be changing as GameStop’s price has bounced off of lows not seen since the fall of 2005. GameStop (GME), headquartered in Grapevine, Texas, is the world’s largest video game retailer operating over 6,400 stores in 20 countries.
Since 2005, GameStop has grown earnings at over 30% per annum, some 13 times faster than the earnings growth of the S&P 500 of 2.3% per annum. Also, GameStop’s long-term debt to total capital of 16% compares very favorably to the 52% debt to total capital for the S&P 500. Yet GameStop’s shares are capitalized at 9.4 times earnings, almost half the 18.2 PE for the S&P 500. Healthy GameStop generates a ton of cash, is not a capital intensive business, is gaining market share and generates returns on invested capital well above its cost of capital.
Above-Average Growth/Below Average Valuation
In Figure 1 below, we look at the S&P 500 through the lens of our EDMP, Inc. F.A.S.T. Graphs™ since 2005. Note that the S&P 500 was trading at approximately the same 18-plus PE ratio in the beginning of the period as it is now at the end (red arrows). Earnings growth, including an estimate for 2010 for the S&P 500, is a mere 2.3% (red circle).
Figure 1. S&P 500 6yr EPS Growth correlated to Price (click to enlarge)
Figure 2, looks at GameStop Corp. (GME) over the same 6-year period 2005 to current. Keep in mind this is the exact same time frame and economic condition for GameStop as it was for the 500 companies in the S&P 500 composite. GameStop Corp.’s earnings achievement is many times better than average. However, inexplicably the so-called market has chosen to capitalize GameStop’s extraordinary results at a mere half the PE ratio of the S&P 500. The S&P 500 with anemic growth trades at 18.2 times earnings, while GameStop’s powerful growth only commands a PE of 9.4. These numbers don’t add up in our opinion.
Figure 2. GME 6yr EPS Growth correlated to Price (click to enlarge)
Figure 3 calculates the performance of GameStop Corp. versus the S&P 500 for the period reviewed in Figures 1 & 2. Even though GameStop’s PE ratio had fallen by half since their 2005 debut, their strong earnings growth still enabled them to soundly outperform the S&P 500. This offers a window of insight into the importance of earnings to investors over the long run.
Figure 3. GME 6yr Price Performance compared to S&P 500 (click to enlarge)
Thesis For Growth
During their March 18, 2010 conference call, GameStop’s management reported that they intend to budget $217 million dollars for expansion. This includes 400 new store openings, improvements to existing stores to improve customer experience, information system support, distribution expansion and digital and loyalty program enhancements. Nevertheless, they expect to generate $600 million of free cash flow from operations leaving them with $900 million of cash at year-end 2010.
In addition to unfounded fears resulting from their CFO’s resignation in order to take a position at Wal-Mart (WMT), threats of competition, real or fantasized, are major factors in our view of why GameStop’s valuation is so low. Investors are concerned that the big-box retailers potentially continuing promotional price cuts during the important Christmas season in order to drive traffic will hurt GameStop’s business permanently. Next is the fear that future game downloads will steal future sales.
In spite of these fears, GameStop keeps adding stores which are very profitable and continues to gain market share. Their lucrative used-game business, which took years to develop, provides a strong barrier to entry or moat. Also, GameStop already has an e-commerce business and is working diligently to stay relevant and current within their industry as it evolves. The following excerpt from their earnings call by Dan DeMatteo, CEO, summarizes their strategy:
Now, I would like to switch and discuss some strategies that we unveiled last fall at the BMO Conference. Beginning later this quarter, we will be testing the marketing of downloadable add-on content and its acquisition right in the retail store. This project has been worked on with our internal IT team and Microsoft. We have great expectations for our ability to drive sales of downloadable add-on content for the industry, and see it as a meaningful way to participate in digital sales. In May, we will be testing a new loyalty program that is designed to increase our share of boxed product sales, increase our knowledge of our customers' purchasing preferences, and allow us to better serve and recommend products to our consumers today and in the future.
And last year, we announced the acquisition of a browser game publisher, Jolt. Beginning this month, you will see marketing in our stores to drive traffic to their game, Legends of Zork. We see this test as another meaningful way we can participate in the growing browser game category, and we will use key learnings from the test to drive traffic to other publisher's browser games.
Summary
Since its public debut on February 28, 2001, GameStop Corp has commanded a historical normal PE ratio of approximately 17. In fact, as can be seen through Figure 4, GameStop shares have traded at or above 17 times earnings most of the time. Only since late 2008 has their PE ratio fallen significantly below 17 (yellow circle). Yet very little has changed fundamentally with the business.
Figure 4. GME 9yr EPS Growth correlated to Price (click to enlarge)
Figure 5 below reports and calculates the consensus 5-year estimated growth rate of 15% from 13 analysts reporting to FirstCall. This is in line with management’s guidance of 14% to 18% growth for 2010.
Figure 5. GME 5yr Earnings Forecast (click to enlarge)
Conclusion
When you look at GameStop by the numbers, the numbers make no sense. We believe GameStop’s low valuation represents a compelling opportunity for growth-minded investors willing to accept some risk for exceptional long-term potential returns. This is why we added to our position in GameStop last week.
Disclosure: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
Disclosure: Long GME at time of writing
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