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GameStop Corp (NYSE: GME)

Recommendation Buy Company description:


Recent Price $19.22
Market Cap (millions) $3270 GameStop is the largest video game
Shares outstanding (millions) 164.7 retailer in the world and sells new and used
Average daily volume (millions) 5.57 video game software, hardware and
52 week range 17.12 – 32.82 accessories for video game systems from
Institutional ownership 95% Sony, Nintendo, and Microsoft. In addition,
Insider ownership 5% the company sells PC entertainment software,
Analyst coverage 18 and related accessories.
Fiscal year end Jan 31, 2010
Investment thesis

Merits:

• Largest video game retailer in


terms of sales and market share.
• Valuation is very cheap
• Business generates lot of FCF.
• Balance sheet is less levered than
the average retail company.
• Company has announced a $300
million stock buyback program.
Revenue (ttm) $9050 million
Net Income (ttm) $393.67 million
FCF /Share $2.4 Risks:
EPS (ttm) $2.35
BV / Share (ttm) $15.8 • Increased competition from big box
Total Assets $5036 million retailers will erode profit margins
Dividend - • Digital downloading / streaming of
Cash / LT Debt $292/ 447 million games
ROIC 17.9%
• Alternative platforms for gaming
ROE 17.3%
such as the Apple IPhone and
ROA 8.8%
Valuation social media such as FaceBook
P/E 7.84
P/FCF 8
Intrinsic value $29
Margin of Safety 33%
I am recommending a BUY for shares of GameStop. At around 8x FY2009E FCF, Gamestop (GME) is
priced extremely cheap compared to its retail peers and also compared to its historical valuation.

Gamestop is the largest video game retailer in the world that 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. Gamestop
operates around 6400 stores in US, Canada, Australia and Europe. Gamestop is headquartered in
Grapevine, Texas. Gamestop also operates several e-commerce sites including gamestop.com and
publishes the Game Informer magazine that has about 3.5 million subscribers.

Gamestop shares are down more than 66% from its highs of $60 in Jan 2008. In fiscal 2008,
Gamestop revenues increased by 24% and eps increased by 36%. In the first three quarters of fiscal
2009, Gamestop SSS have been affected due to a variety of reasons from the economic conditions,
reduced consumer spending, fewer blockbuster games from game publishers, reduced spending on
hardware and tough comparisons with outstanding quarters in fiscal 2008. Despite this, Gamestop has
increased sales in the first and third quarters of fiscal 2009, has been profitable and continues to
generate FCF. Gamestop has paid down debt from $963 million at the end of FY2005 to about $450
million as of 3Q2009. GameStop has $292 million cash on the balance sheet and interest is well
covered at 13x.

Gamestop has four product categories - New video game hardware ( 21% of revenue, 5% gross
profit), new video game software (42%, 34%), used video game products (23%, 43%), accessories
and pc software (14%, 18%). Hardware sales have come under pressure in 2009 due to reduced
consumer spending as well as price cuts effected by Sony, Microsoft and Nintendo on their gaming
devices. The bright spot for Gamestop has always been its used video game category. Gamestop has
historically earned 45%-48% gross margins in its buy-sell business model. This segment has
continued to grow at close to 20% YoY even during 2008 and in 2009. The installed base of video
game hardware systems in the United States, based on original sales, totaled over 185 million units of
handheld and console video game systems. As this base keeps growing, there is an increasing demand
for games, both new and used games. This shift in product mix should help increase gross margins as
margins are much higher for new games and used products.

Industry: The market for video game products and PC entertainment software exceeded $45 billion in
2008 in places where GME operates. Out of the $22 billion market in the United States,$21.3 billion
was attributable to video game products, excluding sales of used video game products, and
approximately $700 million was attributable to PC entertainment software, $19.8 billion in Europe in
2008, Canada was approximately $2.1 billion, Australia approximately $1.9 billion. The Entertainment
Software Association (“ESA”) estimates that 65% of all American households play video or computer
games, 40% of all electronic game players are female.

Seasonal business: This business is seasonal and the company generates most of its income and free
cash flow in the holiday season of the 4th quarter. During Fiscal 2008, GME generated 40% of its sales
and about 56% of the operating earnings during the fourth quarter.

Store expansion: Gamestop has grown by opening new stores and acquisitions both in the US and
internationally. Its largest acquisition was EB Games in 2005 with about 2500 stores. In 2008, it
acquired Micromania, a 332 store company in France as well as acquisitions in Norway and
Newzealand. It paid for the acquisitions with cash on hand and FCF generated through the business.
Its largest operations outside the US are in Canada (325 stores), Australia (350 stores) and France
(332 stores). The company has been opening new stores both in the US and overseas and plans to
spend $200 million on opening new stores in 2010 and reserve another $100 million for acquisitions.

GameStop Corp. (GME) ---- Analyst : Adib Motiwala


The company has grown revenues from about $3 billion in 2005 to $8.8 billion in 2008, with store
count going from 4490 to 6207, eps increasing from $0.81 to $2.38 and FCF/share from $1.5 to $2.4

Customer loyalty program: Gamestop has a customer loyalty program via the ‘Edge’ card. By buying
an annual subscription to the Game Informer magazine, GameStop customers get the ‘Edge’ card. The
edge card gives customers 10% discounts on used games, used accessories and importantly a 10%
bonus trade credit when trading used games/ accessories in stores.

Prelaunch marketing: This is another aspect of GameStop stores that set it apart from the
competition. GameStop stores host events at midnight during game launches where gaming
enthusiasts get to play the new game before its official release, participate in contests.

GameStop’s unique reservation process, trade currency, exclusive content, and prelaunch marketing
increasingly drive the new game consumer to them as the preferred source for new titles. Vast
physical network for stores in US and overseas helps it drive deals from publishers and platform
owners.

What the bears are saying:

Digital downloads of games will make Gamestop irrelevant

Here is why these fears are blown out of proportion.


(1) Game availability: I visited a GameStop and BestBuy store and checked on the latest and best
selling games. These games (Call of Duty: Modern Warfare 2, Final Fantasy 13, God of War
III, Super Mario Galaxy II) are not available as a digital download.
(2) Game Storage: Most of these games are huge in terms of storage needs. They tend to be
anywhere from 10GB – 30GB in size. The typical hard drive on the current consoles is 64-
128GB, 256 GB is an exception. Hard drives come with their own set of issues such as stoage
limit, physical back up requirements, disk fragmentation, slow down.
(3) Internet Speeds: Even if the new games were available for download, consider the time it
would take to download such a huge game – anywhere from 30minutes to 3 hours, depending
on your internet connection. In many parts of the world, high speed broadband connections
are not so prevalent and they are expensive as well. ISPS usually charge for bandwidth usage.
Downloading large games can become very expensive in such countries. So, while its all good
to say digital downloads is the future, that trend is yet to play out and the infrastructure to
support it does not exist.
(4) The consumer mindset: With digital downloads, you get an activation key that makes the
game tied up to a specific console. You cannot then download it on your friends console when
you go to visit him. You cannot exchange/loan games to your friends. The game publishers are
trying to prevent piracy, but this works to the disadvantage to the consumer. A gamer would
much rather prefer to carry his collection of games to his friends’ house. Also, you cannot
possibly sell the digital games. So if a consumer bought a game he is not happy with after a
while, he is stuck with it and has lost $40-$50. Also, game rentals would be impossible.
(5) With the advent of online streaming movies and movie downloads, a similar argument has
been made in the past against NetFlix. However, DVDs are still popular and people rent them
from NetFlix and also use the Netflix streaming service. Similarly, Gamestop has made moves
towards digital distribution. It intends to expand its ecommerce sites in the countries it
operates in and integrate them closely with the physical operations. It also has acquired a
majority stake in Jolt Games who makes browser based games. Last I checked even though
downloading music on iTunes was ubiquitous, major booksellers and even Amazon are still
selling physical music CDs. Trends are not instantaneous as they are made out.

GameStop Corp. (GME) ---- Analyst : Adib Motiwala


OnLive Streaming Service

OnLive is a new cloud computing based on-demand game service that will launch in June 2010. The
concept of OnLive is gaming without consoles and games being stores on servers in the cloud. Games
would be accessed via a PC or Mac or using a hardware devices connected to a TV. This service could
potentially disrupt both the console makers and also retailers that sell the physical games. Monthly
subscription to access the service is set at $14.99. There will extra cost to rent / buy the games. The
service will be initially launched in the US market. This is yet another potential threat to GameStop,
but it has yet to be played out.

Competition from other big box retailers

Retailers such as Walmart and Best Buy have competed with GameStop in the new software and
hardware for a long time. Despite this Gamestop has continued to grow profitably and take market
Best Buy’s video game business was down 10.9% in the third quarter, the same quarter that
share.
GameStop announced video game sales were up 4% for new games and 19% for used games. In
3Q2009, their market share for new game software increased by 150bps over last year.

Competition in used segment

In recent quarters, Walmart and Bestbuy had initiated a pilot program where they placed in-store
kiosks that would accept pre-owned games from customers and give them store credit / cash. I spoke
to a BestBuy employee who said that the kiosk would hardly ever be noticed by customers and the
program was a total failure. There was no human element to this and he did not see how this would
be successful. The company that made these kiosks, e-Play LLC, has suspended operations as can be
seen from their website http://www.e-play.com/. Amazon also started a games trade-in program
where customers ship games to Amazon for free and get a gift card. The success of this is yet to be
seen. Gamestop’s customers typically sell their used games for store credit (that is valid in any
GameStop Store and never expires) and with that they usually purchase other new or used games.
There is a certain element of instant gratification in this transaction that is being ignored by the
analysts and media. Yes, some of the patient casual games could sell their games to Amazon or Ebay,
however the typical gaming enthusiast would like to get his hands on the next game. Also, there is a
certain science and expertise to the used game business that is grossly misunderstood. GameStop has
proprietary programs and processes in place that help them decide the price levels for the used
games, inventory and stocking at different stores based on demand. The company also operates
several refurbishment centers in major markets, where used games are reconditioned, tested and sent
back for sale to the stores. There is an entire infrastructure behind the success of the used game
segment that could be taken for granted. This business has grown at 15-20% for the last several
years for GameStop.

Competition from games on smart phones/ social media gaming

In recent times, gaming on smart phones especially on Apple’s IPhone has taken off. Smaller
publishers and big names such as EA have made games available for the IPhone. However, these
games sell for much less ($5-$10) compared to the $50-$60 for games sold on the consoles. Also, the
experience of playing games on these devices is much different than that on big screens. Also, it can
be argued that some consumers would be introduced to gaming via these devices and then they may
turn around and increase demand for console based games.

GameStop Corp. (GME) ---- Analyst : Adib Motiwala


CFO left the company after a very short stay

Catherine Smith who had been with the company for only six months resigned to take a position at
Walmart international. While that is a concern, at this point, there is nothing to indicate that this is
due to any accounting issues.

Gamestop is exposed to European macro factors

Gamestop has expanded aggressively into Europe and has increased store count from 25 (FY2004) to
1201 at the end of 2008. Sales have been increasing in Europe pretty well. One aspect where Europe
lags behind the mature US operations is in gross margins. Management is committed to deploying US
best practices such as hardware and software refurbishment, stock balancing, and inventory
management which will bring European used margins in line with the historical US performance.

Catalysts for value unlocking

Sheer value: GameStop shares trade at the lowest end of their historical valuation over the last 5
years. A lot of negativity and reduced earnings expectations are already priced into the share price.
On an EV / EBITDA basis, GameStop is priced cheaper than similar retailers at 4x versus 6x for
BestBuy and 5.6x for RadioShack. GameStop is traded at 7.6x FY2010E earnings versus 12x for
BestBuy and 11.35x for RadioShack. As sales and earnings recover, GameStop shares should
appreciate both from increased earnings and multiple expansion ( reversion to mean)

Gamestop is currently valued at a market cap of $3.17 billion and EV of $3.32 billion (based on
10/31/09 balance sheet). FCF in 2009 is expected to land somewhere between $400-$425 million, so
the current EV/FCF multiple is around 8.4x or P/FCF is around 8x. This means that if GameStop were
to merely maintain its current earn, with no growth whatsoever, investors could expect to achieve
returns of 13-15% per year. If I project FCF to grow by a very conservative 5% with a 12% discount
rate, I get an intrinsic value of $29. GameStop has grown FCF by a much higher rate historically. This
gives plenty of room for upside and a 33% margin of safety.

Company Gamestop BestBuy Walmart Radioshack Conns Average


Ticker GME BBY WMT RSH CONN
Trailing P/E 8 15.34 14.58 14 11.72 12.7
Forward P/E 7.36 12 12.36 11.8 15.91 11.9
P/FCF 8.0 29 17.60 17.40 18.0
P/S 0.36 0.34 0.5 0.67 0.17 0.4
P/B 1.40 2.98 2.9 2.72 0.46 2.1
EV/EBITDA 4.07 5.92 7.7 5.661 4.76 5.6
ROIC 17.9% 16% 13.66 12 7.3 6.7
ROE 17.3% 22 21.19 21.48 4.2 13.8
ROA 8.8% 6.37 8.96 9.9 5.22 6.1
Market Cap
($million) 3209.74 16770 205090 2860 161 45618.1
Operating Margins 7.3% 3.90% 5.87% 8.64% 4.78% 6%

Share buyback: Gamestop should generate about $400-$425 million in FCF in FY 2009. Along with
the $290 million cash on the balance sheet, the company should be able to buy back $300 million of

GameStop Corp. (GME) ---- Analyst : Adib Motiwala


stock. At today’s prices, it would be accretive to earnings by about $0.23 per share. This should
provide support to the stock and help drive it up.

Strong game lineup for 2010: Already 2010 has had an excellent line up of games released such as
Final Fantasy 13, Mass Effect 2, God of War III. There are several highly expected games lined up for
2010 that should help drive sales for both new and used games, which in turn helps increase margins
favorably for GameStop.

Free Cash Flow: FCF has grown from $57.7 million in 2001 to $366 million in 2008. This company has
consistently increased FCF despite growing store count and making acquisitions.

Easier comparisons against double digit industry declines: SSS for GameStop fell by 1.5%, 14.1% and
7.8% in the first three quarters of 2009 and with expectations of decline in SSS in the fourth quarter
as well. FY2010 should have easier comparisons with FY2009 and there is a solid game lineup which
was missing in 2009.

Improving economy: As the economic conditions improve further, it can only mean good news for
GameStop.

Conclusion:

Gamestop faces some challenges, but it is far from a broken model about to be made irrelevant in the
video game industry. The company generates ongoing positive FCF and has cash on the balance sheet
to buy back shares, fund future expansion and pay down debt. Analyst will remain negative or
cautious for so long as SSS do not recover and GameStop reports improved gross margins. Because a
true turn in the fundamentals may be more than 12 months away, that largely explains the
extraordinarily low valuation offered today of around 8x FCF. That said, if sales pick up due to the new
game lineup than currently anticipated, the turn in the stock could happen sooner than expected.

GameStop Corp. (GME) ---- Analyst : Adib Motiwala