The world's largest video game retailer announced Jan. 8 that its holiday sales of $2.88 billion were 4.6% less than in 2011. GameStop's (NYSE:GME) comparable store sales in the nine-week period were down 3.5% in the United States and even worse internationally, declining 6.4% year-over-year. The news sent investors scurrying for cover and the stock down almost 6.3% on the day's trading. Is this a sign to sell or buy?
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Worst Showing in Five Years
GameStop's management guidance expects a drop in full-year comparable-store sales of between 7.5% and 9% in 2012, its worst performance in the past five years. Any momentum its stock gained over the last three months (up 8.3%) has been instantly lost with another disappointing holiday report. It's like a broken record. Its stock seems to gain some ground in the back half of the year only to give back those gains early in the New Year upon reporting less-than-stellar holiday sales. It's become an annual tradition. As a result, its stock's total return in the last four calendar years has been 1.3%, 4.3%, 5.5% and 7.3%, respectively. Averaging 4.6% annually over those four years, it's underperformed the S&P 500 on an annualized basis by 1,030 basis points. Buying the SPDR S&P 500 (ARCA:SPY) would have been a much better call.
According to valuation website Trefis, the market for digitally-distributed video games has grown by over 200% since 2010. This is definitely GameStop's future. Competing with Electronic Arts' (Nasdaq:EA) Origin platform, Trefis projects digital revenues of $1 billion by 2019, a lot less growth than what GameStop originally projected. In its April 2011 presentation to investors it predicted digital revenues of $1.5 billion by January 2015. Of course, it was counting on digital revenues growing by 55% in each of the next four years. That isn't happening; however, it's coming pretty darn close. Since 2009, digital revenues have grown from $179 million to an estimated $635 million in 2012. In the holiday period, while retail store revenues failed miserably, digital receipts increased by 40% year-over-year. It was about the only bright spot in an otherwise dreary Christmas. Most importantly, the gross margins that come with digital are much higher than those attached to the sale of new video game hardware or software. Unfortunately, declines in its retail sales usually result in slightly lower digital growth. It's for this reason GameStop will have to figure out how to deliver same-store sales that are flat at the very least.
Although the sale of used video game products is a big bright spot for the company, it declined by 15.6% in the nine-week holiday period due to a lack of new titles released in 2012 along with reduced promotional activity. Nonetheless, its gross margin for used games in the third quarter was 48.3%, 230 basis points higher than in 2011. For the first nine months of the year its revenue for used video game products was $1.67 billion, approximately $1 billion less than new video game hardware and software. Yet, the gross profits for used games were $323 million higher at $814 million. Even its other segment, which includes digital revenue, did nearly as well in terms of gross profits despite revenues being one-third those in the retail stores. Here again, GameStop is hamstrung because used products can't thrive without new products being sold in the marketplace. If GameStop were to suddenly shut down its retail stores, all those profits would disappear. It's betwixt and between.
The Bottom Line
Excluding the huge impairment in the third quarter, GameStop expects to earn at least $3.10 a share in fiscal 2012. After its Jan. 8 swoon, its stock is trading at 6.8 times its 2014 earnings per share, its lowest valuation in a decade. Although many see a dinosaur, its free cash flow yield of 17.3% makes it very enticing as a value play. Forget the idea that it's a value trap; instead, focus on the future. Used games will keep pumping out the profits so digital can keep growing. The year ahead could see GameStop introduce its streaming platform, which would be good news for shareholders who've been waiting since management's $1.5-billion digital revenue prediction back in April 2011.
Although GameStop is far from the perfect stock - at current prices - I believe it's a buy rather than a sell.
At the time of writing, Will Ashworth did not own any shares in any company mentioned in this article.