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Is GameStop an interesting investment opportunity?

Stilian Morrison of Interactive Buyside

Assessing GameStop as an interesting investment opportunity (Part 1 of 5)

Thesis overview

GameStop (GME) is a global specialty retailer of video game hardware/software/accessories and mobile phone re-commerce (unlocking etc.). The company derives a substantial portion of its gross margin (41%) from the purchase and resale of used games, typically from customers, but increasingly from liquidation closeouts and other retailers clearing inventory. The value proposition of GME starts (and ends) with the premise that gamers seek salvage value from their games, particularly those shiny new $60 ones. Salvage value serves as credit toward future hardware/software/accessory purchases without the headache/fees and two-step process of selling for cash into Amazon/eBay/Craigslist before outlaying the next purchase. The GameStop trade-in model is relatively seamless and allows the company to maintain a negative working capital balance that outpaces any big-box specialty retailer.

Management has amply demonstrated to be a group of smart capital allocators within the business and the shareholder base. We estimate average sales per square foot of $900–$950 to outpace Best Buy’s $750–$800 despite GME possessing more than triple the store units (albeit at one-twentieth the square footage). GameStop’s latest store expansion plan focuses on the relatively young Tech Brands segment (where gross margins are not far off the used game segment) following last year’s tactical acquisitions of Apple (AAPL) and AT&T (T) mobile phone resellers. Free cash flow after acquisitions has not gone below $380 million annually in over six years and management has returned all $1.7 billion (37% of market cap) of it to shareholders through dividends and buybacks.

The bearish thesis against GME has long been that either:

  • Some hyper-efficient retailer like WalMart will enter the used game market and take away significant share
  • Digital game copies (which have no salvage value) will replace physical discs and render the gamer value proposition obsolete

WalMart (WMT) in the past tried a version of the used game model using a third-party kiosk approach, not unlike what it does today with Jackson Hewitt for tax preparation. The effort failed miserably after the partner went out of business, but now they seem back for more, this time without a third party. While this approach won’t likely have the same poor result, we believe that GME has a defensible market share based on:

  • Store network distribution (small units in strip mall locations, accessible to both urban/rural consumers)
  • Supply chain efficiency
  • General brand ecosystem (staff members are typically avid gamers who are genuinely interested in chatting up and advising consumers)

As for digital, Microsoft tried a wholesale switch last year with the launch of its Xbox One, to which gamers responded with a vehement “no,” prompting a swift (and embarrassing) turnaround. Gamers are a unique, informed subset of consumer group who hold major sway in an industry that has withstood a secular trend in the growth of the casual mobile game market.

Company overview

GME expects to get to almost 7,000 total stores by the end of the current fiscal year as it expands its Tech Brands segment to roughly 8% of the store base. The average video game store is roughly 1,400 square feet versus  a range on tech brand locations of 900 to 2,600 square feet. Tech Brands represents the latest in a series of patient acquisitions into new verticals that started with digital/DLC for video games and moved into mobile/tablets, wireless, and the powerful Apple hardware ecosystem.

The Market Realist Take

The company revealed on its Investor Day in April that it has diversified into the U.S. wireless and global consumer electronics markets via acquisitions of Spring Mobile and Simply Mac.

GameStop saw profits in the latest quarter, fueled by an increase in its mobile business and demand for the new Xbox One and PlayStation 4 gaming consoles made by Sony Corp. (SNE) and Microsoft Corp. (MSFT), respectively. It said “from launch through April, total market sales in the U.S. Of PlayStation 4 and Xbox One hardware has more than doubled the combined sales of PlayStation 3 and Xbox 360 hardware through their first six months of sales.”

But 1Q revenue missed estimates despite a 7% increase to $2.0 billion. Consolidated comparable-store sales increased 5.8%. The mobile and consumer electronics category, which included Technology Brands results, rose over 100%. The rise was mainly driven by the contributions of Spring Mobile and Simply Mac.

GameStop sales were affected last year by an increasing consumer shift to digital games and social and mobile gaming on smartphones and tablets. According to research firm The NPD Group, hardware sales surged 95% year-over-year in May to $187 million. This was driven by Sony’s (SNE) PlayStation 4 and Microsoft’s (MSFT) Xbox One. Spending on physical gaming software (console plus portable) increased 57% to $274 million. Total physical gaming software (console plus portable plus PC) rose 51% to $284 million. Physical gaming accessories were up 8% to $124 million.

These trends benefit GameStop and its peers in the electronic retail space, including Best Buy (BBY), RadioShack (RSH), Amazon.com (AMZN), and Wal-Mart Stores (WMT) .

Continue to Part 2

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