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GameStop Corp: A Company Needing to Adapt in a Changing Industry

March 19, 2014 | About:

GameStop Corp. (GME) is a U.S. video game and entertainment software retailer. Based in Grapevine, Texas, the company operates 6,700 stores throughout America and Europe. It is the main retailer and often the only choice for gamers of new and used games. Offering a wide variety of used titles, having good customer service, accepting most titles, and also giving the customers credit on new games for their used ones, the pre-owned games (used games) business has generated as much as half of the company’s gross profit.

Having a customer loyalty program (PowerUp Rewards), with more than 30 million users, the company ensured both its new and preowned gaming market, giving benefit to customers (usually young ones that use solely cash), and ensuring its market share against competitors such as Target or Wal-Mart. Though now the online retail store Amazon.com seems to be the most dangerous competition for GameStop.

GameStop Corp Profitability Analysis

Looking at profitability is a very important step in understanding a company. Profitability is —essentially — the reason behind a company’s existence, and a key component in deciding whether to invest in or maintain your investment in a company. In this article I will look at GameStop´s earnings and earnings growth, profit margins, profitability ratios and cash flow. In addition, I will evaluate which institutional investors bought the stock in recent quarters.

Earnings and Revenue Growth

First, I analyze GameStop Corp´s earnings growth. For many stock investors, the most important thing is growth and, specifically, growth in earnings. This is what fuels aggressive growth stocks. Therefore, it is of utmost importance that investors have an idea of how long a company can sustain a certain level of earnings expansion. The company's valuation, and thus the stock price, is almost completely dependent on this fact.

The company generated 53% EPS growth last quarter compared to the same quarter in the past year.

I like the fact that GME generated more than 15% quarterly EPS growth. This came from strong management execution and increased product adoption levels. Management sounded very optimistic in the last earnings call.

It is interesting to see that consensus analysts recently upgraded their estimates for the current year, increasing their EPS projections by -111.42%. This shows that sell-side analysts are confident in the company.

GameStop Corp also shows a 3 year average annual growth rate of 0.42%. It is essential to evaluate the company´s EPS growth trend in the past year in order to get a clear perspective on how the company has been developing.

I am looking for three year annual growth levels above 15%. GME generated less than that.

In addition to analyzing EPS growth, I focus on evaluating GME's top line or revenue growth. The value of common stocks is, of course, closely tied to the sales power of the company. Therefore, an understanding of the company’s growth potential for both the near and long-term timeframes is required before an investment decision.

GameStop Corp reported a 19% quarterly sales growth year over year.

GME generated strong revenue growth. This was fueled by improved product adoptions and continued success in management´s strategy to expand into emerging markets. I require a minimum of 15% quarterly sales growth when investing in high growing companies and GameStop Corp surpassed that level.

I also look at how GameStop Corp increased its earnings over the past three years. GME generated an average three-year annual sales growth of -0.71%. This is a very important metric that Investors Business Daily (IBD)-the best source for growth stocks ideas- pays attention to when analyzing high growth companies, and so should you.

GameStop Corp generated annual sales growth below 15%, which is the minimum I am looking for in growing companies but we should also find out why that happened.

Gross Profit Margin

The gross profit margin is a measure of a company's manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue/sales left after subtracting the cost of the goods/services sold. A company that operates on a higher profit margin than its competitors is more efficient. Investors tend to pay more for businesses that have higher efficiency ratings, as these should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.).

In the case of GameStop Corp, its gross margins over the past years have increased. The five-year low for the gross margin was reported with at 25.8%. On the opposite, the current margin of 29.8% is the five-year high point. Moreover, the TTM gross profit margin of 29.5% is above the five-year average of 27.46%.

A gross margin above the five-year average implies that management has been successful in making the manufacturing and distribution during the production process more efficient over the past five years.

Operating Margin = Operating Income / Total Sales

The operating margin is a measure of the proportion of a company's revenue that is left after paying for variable costs of production, such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs such as interest on debt. If a company's margin is increasing, it is earning more per dollar of sales. Needless to say: the higher the margin, the better.

Over the past 5 years, the operating margin of GameStop Corp has been increasing. In 2009, the company reported an operating margin of 7.7%. Over the past twelve months the margin reached 7.0%.

The TTM operating margin of 7.0% is above the five-year average of 5.44%. This implies that there has been an increase in the percentage of the total sales left over after paying for variable costs of production such as wages and raw materials compared to the five-year average. I am always looking for companies that have improving operating margin trends.

Net Profit Margin = Net Income / Total Sales

A ratio of profitability calculated as net income divided by revenue, or net profits divided by sales. It measures how much out of every dollar of sales a company actually keeps in earnings.

The profit margin is a very useful metric when comparing companies in the same –or similar- industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. Profit margin is displayed as a percentage; a 20% profit margin, for example, means the company has a net income of $0.20 for each dollar of sales.

Over the past five years, GameStop Corp's net profit margin has been increasing in comparison to the five year average margin. The TTM net profit margin of 395% is above the five-year average of 250.6%.

The fact that the TTM net profit margin of 395% is above the 5-year average of 250.6%, implying that there has been an increase in the percentage of earnings that the company is able to keep compared to the company's five-year average.

The listed profitability margins show that the company is gaining strength. I require strong net profit margins when investing in a stock for the long-term.

ROA - Return on Assets = Net Income / Total Assets

It is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as "return on investment."

The 2012 ROA of GameStop Corp 8.69% is slightly below the 5-year average of 9.61%. This implies that the management has lessened its ability to use the company's assets to generate earnings over the past five years.

Free Cash Flow = Operating Cash Flow - Capital Expenditure

A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt.

GameStop Corp generated a ratio of cash flow from operations/total sales of 5.28. The higher the percentage, the more cash available from sales.

If a company is generating a negative cash flow, it shows up as a negative number in the numerator in the cash flow margin equation. This means that even though the company can generate revenue, it is losing money.

Institutional Investors

Several institutional investors have been buying GME in the recent quarters. This is important because hedge funds use strict fundamental procedures before investing in a stock.

In the recent quarter, both Joel Greenblatt (Trades, Portfolio) and Steven Cohen (Trades, Portfolio) -among other prominent investors- bought GME at an average price of $48.85.

Analyst Outlook

Currently, many analysts have a good outlook for GameStop Corp. Analysts at MSN money are predicting that GameStop Corp will retrieve EPS of $3.04 for fiscal 2013 and an EPS of $3.78 for fiscal 2014. Analysts at Bloomberg estimate GameStop Corp's revenue to reach $9.15 billion for fiscal 2013 and $9.85 billion for fiscal 2014. On Nov. 22, 2013, Needham & Company gave GameStop Corp a rating of "Buy" with a target price of $50.60 (signifying significant upside potential from this point).

Conclusion

Although the company has a great user base on their customer loyalty program and most of the gaming (both hardware and software) market share, it is still facing enormous challenges in a changing industry. First, as broadband improves and consoles advance in technology, they’re leaving behind the physical format, and console game publishers are starting to imitate PC market, by giving just the account owner the right to play each game and not pass it, thus taking an important part of this company’s preo-wned game business (which represents as much as 40% of this company´s gross margin).

But GameStop still has the youngsters’ market, which use cash only and are used to going to the nearby store to change their old games for new ones. This company still has an F-Score of 7, which indicates a healthy situation and coverage of all of its debt. Its dividend yield is also close to a one-year high. But in spite of this, all the risks described before are very likely to come true and gradually change the market and industry around, with the PS4 and Xbox One accounts available much of the preowned market is going to be tightly regulated and will get a big portion of this company’s gross margin in the mid long term.

Disclosure: Damian Illia holds no position in any stocks mentioned.

About the author:

Damian Illia
A fundamental analyst at Lonetreeanalytics.com constantly looking for value and income investments.

Visit Damian Illia's Website


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