Gamestop: Pause the Game

Gamestop Corp (NYSE:GME) is the world's largest multichannel video game retailer. GME’s retail network and family of brands include 6,683 company-operated stores in 15 countries worldwide and online at the Gamestop website. Its network also includes: Kongregate, a leading browser-based game site; Game Informer(R) magazine, the leading multi-platform video game publication; Spawn Labs, a streaming technology company; and a digital PC game distribution platform Impulse.

Kongregate Inc., the operator of an online video gaming site, which offers free-to-play video games to over 15 million unique visitors per month, was purchased by GME in August 2010. Kongregate earns revenues from in-game advertising and offering game players the opportunity to advance theirgame play with in-game transactions. Over 14,000 developers have uploaded more than 50,000 games to Kongregate.com that have been played nearly 2 billion times. Game Informer is a monthly video game magazine and website featuring reviews of new title releases, tips and secrets about existing games and news regarding current developments in the electronic game industry. Game Informer magazine is the fourth-largest consumer publication in the U.S. and for its December 2011 issue, the magazine had over 7.2 million paid print subscribers and over 850,000 paid digital magazine subscribers.

Valuation

GME trades at 9.9x trailing 12 months P/E, a 20% discount to its five-year average P/E of 12.4. GME also trades at 3.8x trailing twelve months EV/EBITDA and 0.83x PEG. GME had achieved a five-year average ROE of 15.1% and a five-year book value per share CAGR of 19.7%.

Financial and Business Risks

GME is debt-free with cash and cash equivalents of $138 million representing 5% of its market capitalization of $2.8 billion. GME retired $250 million of remaining long term debt in 2011. This does not take into account off-balance sheet liabilities such as operating leases and purchase obligations.

GME had operating lease obligations and purchase obligations of $1.13 billion and and $690.9 million respectively as at Jan. 28, 2012. GME leases retail stores, warehouse facilities, office space and equipment. These are generally leased under non-cancelable agreements that expire at various dates through 2034 with various renewal options for additional periods. Purchase obligations represent outstanding purchase orders for merchandise from vendors. These purchase orders are generally cancelable until shipment of the products.

The electronic game industry is intensely competitive and subject to rapid changes in consumer preferences and frequent new product introductions. GME competes with mass merchants and regional chains, including Wal-Mart and Target; computer product and consumer electronics stores, including Best Buy; Internet-based retailers such as Amazon. Video game products and content are increasingly being digitally distributed and new competitors are entering the marketplace such as OnLive and Gaikai which are built to take advantage of these new capabilities, and other methods may emerge in the future.

Increased bandwidth capacity and faster download speeds expand customers' ability to access and download the current format of video games and incremental content for their games through these and other sources, GME's customers may no longer choose to purchase video games in stores or reduce their purchases in favor of other forms of game delivery.

Business Quality and Capital Allocation

GME claims to be the largest retailer of used video games in the world. It provides customers with an opportunity to trade in their used video game products in our stores in exchange for store credits which can be applied towards the purchase of other products, primarily new merchandise. It has the largest selection (approximately 3,100 SKUs) of used video game titles which have an average price of $18 as compared to an average price of $39 for new video game titles and which generate significantly higher gross margins than new video game products.

GME is currently pursuing various strategies to integrate these new delivery methods and competing content into the company's business model, including hiring employees with experience in digital gaming and making investments in and acquisitions of digital gaming, streaming and technology-based companies such as Spawn and Pulse, there is no certainty that these strategies will be successful or profitable.

GME has an analysis-driven approach to store opening and closing decisions. GME claims to be aggressive in the analysis of existing store base to determine optimal levels of profitability and close stores where profitability goals are not being met or where it can attempt to transfer sales to other nearby existing stores and increase overall profits. With leases for 1,634 and 2,268 stores expiring in 2012 and 2013, respectively, GME has the option to exercise discretion if things turn ugly.

GME has a 12.5% dividend payout ratio and a dividend yield of 4.3%. GME initiated its first dividend in February 2012. Through stock buybacks and debt retirement, GME has returned more than $500 million, or 97% of its free cash flow, to shareholders. Shares outstanding have decreased by 20% compared with the share count four years ago, indicating significant value creation for shareholders.

Conclusion

After rebounding from a historical low P/E of 6.9x in July 2012, current valuations for GME are not enticing.

Disclosure

The author does not have a position in any of the stocks mentioned.

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