Game’Stops’ Its Rally

GameStop Inc. (GME), a specialty retail company, operates in the niche electronic gaming sector. It is the world’s largest video game retailer, operating 6,188 stores internationally. GME has come under scrutiny in the past few weeks as competitors have emerged around it’s Q4 2008 earnings announcement. GME’s revenue breakdown:

Product/ Geographic

1. New Video Game Hardware: 24% United States: 77%
2. New Video Game Software: 39% Europe: 11%
3. Used Video Games: 22% Canada: 6%
4. Other: 15% Australia: 6%

The word retail over the past year elicits thoughts of discretionary spending cuts and diving stock prices. GameStop’s niche used video game segment, however, makes it a consumer ‘tradedown’ hotspot similar to the likes of McDonald’s (MCD) in the restaurant sector. GameStop is the largest retailer of used games. Customers “trade-in” used video games, consoles and accessories for store credit. GME’s average used video game price is $16 versus a price tag of $42 for new games. Gross margins on its ‘Used Video Games’ segment is nearly 50%. The segment contributes just 22% of revenues but 43% of gross profit.

The Story

GameStop announced in late February that its fourth quarter results would come in at the high end of expectations on strong holiday sales. The company projected a fourth quarter increase in sales (22%) and same-store-sales (9.6%). Even more encouraging, it released 2009 guidance with expectations to continue to outperform the retail sector. EPS was projected to grow 18-22% (vs. 16% analysts’ expectations) and sales rising 10-12% (vs. 10% analysts’ expectations). GME’s stock soared on the news, up 10.45% on the day.

March 5th brought the shares crashing 14% as Amazon.com (AMZN) announced it was entering into the used game trade-in business. Amazon’s “mail-in” approach, however, differs from GameStop’s “instant-gratification” retail method. GameStop tested this mail-in model several years prior and found consumers responded better to the retail business. While Amazon has the ability to leverage its economies of scale in the space, the analysts’ consensus seems to view the threat as minimal. UBS analyst Ben Schachter stated, “‘We believe the ‘instant gratification’ of the trade-in process at physical stores remains a key advantage for GameStop.” Likewise, SunTrust Robinson Humphrey analyst David Magee wrote, “Amazon is a formidable operator, but given GameStop’s deep specialization in the used business, if GameStop didn’t see a line of business here worth continuing we are hard pressed to imagine others gaining sufficient traction with it to pose a real threat.” Nonetheless, the stock’s plummet was a cause for concern.

Since the date of the Amazon announcement GME has been up 18.6% while the Consumer Discretionary index (XLY) has rallied 25.4%

4QFY08 Earnings

GameStop announced 2008 fourth quarter earnings Thursday. EPS for the quarter came in at $1.39, or $1.34 excluding merger-related income. Excluding the merger-related income, this is a 17.5% increase over Q4FY07 EPS. This was at the top end of GameStop’s recently updated guidance for the quarter and in line with analysts’ average estimate of $1.34. Total sales for the fourth quarter increased 21.9% and same-store-sales were up 9.6%. Strong products for the quarter include Ninendo’s Wii console and Activision Blizzard’s “Guitar Hero” game.

GameStop’s outlook for 2009 remained positive. Projections for 2009 were:

• Total sales growth between +10.0% and +12.0%
• Comparable store sales of +4.0% to +6.0%
• Diluted EPS increasing +18% to +22%

Additionally, management also expects free cash flow of over $500 million, after investing $170 million in capital improvements (plans to open approximately 200 stores). CEO Daniel Dematteo addressed concerns regarding Amazon, stating, “The online trade model was tested by us and we saw a very little consumer acceptance as the consumer needs the immediacy of the used game values to purchase new games. We do not believe that this will work as the consumer that is willing to wait will sell peer-to-peer as they always have and get more money.”

Moving Forward

Despite seemingly across-the-board rosy earnings/guidance, the stock ended the day down 2.35% vs. the +4.61% move by the XLY. Possible rationale for GME’s poor performance on the day include:

• Profit-taking after the initial run-up immediately following the announcement, on top of the 8% gain the stock has made Monday through Friday
• A significant jump in GME when they initially raised guidance to $1.33 to $1.34. Investors may have been hoping for another pleasant surprise on the upside this morning
• Relatively weak comp sales projections for the 1QFY09. GME expects 0% to 2% comps for the Q1, vs. last year’s 27% rise

The 6.18% recovery in the stock (vs. -2.61% decline in the XLY) draws weight to the above arguments. The next few days for GME will be very telling. That being said, I would avoid the stock in the coming weeks, though not based on anything fundamental with company. Ultimately, GameStock is a discretionary company that will trade with the ups and downs of the market (and the consumer). In that vein, I do not see the market rally of the past weeks as sustainable. Things to keep in mind regarding macroeconomic recovery:

• Since the S&P’s (^GSPC) low on March 9th, the equities market has made its fastest advance in 70 years
• There has been one too many Sunday evening announcements from the Treasury/Federal Reserve to allow for sustainable price discovery
• Much of the recent rally is still based on expectations (with no execution) of efficiency of the stimulus measures
• The government’s life support of otherwise bankrupt companies means the excess debt (leverage) still has not been purged from the system via cyclical cleansing. Likewise, the leveraged Treasury balance sheet is wreaking havoc on the credit markets (which has not seen the rally the equities market is experiencing)

Disclosure: The mutual fund the authors are associated with is long GME

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