GameStop Corp. (GME)

Current price $21.87 (close of trading 12/02/09)

General notes:
•   The company continues to expand, looking to open 400 new stores in 2009, invest $170 million in capital improvements, and they still expects to pull in more than $400 million in free cash flow. Impressive but I am concerned about this rapid expansion.
•   The company has 6,333 stores around the world now. The United States account for 4,337 up from 4,180 last year. Their second largest market is Europe. They operate 1,247 stores in 13 countries up from 745 stores last year. The Micromania acquisition accounted for 328 of those stores. And the debt they have on the balance sheet is from this and another past acquisition. More on these below.
•   Insiders made purchases back in May and June but since 3 directors sold around $24-26 price, last one being 11/24 http://finance.yahoo.com/q/it?s=GME

Company Sales breakdown:
•   New video game hardware = 17-20% (falling)
•   New video game software = 35-42% (falling)
•   Used game products = 25-30% (rising) = good since it’s the highest margin category
•   Other = 12-15% (stable)

Company Gross profit breakdown (Q3 report):
•   New video game hardware 8.3% vs. 7.7% last year
•   New video game software 22.6% vs. 22.5% last year
•   Used video game products 47.3% vs. 48.2% last year
•   Other 34.9% vs. 35.5% last year

News that drove the stock price the past 5 months:
•   In June to early July stock falls from $25 to below $21 on a bunch of bad game console and game sale reports and Best Buy entry into the used games market. Best Buy will offer automatic kiosks that allow one to scan used games to find out what they will pay for them. If you accept the offer you get a coupon for purchase at Best Buys.
1.   Best Buys has only 1,023 stores in the U.S compared to 4,337 for Gamestop. This is a major convenience factor for people who want to trade in games. Gamestop’s stores are just about everywhere: the McDonalds of the video game industry.
•   In mid August, Q2-09 earnings came out along with an announcement of lower earnings guidance – stock sold off from $26 to $22.50 – some points from Q2:
1.   Cash on the balance sheet decreased from $540 million a year ago to $197 million at the end of Q2. Management has paid off about $50 million of debt which stands at $495 million now and a lot of A/R.
2.   On the valuation front, even if the lower of guidance is met, GME is still trading for about 10 times expected earnings
3.   MF CAPS community downgraded GME to 3 stars after earnings
•   End of August (8/31), Goldman Sucks upgraded shares to ‘conviction buy’ – stock begins $4 ascend in the next month
1.   GS believes valuation has fallen below their industry growth framework, and earnings expectations, for a long time aggressive, are now beatable, in their view. Also, they see a powerful cash flow story emerging as GME nears paying off its remaining debt and could turn to buying back shares. Lastly, they see secular concerns around the business as overblown; digital downloading is not an existential threat as current console games are too big to download, and the Used business has significant barriers to entry; GME should continue to dominate that market. Goldman's $28 price target suggests 19% upside.
2.   GME stock is an emerging cash flow story, which beginning as soon as next year could be deployed towards share repurchases, driving significant upside to earnings. With minimal capex requirements, even with its current pace of store growth, and efficient working capital on little net inventory commitment, GME is a strong generator of cash, expected to produce $450 mn of free cash this year. For the past several years, GME has used its free cash to pay down the $940 mn of debt it issued to purchase Electronics Boutique in 2005 and the $236 mn it issued to buy Micromania in late 2008. As of the end of 2Q09, it has less than $500 mn of that total debt remaining. With an expected cash balance at the end of this year of nearly $1 bn and annual free cash flow in the range of $500 mn, the company will be building a sizable amount of excess cash.
•   Mid-September – rumor that Best Buy might buy GME – stock continues to go higher, eventually hitting $28 by mid-October.
•   Early October (10/8) – Wedbush upgrade – adding on to the stock rise, eventually hitting $28 by mid-October
•   Mid-October – stock trades down from $28 to $25 on a downgrade and bad Sept. game sale report. The downgrade actually spells out 6 long term bull case points for Gamestop:
"We continue to see GME benefiting from: 1) expansion of the gaming cycle to new demos; 2) countercyclical demand in the Used business; 3) hardware price cuts; 4) software improvements; 5) easing foreign exchange comps; and 6) international expansion. These drivers should bolster GME's under-appreciated cash flow and balance sheet strength, which could be leveraged for a sizable share repurchase. However, these funds may not be available until January 2010, and the near-term compression in the gaming cycle will likely undermine investor confidence despite the strong title slate.
•   November – stock moves between $24 and $26 on a series NPD game console and software reports and a Goldman Sucks downgrade (yes, 3 month later GS changed their mind), taking GME off the firm's "conviction buy" list:
1.   Goldman analyst Robert Higginbotham fears that industry sales data for the month of October -- scheduled to be released by industry watcher NPD Group tomorrow -- will be far bleaker than the estimate calling for a 9% to 11% year-over-year decline.
•   Mid-November (11/19) – Q3-09 earnings come out – stock goes up from $24 to $26 on better than expected sales and less of a SSS decline:
1.   Management expects to earn $400 to $425 million in free cash flow by the end of the year.
2.   GME trades for 10 times expected free cash flow for 2009. The stock is no doubt undervalued if the company continues to grow at double digit rates as they have historically.
3.   GME spent the last 18 months studying the digital marketplace and is positioning the company for growth in the digital space. GME's digital business is engaging casual, browser, and mobile gaming. Management expects this new division of their business to provide good growth in the future.
4.   MF CAPS rating for GME moves back up to 4 stars again
•   Early December (12/02) - WMT cuts prices on new games and offer shoppers a special promotion for buying a Wii – GME trades down 8% to below $22
1.   "This news is clearly a negative for (GameStop) which generates the bulk of its sales during the holiday season and may be forced to reduce prices to stay competitive," said Janney Capital Markets analyst Tony Wible in a note to investors. He added that many of GameStop's stores are near Wal-Mart outlets, and GameStop "has historically sought to benefit" from foot traffic at the big box retailer.
2.   GME already reacted and lowered prices on some of the games
3.   GameStop, like most video game companies, makes a big chunk of its annual revenue during the holiday season. GameStop has been optimistic about the holidays, and in November it reaffirmed its guidance for the fourth quarter.
4.   MF SA note: GME earns less than 10% of its gross profit on new hardware and almost 50% of gross profit on used game sales, so it's difficult to determine what impact competition will have on GME's business since the WMT move impacts new game sales and the Wii console only.

General Market Thinking about GME - Negatives only with counter reply:
•   Digital game downloads replacing a need for physical games, thus physical stores
1.   GME combating this with a launch of Casual Digital Store and a recent acquisition of Jolt Online Gaming (11/20). Also large games, small hard drives, and long (18 hours type long) download times make this threat appear more serious further down the line than now. (11/10 – GME Download Now service offers over 1000 titles, ranging from traditional sports and action titles from publishers such as Eidos and Capcom, to casual releases from the likes of PopCap Games.)
•   E-Play is a kiosk operator like RedBox. Wal-Mart will test E-Play kiosks in 77 of their stores. E-play will offer $1 videogame rentals. It will also allow trade-ins. Users can turn in used games of Nintendo Wii, Microsoft Xbox and Sony Playstation in exchange for credit on their credit cards. The kiosks can hold about 4,000 movie and game discs. The movie rental function will be turned off in stores that also have a Redbox kiosk. Best Buy and Blockbusters are also testing the machines.
1.   Gamestop said they investigated E-Play and decided not to use them. They believe the success of their used game model is that their customers want the ability to take the money for the use games and immediately use it to buy the new games. The kiosks don’t allow for this. Another factor they believe is important is regulations. The used business is heavily regulated with huge compliance burdens. These regulations are in place to prevent the fencing of stolen merchandise. Gamestop invests heavily in training, systems and personnel to be compliant with thousands of regulations across the country. Over 50% of their stores require some type of license to buy and sell used merchandise. About 25% of their stores require fingerprints and about one third of them have a product hold requirement.
•   CFO was also a founder of the company leaving (transitioning out next year) and is being replaced by a CFO from Centex, the homebuilders.
•   Amazon / Best Buy used game threats
1.   GME introducing a new initiative – an interactive digital kiosk. It is in test stores now, and their goal is to roll them out to over 1750 stores by early 2010. This kiosk allows customers to view new game content before buying it. That bit of customer service will them another advantage over big-box stores like Best Buys.
•   Companies like Take-Two Interactive and Microsoft beaming games directly to consoles, undercutting th