Magic Formula Stock Review: GameStop (GME)
GameStop is the world's largest retailer of video gaming software, hardware and accessories. The company acquired competitor Electronics Boutique in 2005 and now operates over 5,000 locations, including over 1,000 outside of the U.S. GameStop has very strong market share in the huge video gaming market, garnering 22% of all industry sales in 2006. While the stores sell new games and consoles, GameStop also focuses on buying and re-selling used games. This has been a lucrative business. Used game sales generate a 50% profit margin compared to about 20% for new games. As a result, used game sales generate 40% of GameStop's profits, despite contributing only 25% of revenue.
This stock has been popular with the growth crowd over the last few years, and rightfully so. Store count has exploded from just over 1,500 in 2004. This, plus the continued expansion of the market, has led to some pretty impressive growth stats. Over the past 5 years, GameStop has grown revenues at a compounded 26.7% annually, operating earnings at 42%, and free cash flow at 43%. The stock price has nearly tripled since the beginning of 2004, despite dropping over 60% from a price over $60 at this point last year.
There are still ample opportunities for continued growth going forward. The video gaming market continues to grow organically. Estimates are calling for continued 10%+ growth rates over the next 5 years. Game producers continue to try and expand the addressable audience into "casual" gamers, and generations that grew up on Atari continue to play games into adulthood (the average gamer is 33 years old). The industry has very well defined cycles, with the strongest sales coming 3-4 years after the start of a new generation of consoles. That is the period we are entering now, as Microsoft's Xbox 360, Sony's Playstation 3, and Nintendo's Wii all were launched in the 2006-2007 time period. While GameStop has a large store base, locations are small and can be supported by small markets, leaving plenty of space to open new stores in both the U.S. and Europe.
Financial health is not a concern. GameStop took on close to a billion dollars of debt to acquire EB, but nearly half of that has been paid off. Interest coverage ratios are plenty comfortable - operating earnings cover interest payments 18 times over. Cash reserves nearly equal debt, free cash flow is strong, and the current ratio (current assets / current liabilities) is about 1.5.
With these growth prospects coupled with an earnings yield valuation over 18%, I believe GameStop makes an attractive MFI buying opportunity.
However, competitive pressures prevent me from nominating GameStop as a MagicDiligence Top Buy. There are no moat characteristics native to the business, like switching costs or regulatory barriers. A potential buyer can just as easily purchase his console or copy of Call of Duty from Wal-Mart (WMT), Best Buy (BBY), or Toys R Us. On new games and hardware, GameStop has no pricing power - pricing is standardized across retailers.
The one place where GameStop has built customer loyalty is through their trade-in and used game programs. But even these are not durable advantages. Amazon (AMZN) and eBay (EBAY) can both be utilized for liquidating old games, often at better terms than GameStop offers. Nothing is stopping a competitor like Best Buy from starting a trade-in program of their own. More generally, digital distribution is a major threat to GameStop's used game model. All 3 new consoles have the ability to buy and download old titles at reasonable prices. The latest Xbox 360 software update allows storage of new games to the hard-drive, a precursor to digital distribution of new titles. Mobile devices like the iPhone utilize a fully digital distribution method for gaming software.
Additionally, publishers are trying to get more bang from their development buck by creating "add-on" packages to existing games. Examples of this are the upcoming expansion for Grand Theft Auto IV, as well as the myriad of downloadable tracks for the Rock Band and Guitar Hero franchises. These "add-ons" extend the life of a new game and completely bypass retailers like GameStop.
GameStop is a good company operating in a growth industry, and makes a fine MFI buy at this price, but be wary of the competitive pressures that are materializing.