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Gamestop Headed for Oblivion? Not So Fast!

Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When I began researching Gamestop (NYSE: GME), I thought I was forming an opinion on a "battleground" stock -- a stock where a vocal contingent of bulls and bears sharply disagree with one another. However, I quickly discovered that Gamestop is not a battleground stock at all; hardly anyone is shouting 'Buy!' Many investors hold the opinion that Gamestop is going the way of Blockbuster. After all, this is the age of the internet. Everything is going online, including video game distribution. The thinking goes that physical disks will soon be unnecessary and users will simply download games directly onto their consoles. Thus, Gamestop's entire business model will evaporate overnight.

Tempting as it may be to accept the conventional wisdom and move on to a different stock, Gamestop may represent a compelling risk/reward at its currently-depressed market valuation. Before addressing the very real existential risks facing the company, I want to show you just how great this business is.

Historical Performance

Gamestop is a remarkably sound business with a stellar operating history. It has extremely low free cash flow margin variation -- even lower than Microsoft's. This means that the company reliably converts sales into free cash flow, a reflection of its monopolistic position in the United States. Although Gamestop converts only about 5% of sales into free cash flow, competitors like Wal-Mart and Best Buy do not threaten to reduce that margin because Gamestop has scale advantages (especially in its marketing and trade credit programs).

Gamestop is highly dependent on the market for used video games. It derives only one quarter of its revenues, but nearly half of its profits, from used games.

 

<img src="/media/images/user_13490/sales-and-gross-profit-as-percent-of-total-sales-and-gp_large.png" />

The rest comes from sales of new video games and game consoles. New video game sales tend to increase when new consoles are released. The current console cycle has lasted longer than usual, but rumors are that Sony (NYSE: SNE) will unveil the PS4 in late 2012 and Microsoft (NASDAQ: MSFT) will release the Xbox 720 in time for Christmas 2013. Consequently, sales of new video games generate demand for used games by casual gamers that want to buy new releases at a discounted price. Gamestop's trade credit program makes it the premier used-game trading hub in the United States. Thus, Gamestop's profitability should improve at the start of the next console cycle.

The two things I want you to take away from this section are (1) Gamestop faces almost no competition from retailers in the U.S. and (2) it is dependent on the market for used video games. Now let's shift our focus to threats to the used game market.

Gloom and Doom

There are essentially two risks to Gamestop's used game business model: (1) technology evolves to enable users to download games directly to the console and (2) next-gen consoles drop backward compatibility, thus putting a large dent in used video game sales.

The most serious threat is the technology for digital downloads. Eventually, gamers won't even need to get off the couch when they want to buy a game. Instead, they will download it directly to their console via a broadband connection. However, the technology that would wipe out Gamestop's business does not yet exist.

Downloading a full game on a console takes several hours -- sometimes more than 12 hours, depending on the file size and connection speed -- and it isn't going to get faster any time soon. The two factors determining download speed are broadband connection speed and file compression. As for the broadband speed, there is no doubt that this will continue to increase. The technology is there and the investment is being made.

The second factor, file compression, is another story. The lossless compression technology currently used for digital downloads is already as efficient as math says it can be, so it will take a technological breakthrough to compress file sizes enough to make digital downloads worthwhile. At the same time, game file sizes are increasing, so compression technology will have to improve at an even faster rate. All of this points to Gamestop hanging around for at least another decade.

The second threat is that consoles may not support backward compatibility in the future. To understand why publishers would encourage such a change, let's quickly look at the market for used textbooks:

College textbooks didn't always cost a lot of money. Back in the 1970s, nobody was complaining about how much they had to pay for books (nor about the cost of tuition, for that matter). Publishers were content to sell books at prices that allowed them to recoup their investment and earn a profit over the course of 3-5 years of selling a textbook. However, sometime between then and now a robust market in used textbooks emerged. Instead of students buying textbooks from the publishers year after year, only the students attending class in the first year of a textbook's use needed to buy a new book. Students in subsequent semesters could buy used textbooks from old students at a discounted price. Thus, publishers suddenly had to realize all of their profit in the first year, thereby inflating the price of new textbooks and squeezing publishers' margins.

The same has happened in the market for video games, and video game publishers are none too pleased. Since console-makers want to attract publishers to their platform, they too are willing to join the effort to eliminate the used game market. In fact, rumors were circulating at one point that Sony's PS4 would not support backward compatibility. Then again, similar rumors circulated about the PS3.

But the used game market isn't going anywhere anytime soon. If Sony removes backward compatibility from the Playstation, Microsoft can increase customer satisfaction (and market share) by including support for old games. It is important to remember that consumer behavior ultimately determines production. As long as consumers demand backward compatibility, console-developers will have to give it to them. Thus, I don't see this being an issue as long as physical disks are used to distribute games.

Even if games could be instantly downloaded onto a console today, would consumers want them? Consumers benefit from being able to trade physical disks in a used game market. You can buy a new game for $60 and sell it back to Gamestop a month later for $50. Alternatively, you can hold onto it longer and still get a decent price later on from a more casual gamer. I can't emphasize enough the importance of consumer desires; just because it makes sense for publishers to eliminate the used game market does not mean consumers will allow them to do it.

Valuation

I wouldn't have spent more than about 10 minutes looking at GME if I thought it could go to zero. The company is generating ample free cash flow -- currently yielding 18.5% -- and has room to cut SG&A and capex if necessary. With no debt on its balance sheet, the company can produce enough free cash flow to return the entire enterprise value to shareholders over the next 5 years. Management has aggressively bought back shares and has committed to returning more than 100% of free cash flow to shareholders through dividends and share repurchases. So in the worst-case scenario where you have rapid evolution of compression technology and equally-rapid adoption of digital downloads, investors' downside is probably no more than 20-30% at today's price.

In the best-case scenario, GME would trade like the wide-moat monopoly that its historical financials remind me of. Normally I want at least a 10% free cash flow yield on a business, but great businesses with wide moats deserve something closer to a 15x multiple. I don't like detailed forecasts, so let's just apply a 5% free cash flow margin to LTM sales and multiply by 15:

            $9 billion x 5% = $450 million x 15 = $6.75 billion or $54.51 per share

This is what I would pay for GME if there were no questions about its future. The concerns addressed in the previous section are valid and may eventually come to pass, so there's no way I would pay $54 per share. But the market is currently pricing the company as though its business model will be completely eroded within five years. I don't think this will be the case. I think Gamestop will still be producing a lot of free cash flow in five years, maybe even in ten. So, an exact valuation isn't what we need here. We just need to ask ourselves what the downside is in a worst-case scenario and recognize that there's substantial upside in the case that the fears of obsolescence are overblown.

Final Thoughts

Gamestop is not a company Warren Buffett would buy. It will eventually go out of business, or at least it will have to change its business model if it wants to be in business in 30 years. But, as we wait for the technological breakthrough and subsequent consumer adoption of digital downloads, Gamestop is producing a ton of free cash flow and returning all of it to shareholders.

So...is Gamestop headed for oblivion? Yes, but not so fast!


titans8904 has no positions in the stocks mentioned above. The Motley Fool owns shares of GameStop and Microsoft and is short Sony (ADR) and has the following options: long JAN 2013 $22.00 calls on Sony (ADR). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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