Analyst: GameStop’s Core Game Business Is Positioned for Growth

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The following is an excerpt from a report compiled by Michael Pachter of Wedbush Securities.

On Tuesday, GameStop (NYSE:GME) held its Analyst Day in Dallas. The day consisted of tours of the company’s Refurbishment Operations Center (ROC), its new prepaid mobile concept, a Simply Mac store, and a GameStop store. Management made several presentations on each of these concepts, plus Spring Mobile, and outlined the company’s growth strategy.

We see synergies between GameStop’s buy-sell-trade model and its entry into technology retail. We see significant potential for the company’s expansion into prepaid mobile, as we believe that the new stores provide a logical outlet for its growing inventory of used smartphones. We see less synergy from the Spring Mobile concept, but acknowledge that GameStop’s growing presence in the buy-sell-trade of mobile phones and tablets is positioned to gain from a steady supply of trade-ins from the Spring Mobile new phone business. We see the least synergy from Simply Mac, which we think is an interesting concept, but it has far less in common with GameStop’s core business than the other two.

The company’s core game business appears to us to be in fine shape and positioned for growth. GameStop’s management shares our view that video game software sales will once again begin to grow later this year, and GameStop appears positioned to continue to gain market share as its used game business provides value to its customers that is difficult to replicate. We expect free cash flow from GameStop’s core game business to grow, and expect the company to fund the expansion of its Simply Mac and prepaid and post-paid mobile retail stores from free cash flow.

Investment in its new concepts could drain $100 million of free cash flow. At the high end of its spending plans, GameStop intends to invest in store expansion and acquisitions to grow its footprint in prepaid and post-paid mobile and in Simply Mac.

The target margins from the two mobile businesses are similar to GameStop margins, making further investment reasonable, in our view, notwithstanding our skepticism about the strategic fit. The target margins from Simply Mac are significantly below GameStop margins, causing us to question whether the expansion of the concept makes as much sense. However, management proposes to add only a modest 20 Simply Mac stores this year, allowing the concept to prove itself at scale before committing further capital.

On balance, we think that GameStop management is prudently investing in businesses that will insulate it from cyclicality in the game business, and will likely more than offset inevitable cash flow declines once game downloads begin to cut into physical disc sales. We believe that physical discs will be around for at least another decade, and think that overall game software sales growth will allow GameStop to grow its annual free cash flow generation by $200 million or more before reaching a plateau.

However, it is clear that console manufacturers and game publishers are intent upon offering digital downloads of all games, likely commencing this year, and we expect some form of cloud gaming to cut into physical product sales at some point in the future. GameStop’s investment in its new technology retail businesses is intended to grow its cash flow more rapidly than many have likely modeled and to allow it to continue to grow its overall business even if its core video game business should begin to decline.

Maintaining our OUTPERFORM rating and 12-month price target of $60. Our PT is based on 15x our FY:14 EPS estimate of $4.02. Although many quality retailers trade at 20x EPS, GME faces headwinds from digital and the impact of the next-gen console transition on current-gen sales.

Risks to attainment of our share price target include changes to game release timing, the effects of competition, supply of video game products, macroeconomic factors, and slower-than-expected consumer demand for video game hardware and software.

Investment thesis: We continue to believe that GameStop’s core business will have a long tail. As long as physical video game products are produced, we expect GameStop to remain the market leader at retail, and we believe that the company’s large used game business solidifies its relationship with a very large segment of the gaming population that values used games as currency to fund new game purchases.

Given that next-generation consoles contain disc drives and there are no plans by the manufacturers to block used games, we think that GameStop has at least 10 years of runway left in its core business. In the meantime, the company is leveraging its pre-eminent position in selling used game consoles by offering used smartphones, tablets, and other consumer electronics, and we expect substantial growth from this category over the next several years. GameStop management has consistently returned the company’s free cash flow to investors, and we expect them to continue to do so, suggesting to us that EPS growth will continue for much of the next decade.

Michael Pachter is an analyst at Wedbush Securities.

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