“The problem with Gamestop is you need to be able to have both good hardware and software sales. Not until later next year do I expect Grand Theft Auto. We had Rock Band, Guitar Hero. Those are all played out. I can’t get behind GameStop not because they’re not a great company but because they don’t have enough good stuff to sell.” — CNBC’s Mad Money 11/17/2009
The quote above is a bearish recommendation on GameStop (GME) from Jim Cramer in Tuesday night’s Lightening Round, but we think he has missed a great opportunity. Cramer refers to his lack of faith in both video game hardware (consoles) and software (games) sales this holiday season. There is no doubt that the conventional wisdom of video games being resilient to recessionary spending trends has proven to be less true than most believed.
We find it a bit strange that Cramer would single out video games as the segment of retail he sees struggling this holiday season. In the same show, he reiterated his stance that the market continues to be too pessimistic about retailers (retailers are “en fuego”) coming into the holidays and recommended buying Guess (GES), J. Crew (JCG), and The Home Depot (HD). He may be correct that clothing retailers could start to get some traction this holiday season, as clothing is always a common gift. But can he really think more families will buy a new appliance or flooring for the holidays? 
I know I am selling Home Depot short because there are plenty of gifts sold at The Home Depot each year, but GameStop is the quintessential gift shopping destination. Look at the seasonality of these companies; current estimates have GameStop making 62% of profit and 40% of sales in the upcoming quarter, whereas Home Depot claims only 10% of profit and 21% of revenue. Clearly, this time of year is the bread and butter for the gaming industry which makes logical sense.
Furthermore, the timing of this is suspect as surely Cramer heard of the unbelievable sales last week from Activision Blizzard’s (ATVI) new “Call of Duty: Modern Warfare 2″. The game’s release blew away all previous launch sales records. Investment blog 24/7 Wall St called the game, “the biggest launch in history across all forms of entertainment,” and the numbers back it up. “MW2″ sold 4.7 million copies for $310 million in the U.S. and U.K. alone in the first 24 hours! Not being an expert on the industry, I do not know what other games are expected to be a hit this season but clearly the demand has never been higher. As far as hardware goes, makers of consoles have gotten aggressive and lowered prices recently, but these are not where GameStop makes its profits anyway. The vast majority of margin comes from new and used game sales.
Even with the seasonality being an attractive piece of the investment thesis, perhaps the most compelling thing about GameStop is the valuation. GameStop’s stock has taken a tough hit in the last few years with the troubles in the video game industry. However, fundamentally the stock has held up remarkably well despite growing competition from the likes of Amazon.com (AMZN) and Walmart (WMT). Earnings are expected to be 5% better than a year ago on sales increases of nearly 3% in fiscal 2010 (ends Jan.). The market has historically been willing to pay between 9.2x and 20.9x cash earnings per share but the current level of price-to-cash earnings is only 7.2x. Similarly, the market has historically given GME a multiple of .51x to 1.18x sales, and the current metric is well below that at .44x.
At Ockham, it is clear that we have an Undervalued stance on this stock, and are confused by Cramer’s recommendation on it. He is overall so positive that retail is going to surprise to the upside, but when it comes to video games he retreats. We believe there is substantial upside for long term investors in GME, and we could reasonably see it trading at $30 in the next year.
