“There has been a lot of buzz lately that GameStop might be acquired…It reported results that blew away street estimates.” — Bloomberg TV’s In The Loop 3/18/2010

Readers of this blog by now have probably heard us beat the drum about GameStop (GME) being an extremely attractively valued stock, and today we feel somewhat vindicated and will continue to beat that drum following an impressive fiscal fourth quarter report.  The last year has been a difficult one for the video game industry, and as the world’s largest video game retailer, GameStop has clearly fallen out of favor with the market.  Same store sales dropped nearly 8% as spending on consoles was especially weak. 

Critics argue that GameStop will go the way of Blockbuster (BBI), which is teetering on the verge of bankruptcy, because video game sales will increasingly go digital.  The theory goes that bricks and mortar will be an anchor on results and it is only a matter of time.  However, as we see it, there is one extremely important difference between GameStop and Blockbuster: profit.GME

Recall, if you will, Blockbuster has not turned an annual profit in six long years, and the losses have widened for the last 4.  Even when Blockubster was in its heyday around the turn of the millennium, profits were hard to come by, which doesn’t speak well of management.  In contrast, GameStop reported a fiscal fourth quarter 2010 (ended Jan.) net income of $215.9 million or $1.29 per share, which is better than Wall Street estimates of $1.27 per share.  That means for the year the company earned $2.28 per share, so even after today’s 9% rally the stock trades for 9.5x trailing twelve month earnings.  The midpoint of 2011 EPS guidance comes in at $2.63, which is 15% growth in the next year.  Overall sales grew by 3.1% over the past year, which hardly warrants the catastrophic tone that some have taken towards the video game industry.  Management said they expect a decent rebound in sales growth next year, calling for growth of 4% to 6%.  The midpoint of the guided sales range would equate to $9.53 billion or $150 mln better than consensus analysts’ estimates.

Are the headwinds for GameStop? Of course.  The threat of aforementioned mentioned digital distribution may cut out distributors like GameStop completely, as game developers may connect directly to consumers.  There is growing competition particularly in used game sales from some of retail’s heaviest hitters like Walmart (WMT) and Amazon (AMZN), but as of yet GameStop has effectively managed to maintain and even grow profits in the face of competition.  At least up to this point, gamers like the feeling of physically holding a highly anticipated game purchase and GameStop instantly gives this to them while Amazon and Walmart do not. 

Will a service like Gamefly pester GameStop like Netflix (NFLX) has Blockbuster?  This one is doubtful, in my opinion; games are different from movies in that they are used repeatedly rather than a single use at a time.  One great thing about Netflix is sending a just-viewed movie back in order to get another one that you have been waiting to see.  Gamers however invest time in the game, and while Gamefly will attract some serious gamers looking to test out games for their next purchase, we think it has less appeal for the average gamer and have less of an effect on GME.

By looking at historically normal valuations, it is clear that the market has priced in a substantial amount of downside has been priced into GameStop already.  For example, GME’s price-to-cash earnings of 5.7x is well below the historically normal range of 8.3x to 19.1x.  Furthermore, price-to-sales over the last ten years has historically ranged between .46x to 1.08x, but the current multiple is .37x with sales expected rise in the year ahead.  We currently have an Undervalued rating on GME, and based on the market’s normal valuation of this stock, we think it could trade in the high-$20 without any concern over valuation give current fundamentals.

So, with strengthening fundamentals and an extremely strong balance sheet, we believe long term investors have not missed the up-trend in GameStop after today’s nice bump.  Management has delivered consistent performance and the underlying fundamentals will eventually be recognized by the market.  With the current valuation, it is no surprise to that there have been rumors in the past week of a potential private equity acquisition looming around this company.

GameStop Surges and Proves It is No Blockbuster