Fun and Games Ahead for GameStop

This column was originally published on RealMoney on Nov. 23 at 2:01 p.m. EST. It's being republished as a bonus for TheStreet.com readers.

It's little wonder that video-game fans stood in line this week to buy the meager shipments of the Xbox 360 from Microsoft(MSFT). Or that they will line up to do it again for Sony's (SNE) PlayStation 3 early next year. These are fantastic pieces of supercomputing hardware, each with components that take players to the edge of the possible.

Both companies sell their consoles at a loss, however, so the big near-term question for traders is which retailers will benefit most from this new wave of interactive entertainment devices. Investors have already made a big bet on video-game chain GameStop (GME), which reports earnings Tuesday, and initial indications suggest they will be rewarded.

Spun off by Barnes & Noble(BKS) in November last year, GameStop has since rapidly grown to 4,200 retail stores after a merger with Electronics Boutique, focusing on strip-mall locations. It sells new and used gaming hardware, software and accessories, and it produces the magazine Game Informer, which reportedly has a circulation of 1 million. The company also operates the online outlet ebgames.com and gamestop.com. On Tuesday, it hosted Xbox debut parties at 1,600 locations.

This round of hardware releases represent a significant technological leap for the video-game industry. The previous generation of devices ushered in DVD movie capability when the stand-alone players were still pricey. Now they are moving farther ahead with a processing power that shames most business desktop computers, allowing game publishers to create incredible experiences that will pull even more eyeballs away from movies and television. The PlayStation 3 will be the cheapest way into a Blu-Ray high-definition DVD player. Sony and Microsoft both use high-end multiprocessor technology in their consoles, with Sony finally taking the wraps off of its highly touted Cell processor.

It's little wonder, then, that the nation's leading dedicated video-game retailer is selling at a premium itself, trading in the high $30s at a P/E multiple of nearly 27. With the stock trading sideways between $28 and $38 since June, traders have clearly been torn between the goal of buying ahead of the new wave of consoles and games and selling on their arrival. Citigroup analyst Elizabeth Osur says she expects shares to break out to $45 over the next six to 12 months, driven by what she thinks will be a 35% estimated five-year growth in earnings. She is looking ahead to the peak software growth year of this cycle in calendar 2007 and estimates earnings per share to be a whopping $2.85 for fiscal 2008.