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We are bullish on the long-term prospects for the video-game industry. A more affluent population is playing video games, and this group is willing to open its wallet to buy the latest titles. With the start of a new video-game console cycle under way, one stock that we wanted to look at for the model portfolio is
, which was recently trading at $40.57.
As the nation's largest retailer of video-game hardware and software, GameStop is poised to benefit from what could be a very strong and prosperous cycle that kicked off with the
Xbox 360 video-game console release in November. Two other consoles are expected in 2006: the
PlayStation 3 and the Nintendo Revolution.
GameStop, which recently merged with competitor Electronics Boutique, operates about 4,200 stores in the U.S. and Europe. The company also sells video-game hardware, software and related accessories via the Web, and it publishes
magazine. GameStop's exclusive focus on video games differentiates it from mass-market consumer electronics retailers such as
and makes it a prime destination for video-game enthusiasts.
In addition, GameStop has a highly lucrative business selling used video games, which comprise about 30% of sales. We believe the used-game business is a huge strength for GameStop, because retailers often force gamers to buy bundles, which can include four or more games, along with their new console. We believe gamers will sell the unwanted games back to GameStop, which can resell them to other users.
Used games deliver higher profit margins than new games. Even though used games are only 30% of GameStop's sales, they generate 45% of gross profits. In addition, used-game sales extend the marketing life of old consoles, as lower-income consumers who can't afford newer, more expensive consoles can opt for used models.
Analysts expect GameStop to generate earnings of $1.77 a share on revenue of $5.04 billion for the fiscal year ended January 2007, which is roughly flat with fiscal 2006, a very strong year for GameStop. However, industry software sales for January were down 5% year over year, and key software publishers
both issued weak outlooks for the year.
In addition, the Xbox 360 rollout has been a disappointment because of a lack of supply of consoles, as well as a small and uninspired game lineup. It is also being reported by numerous media sources that the launch of Sony's PlayStation 3 is facing delays. And when the PlayStation 3 does hit stores, it will almost surely be in short supply as the Xbox 360 is today, causing even more gamers to wait. Therefore, it is possible that these estimates on GameStop are too aggressive and that the company could report disappointing earnings this year.
From a macro perspective, GameStop is a late-cycle play that is strongest when console penetration is at a peak and gamers spend more money on games, which generate higher profit margins than consoles. And while waiting for new consoles such as the PlayStation 3, gamers are likely to slow down their purchases of games for the current generation of consoles such as the Xbox and PlayStation 2.
As gamers wait longer and longer to find a store with an Xbox 360 in stock, and for the PlayStation 3 to arrive, game sales are more likely to be disappointing. We believe an earnings disappointment for GameStop, driven by a small installed base of new consoles, could provide a better entry point than the current quote for long-term investors.
One bear case on the stock focuses on the prospect of software publishers selling games directly over the Internet instead of on DVD disks, which are the current standard. While this is possible, the risk is overblown. First, the cost of manufacturing a disk and box is tiny compared with the enormous amount of money put into actual game development. In addition, new games contain an enormous amount of data and would take a very long time to download; software publishers would have to make investments in their infrastructures to avoid frustrating customers.
Also, Sony is banking on PlayStation 3 to drive adoption of its next-generation Blu-ray DVD format, which allows more information to be stored on each disk than the current-generation DVD standard, and Sony is not about to abandon this standard in favor of downloads. Internet downloads may work for small game updates, such as patches to fix glitches, but we doubt it will become the standard for quite some time, because most game consoles are not connected to the Internet.
Competition is our main concern with GameStop, but we believe its exclusive focus on the growing video-game market gives it an advantage over its rivals. Although Best Buy has tested selling used games in its own stores, there is not yet an indication of a full rollout in Best Buy stores. Plus, we believe the game business is big enough to support several players.
So while the used-game business may boom in 2006, we will wait until we have better visibility into the new cycle to initiate a position in GameStop. With only one new console starting to gain some traction and another two with uncertain launch dates, we believe there will be a better opportunity to buy GameStop shares later in the year, or even in 2007.
The TSC Breakout Stocks Team is Michael Comeau and William Gabrielski, research associates at TheStreet.com. In keeping with TSC's editorial policy, they don't own or short individual stocks. They also don't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. For more information about Breakout Stocks, please