Specialty retailer GameStop (NYSE: GME) has had a brutal run lately. The video game stock is down 28% in the past year, as investors are increasingly worried about the future of physical video games.
In an age in which more games are being played on mobile devices, and digital downloads threaten GameStop’s bread-and-butter trade-in program, investors are rushing for the exits.
But in a volatile market – and especially when a company makes a change to its core strategy – investors tend to sell first and ask questions later.
Putting the Fun Back in Fundamentals
GameStop continues to generate strong profits from its lucrative trade-in model, as well as from the popular Xbox One and PlayStation 4 consoles.
Last year, total sales inched up 0.7%, while earnings per share rose 8%. GameStop’s sales growth looks unimpressive, but the company was hit hard by the rising U.S. dollar last year. Sales increased 5.4% in constant currency terms.
And GameStop is highly profitable. In fact, last year’s $2.9 billion in gross profit was a record for the company, despite the fact that it faced very difficult comparisons since the Xbox One and PlayStation 4 were both released back in 2013.
But investors aren’t convinced. Judging by the stock price reaction, you’d think video game hardware is a dinosaur. That’s simply not true.
GameStop Isn’t Going Anywhere
Investors may recall that a few years ago Microsoft (NASDAQ: MSFT) toyed with the idea of embedding codes into its games so that each copy could only be played by its original owner. This was to prevent reselling, which ate into Microsoft’s sales of new game software. It ended up scrapping that idea, because consumers were outraged.
It’s true that GameStop makes fat margins from game resales. But it’s also true that gamers want the ability to buy and sell used games. And it’s unreasonable to think video games will be download-only at any point in the foreseeable future, because the technology simply isn’t equipped for that.
It’s one thing to play “Angry Birds” on a smartphone. It’s another thing entirely to think that a full-length title like “The Legend of Zelda” could be download-only. That download would take an extremely long time, and the quality of the game would surely be far lower than its fans have come to expect.
Expansion Strategy Could Pay Off
To hedge its bets, GameStop has invested significant resources in building businesses outside its core focus. Most investors know GameStop to be a video game retailer, which it predominantly is – it has more than 6,000 stores in the U.S. alone.
Moving forward, the company is expanding its reach beyond video games. It now operates a technology brands segment, consisting of its Spring Mobile and Simply Mac businesses. Spring Mobile operates 890 AT&T (NYSE: T) branded wireless retail stores, where it sells both prepaid and postpaid AT&T and DirecTV products and services.
The Simply Mac stores buy and sell new and used Apple (NASDAQ: AAPL) products. GameStop also operates ThinkGeek stores, which sell collectibles.
These decisions may worry investors. Some analysts are interpreting the moves as acts of desperation. But it really boils down to a matter of perspective. GameStop management stated its goal is for more than 50% of its operating profit to come from areas other than physical gaming by 2020.
One could simply argue that these moves represent valuable diversification to protect the company against the worst-case scenario. And it’s not like these are poorly performing businesses. Quite the contrary. In fact, the phone selling and collectibles businesses are profitable – and growing at a rapid clip.
Last year, mobile and consumer electronics category sales increased 25.8%, while collectibles sales soared over 300%.
Turn on GameStop for Value and Income
The market is clearly pessimistic when it comes to GameStop, but at a certain point, a beaten-down stock becomes too cheap. That appears to be the case here.
Shares of GameStop currently trade for a dirt-cheap 8 times trailing earnings per share and 6 times forward EPS estimates. In addition, the stock has a hefty 5% dividend yield. The company generates more than enough free cash flow to sustain its dividend and advantageously buy back its own stock at these low prices.
Investor sentiment is extremely negative, but as GameStop’s multichannel strategy proves its worth, investors will come around. If things go as GameStop management expects, this video game stock may not be this cheap for long.
DISCLOSURE: Bob Ciura personally owns shares of Apple (NASDAQ: AAPL).
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