Gamestop (GME): Up to Buy – Goldman Sachs

Goldman Sachs is upgrading Gamestop (NYSE:GME) to Buy from Hold with a 12-month price target of $25 (prev. $20) on a combination of higher operating assumptions from new software and hardware as well as assuming share repurchases supplement dividends to the point of reaching 90% of FCF returned.

– Goldman’s estimates stand about 14% above consensus.

They see outperformance of GME shares for three reasons:

1) 2012’s ytd declines have been largely driven by supply rather than demand, and supply will improve in 2H12. As stronger releases hit shelves in 2H12, Goldman expects industry declines to slow, improving sentiment around GME shares.

2) Consensus estimates are not fully factoring in the launch of the Wii U and its impact on 2013 revenue. Even if the Wii U underperforms the original Nintendo Wii by 50%, it will contribute 13 points of growth to software sales. Given the strong lineup of already announced titles for 1H13 and the soft comp from 1H12, the firm expects EPS of $3.82 for GME – 14% above consensus.

3) GME’s cash dividends and share buybacks provide an attractive cash return to shareholders, and build in support for the shares. Given the ~19% FCF yield and ~5.5% dividend yield, they see downside risk somewhat tempered in the near term. GME has returned 114% of FCF over the 12 months ending in April, and the firm doesen’t think consensus reflects the consistency of its share repurchases. Its dividend yield is the highest in Goldman’s Hardlines coverage, with Staples the closest at 4%, while on a rent-adjusted EV/EBITDAR basis GME trades at 3.9x 2013E vs BestBuy at 4.7x, and office retailers at an average of 5.7x.

While they share investor concerns about the long-term state of physical retail for games in an increasingly digital environment, and reflect this in their 6.5x target EPS multiple, Goldman believes for core console based games disruption of the retail based model is unlikely for the next 2 years given 1) limited hard drive space on consoles today, 2) mass adoption of the next generation of Microsoft or Sony consoles not until 2-3 years after a 2013 launch, or 2015-16, and 3) consumer preference for the salvage value of used games.

* And now for the most interesting part of the call: History of GME shares around console launches

GameStop shares have historically appreciated drastically following the launch of a new console cycle, even when market sentiment leading up to the launch is very negative.

Investor behavior appears similar to the last console cycle.
Leading up to the launch of Microsoft’s Xbox 360 (which ushered in the current console cycle), there was a great deal of negative sentiment surrounding GME shares, as is evidenced by the spike to nearly 50% short interest in October of 2005 – mere weeks before the console’s launch. At that time, there was concern that the new consoles would see poor adoption rates, and that due to the console’s improved internet connectivity, digital distribution might cut GME out of the channel. Short interest went on to plummet for the next year while GME share prices appreciated over 50% in the same period. In the two years following the launch of the current generation’s first console, GME share prices more than tripled.

While Goldman acknowledges that the competitive landscape for gaming has changed since 2005, they still believe that the concerns about adoption rates and digital distribution are overdone, at least for the next two years given 1) no new disruptive console from Microsoft or Sony until late 2013 at the earliest, and 2) a further 2-4 year lag beyond that
for mass adoption.

Notablecalls: Goldman has been Neutral-rated in GME since 2009 and looks like they are calling for another big upside move in the name similar to what we saw in ’05-’06. This should generate ample amount of interest, especially given the 40% short interest.

Investors consider the business model broken but Goldman says it ain’t so. Digital distribution will be just another part of GME’s business.

Also, we may have a big catalyst in the form of Nintendo’s Sept 13th press event where they are expected to announce Wii U along with the launch date. We are now in the 8th year of the current console cycle and the Wii U will represent the start of a new one, which is a positive for GME.

The stars may finally be aligning for them.

I’m guessing the stock will be trading closer to $20/sh level today and possibly higher in the coming weeks. All-in-all this is more of a solid L-T call.

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