Monday, August 31, 2009

GameStop (NYSE:GME): Upgraded to Conviction Buy at Goldman Sachs

Goldman Sachs is upgrading GameStop (NYSE:GME) to Conviction Buy from Neutral this morning with a $28 price target.

Firm believes valuation has fallen below their industry growth framework, and earnings expectations, for a long time aggressive, are now beatable, in their view. Also, they see a powerful cash flow story emerging as GME nears paying off its remaining debt and could turn to buying back shares. Lastly, they see secular concerns around the business as overblown; digital downloading is not an existential threat as current console games are too big to download, and the Used business has significant barriers to entry; GME should continue to dominate that market. Goldman's $28 price target suggests 19% upside.

After two quarters of downward earnings revisions Goldman now has forecasts above the Street. Beginning with 3Q09, where they are 3c above consensus, they expect the company to begin reporting favorable numbers against a lowered bar. As the company meets or exceeds earnings expectations, they believe valuation levels will rebound to closer to levels suggested by our industry growth framework. The combination of a healthier release slate and easing compares should drive accelerating industry growth going forward, which should become evident through monthly NPD trends.

They are raising estimates on continued strength in new store productivity and the recapture of Used margins in 2010. 2009 estimate increases to $2.57, from $2.52; 2010 rises to $2.91, from $2.68; and, 2011 rises to $2.82, from $2.55.

- After two quarters of sharp downward revisions to guidance, Goldman finally sees earnings estimates as achievable, and even beatable. Going back to the beginning of the year, Goldman's forecasts had stood at more than 30c below consensus, as shown in Exhibit 1, whereas today, their forecasts are actually modestly above consensus. Firm believes the company has lowered the bar tremendously, issuing more than achievable back-half guidance, particularly in 3Q where they stand 1c above the high-end of guidance and 3c above consensus.

- Another positive they see in GME stock is an emerging cash flow story, which beginning as soon as next year could be deployed towards share repurchases, driving significant upside to earnings. With minimal capex requirements, even with its current pace of store growth, and efficient working capital on little net inventory commitment, GME is a strong generator of cash, expected to produce $450 mn of free cash this year. For the past several years, GME has used its free cash to pay down the $940 mn of debt it issued to purchase Electronics Boutique in 2005 and the $236 mn it issued to buy Micromania in late 2008. As of the end of 2Q09, it has less than $500 mn of that total debt remaining. With an expected cash balance at the end of this year of nearly $1 bn and annual free cash flow in the range of $500 mn, the company will be building a sizable amount of excess cash. Deploying it towards share repurchases would drive significant upside to Goldman's earnings estimates. Annual share repurchases of $500 mn, roughly in-line with free cash flow, would drive 16% upside to 2011 earnings, even assuming repurchase prices in-line with firm's price target for the stock.

Notablecalls: I like this call. The target could have been somewhat higher given the fact GME is the cheapest name in the space but note how Goldman hints there could be upside from share repurchases.

The short interest stands at 10%+ and with a GSCO upgrade at least some of these guys (and gals) are going to run for cover.

I see this one going to $24.50 and $25 if the market behaves (big IF).

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