Pachter: GameStop To Lose Ground To Target, Wal-Mart?

Despite officials from major U.S. video games retailer GameStop reporting record sales of $7.1 billion in the company’s fourth quarter, Wedbush Morgan's Michael Pachter has stated that the company is likely to lose ground in future to retailers such as Wal-Mart and Target. Though Pachter admits that the company had “broad strength” in both software and hardware sales, and gained market share during the fourth quarter, he is “somewhat surprised” by GameStop’s revenue guidance. “The company suggests it can grow its software sales by 24-29 percent -- implying a 9% contribution from new stores -- and grow its hardware sales by about 9-10 percent entirely from new stores,” said Pachter. “In the context of last year’s 39% software sales growth and 55% hardware sales growth, these targets appear modest,” Pachter noted, but felt that with GameStop’s suppliers (publishers Activision, Electronic Arts, Ubisoft and THQ) expecting software sales growth of only 10 – 12% for the year, and most industry observers (Pachter included) expecting hardware dollar sales to be flat for the year they were unlikely. Pachter referred to “GameStop management’s apparent memory lapse about its performance in holiday 2002,” in which the company “consistently” guided to growth but before the end of the year preannounced a shortfall, attributed to a shift in hardware market share from it and peer specialty retailer Electronics Boutique (since merged into GameStop) in favor of the mass merchants on the anniversary of the Xbox and GameCube launches." “It appears that once hardware supply was sufficient to satisfy demand, gift givers tended to purchase hardware when it was convenient, causing a market share shift from destination specialty retailers in favor of more frequently visited mass merchants,” said Pachter. “We expect a repeat of the 2002 phenomenon in 2008,” Pachter continued. “We expect hardware sales to be flat to slightly negative for the industry in 2008, with dramatic increases in Wii and PS3 dollar sales offset in full by dollar sales declines for the PS2, PSP, DS and Xbox 360. We expect overall Wii and PS3 dollar sales to grow by approximately $400 million per console in the U.S., but expect the other consoles to decline by around the same amount. At the same time, we expect the Wii supply situation to increase by 150,000 per month, on average, with allocations of hardware favoring the mass merchants once supply and demand are in balance. We expect the first glimpse of this allocation shift to occur on May 19, when Nintendo launches Wii Fit.” “This device is not aimed at hardcore gamers, but is instead intended for more casual (and out-of-shape) consumers,” said Pachter. “We have learned that Nintendo of America intends to support the Wii Fit launch with the biggest marketing campaign in its history, and believe it is unlikely that such a large marketing campaign is intended to disproportionately benefit GameStop. Rather, we think that the Nintendo campaign is likely to feature key retail partners such as Target and Best Buy, notorious for attracting so-called ‘couch potatoes’.” Further expanding on his point, Pachter noted that merchants such as Best Buy and Costco are expected to drive same store sales growth in 2008 by selling a large number of HDTVs, and he anticipates that many retailers will cross-sell PS3s as Blu-ray players to HDTV purchasers. “GameStop’s belief that it can grow its hardware sales in this competitive environment sounds overly optimistic to us,” but Pachter did concede, “Notwithstanding the publisher estimates for software sales growth, we believe that the industry is likely to grow by 20% in 2008. This makes us comfortable that GameStop can grow its overall software sales at the high end of the 24 – 29% rate implied by its guidance.” “Similarly, we agree that growth of the company’s used game business is highly correlated to new software growth (after all, each used game begins its existence as a new game), and we anticipate used game sales will grow by 29%,” Pachter continued, but still questioned GameStop’s hardware sales growth confidence. “We have modeled a 1% decline in hardware sales for the year.” These estimates lead us to the conclusion that GameStop can grow its earnings substantially in FY:08, and our $2.37 estimate is slightly above the high end of company guidance. In FY:09, we expect comps to moderate to 3%, but again expect the mix shift in favor of higher margin software to allow the company to grow EPS to $3.08. Concluding, Pachter broached the question as to why Wedbush Morgan have a “hold” rating on GameStop, a company expected to grow earnings by approximately 30% for each of the next two years. “The answer is quite simple: we expect the mix to shift in favor from higher margin software to moderate and as a result more modest earnings growth. We think it is reasonable to expect that overly exuberant investors may drive GameStop shares well above our target price, as growth is difficult to come by, but we think it is prudent to recognize that GameStop’s run as a secular growth story will likely come to a halt over the next two to three years.”