Monday, March 28, 2011

GameStop Set to Disappoint the Market in 2011?

GameStop $GME is a business that has been aggressively shorted over the last few years, but is it now becoming a contrarian play? Investors have been quick to sound the death knell for GameStop due to the ‘oncoming’ onslaught of online gaming sales, and according to Yahoo Finance the short percentage of the float was around 24% However, the recent results were superficially quite good and the stock rallied. Is it time to buy?

GameStop Earnings and Margins
A quick look at revenues over the years (year end to Feb)...

Sales ($m)20072008200920102011
New Video Game Hardware1,073.71,668.91860.21,756.51,720.0
New Video Game Software2,012.52,800.736853,730.93,968.7
Used Video Game Software1,316.01,586.72026.62,394.12,469.8

...reveals that growth in the Used Video Game Software segment appears to be slowing. The importance of this can be demonstrated by a look at gross margins.

Gross Profit ($m)20072008200920102011
New Video Game Hardware77108.2112.6113.5124.9
gross margin7.2%6.5%6.1%6.5%7.3%
New Video Game Software427.3581.7768.4795819.6
gross margin21.2%20.8%20.9%21.3%20.7%
Used Video Game Software651.9772.6974.51121.21140.6
gross margin49.5%48.7%48.1%46.8%46.2%
gross margin34.4%33.9%33.6%33.8%34.4%

Over the years, the used game segment has made up the bulk of profits but growth appears to be slowing.  I think this is an understandable issue and I would like to explore the reasons why.

GameStop Structurally Challenged?
There are four main challenges to GameStop and I think all of them are significant.
  1. Best Buy and Walmart are encroaching on their market share
  2. Online merchants are grabbing market share from in-store sales
  3. Software manufacturers are shifting to delivering the games online (avoiding piracy and protecting IP is a key driver here)
  4. They are being forced into the 'long tail' of retail (superstores are selling the blockbuster titles) which is an area that is not their forte
The likes of Best Buy $BBY and Wal-mart $WMT, as indicated in an earlier article, are seeing some of their traditional markets erode to online competition. Therefore, they are seeking new ways to sell to their captive audience of shoppers. Naturally, selling new and used gaming software fits perfectly into the sales demographic of kids making trips to their outlets. This competition is significant for GameStop.
Similarly, online competitors like Amazon are continuing to grab competition from GameStop. The advent of smart phones that can read bar codes and immediately compare prices will pressure margins for ‘bricks and mortar’ retailers. GameStop will still be able to offer the ‘retail experience’ of kids checking out new releases but as the tables indicate hardware sales are low margin, and new software sales do not make up the bulk of GameStop’s profits.
However, the key challenge for GameStop will come from how the gaming companies deliver files. With the advent of 4G and other ‘fat bandwidth’ provision, it will become feasible for games to be sold online. This has great advantages to the gaming industry because they will be able to insure against piracy by selling gaming upgrades and licences to the original purchaser. This helps avoid the kind of piracy that is rife in this form of Intellectual Property. This will be a significant problem for GameStop and I think will hurt them sooner rather than later.

A Value Trap?
I think there is a value trap here. GameStop are talking about closing 200 stores and opening 200 others in an attempt to restructure the business, but I think the decline and structural challenges are already showing in the numbers. Let’s look at sequential numbers...

Gross Profit ($m)Jan-10May-10Jul-10Oct-10Jan-11
New Video Game Hardware40.921.225.921.756.2
gross margin5.5%6.1%8.2%7.9%7.2%
New Video Game Software322.2174.5141.7182.4321
gross margin20.6%20.0%21.4%21.7%20.1%
Used Video Game Software360.7274.4260250.2355.8
gross margin46.4%48.1%46.0%47.4%44.2%
gross margin33.6%34.7%34.8%35.9%33.3%

..and margins are clearly falling in the used games category. However sales are doing ok (on a like for like comparison)

The reason for this is that I suspect Sales for the used game segment will do well for a while due to the hardware upgrading cycle causing lots of new inventory to become available. Unfortunately, for GameStop this will be sold off a lower margin and is likely to get lower still, as games shift to being delivered online. All of which creates a value trap for GameStop, they could be reporting good sales growth but I would keep an eye on used game software margins. I think they are set to fall aggressively.

Sunday, March 27, 2011

Is Traditional Retail Structurally Challenged?

One of the key secular growth trends set to dominate retail over the next few years is the transition from bricks and mortar sales to online sales.  Another, more cyclical, theme relates to the unequal nature of the economic recovery.  Put simply, emerging market demand is pushing up the price of those goods that the lower income groups spend a larger part of their discretionary income on.  So with higher food and energy prices there will be less spend on consumer discretionary for lower income groups.
Putting these two themes together, it is not hard to see that businesses like Best Buy $BBY, Family Dollar $FDO and Dollar General $DG should be structurally challenged. Indeed, Best Buy gave Q4 results recently and it disappointed the market with its outlook and guidance. However, the likes of Nordstrom $JWN and Coach $COH (Japan aside) have been demonstrating good growth.  Moreover, companies like Amazon $AMZN and Walmart $WMT are key beneficiaries because they both can grab market share from the likes of Best Buy.

What Best Buy Earnings are Telling the Market
Best Buy gave numbers and guidance
  • Full Year Guidance of $3.30-$3.55 vs. $3.56 estimates
  • Q4 revenue decline by 2%
  • Same stores sales decline of 4.6% partially offset by new store growth!
  • Gross Margin expansion
Clearly, Best Buy has some issues to deal with and the company was quick to cite disappointing sales of higher margin TV sets and net book sales. Moreover, declining sales has had an effect on inventory and analysts were quick to focus on the rising inventory plus working capital requirements. High inventory is a problem because it implies a reduction in future margins (to shift slow moving stock) and it also raises question about the structure of the business.


So we see that the revenue/inventory ratio is rising. This is not usually a good sign.

The Case for Making Best Buy a Best Buy?

The positive case for Best Buy is best made with reference to its evaluation and restructuring program. The decline in sales could be seen as a result of an unfavourable product sales mix (TVs, net books, lack of new upgrade cycles for windows) and the difficulty of beating tough comparable sales. There is no doubt that Best Buy is generating huge amounts of free cash flow and it is capable of using this cash to generate EPS growth via share buy backs. Indeed, current analyst (and company) estimates do not account for buy backs. More importantly, Best Buy is generating the cash in order to restructure the business.
The restructuring program centres on shifting sales towards things like Best Buy Mobile, tablets and gaming. In addition, Best Buy is reducing the size of stores in the US so the possibility exists for an increase in sales per square foot as well as learning how to maximise sales in new stores.  Gross Margins rose in these results and the company has been aggressively controlling SG & A costs. Initiatives like ‘buy online pick-up in store’ are intended to differentiate Best Buy from online only competition and are reflective of how Best Buy is competing.
We can see these issues reflected in gross margin growth which has been in sequential decline.

Gross Profit9,54610,99812,1602,7932,9182,9833,94312,367
Gross Margin23.9%24.4%24.5%25.9%25.7%25.1%24.3%24.6%
However, on a yearly comparison Q4 gross margins were actually up.  

Best Buy a Structurally Challenged Stock?
The negative case centres on the argument that-despite the cheap evaluation-Best Buy is structurally challenged and these issues will see a future decline in earnings and cash flow generation. For example, a comparable retailer in the UK is HMV (cds, dvds, games etc) and this company looked very cheap for a long time on traditional evaluation metrics. However, the share price continued to decline with ongoing structurally challenges. This is a significant point because Best reported that European sales growth and gross margins were negative.  As HMV went, so could Best Buy.   Indeed, many of Best Buy’s initiatives are focused on restructuring to face the online threat, but is the company capable of meeting these challenges?
For example, reducing store size is wonderful, but it implies reduced sales of ‘bulky’ products and these products tend to be those sold in store.  Retailers tend to buy IP based purchases online and it is this type of purchases  (mobile, tablet, gaming etc) that Best Buy think it can expand into. Furthermore, opening new stores when existing sales are in decline is usually a bad move in retail. It suggests that the company will be implementing more of a failing business model or sales mix.
Similarly, new technological developments like customers being able to scan barcodes and search online for cheaper alternatives will challenge Best Buy margins and sales growth. Moreover, online retailers specialise in ‘long tail’ provision, so if Best Buy wants to compete with them they will have to hold larger inventory and that will eat into cash flow generation.
Essentially, new technologies and ‘convergence cannibalisation’ (ex cameras, computers, phones, ipods merging into a single device) from companies like Research in Motion $RIM and Apple $AAPL are challenging retailers like Best Buy. Unfortunately, this comes at a time when discretionary spending in middle income America is being pressured by high food and energy costs.
Whilst Best Buy Mobile sales growth is good, this could be seen as being driven by a cyclical uptake of things like smart phones of which Best Buy is not particularly well positioned to take advantage of for follow up sales.

Is Best Buy a Stock to Buy?
On balance, I think not. The stock trades at $29.22 and has an EV of $13.45bn.  I think that history shows us that despite the superficial attractions of a high free cash flow yield (above 10%) and low P/E ratio of 8.8x  the structural trends against this business are significant. I would look for a fall in comparable sales to revenues ratios before considering a long term purchase of this stock. For short term investors, I suspect that given improved macro-economic fundamentals there is some upside here because investors will like the evaluation-after all every stock has a price- but I think the challenges for Best Buy will accelerate and, I place little confidence in the forecast estimates.

Thursday, March 24, 2011

Compact Ultrasound Sales Seen as Rising 11% Globally, Good News For Sonosite

Ultrasound manufacturer Sonosite $SONO is a stock that has been in the doldrums recently, but a disciplined investor will take the opportunity to buy more provided he continues to believe in the earnings prospects.  I do, and I think I am, so I bought some more! Sonosite was featured at length in an article linked here and I think it has good earnings potential as well as being a potential bid target.

Furthermore, an interesting report was recently released which adds strength to the potential for this stock to go higher. In a report produced by Harvey Klein of Klein Biomedical Consultants, the compact ultrasound market is predicted to grow at 13% per annum over the next five years. In the US the market is forecast to expand from $276m in 2010 to $505m in 2015. Outside of the US, the market is expected to grow at 10%

In addition, the report cites Sonosite's 2010 US market share as being 42% and an investor only has to look at the next two players (GE & Philips) to find potential acquirers of Sonosite. If the market plays out as expected, Sonosite's US sales (provided they keep market share) could rise to at least $212m by 2015.

Given the recent analyst upgrades, now looks like a good time to pick some up. I bought some more.


PR Web, 'Leading Industry Analyst Reports Record Highs In U.S. Compact Ultrasound Revenues For 2010'

Wednesday, March 23, 2011

Cree Disappoints Again!

Cree $CREE , the market leader in LED lighting , updated the market with guidance and it wasn’t pretty. The stock was previously featured in an article here which discussed the company’s issues at length. Earnings View has also featured LED equipment manufacturer VEECO $VECO in an article found here  and essentially the forces causing their stock price downturns have continued.

Returning to the CREE update-and referencing earlier work- the updated Q3 guidance is as follows
  • Updated Q3 revenue guidance of $215-220m vs. previous guidance of $245-265m
  • Note that the previous guidance had been lower than analyst estimates of $288m for Q3
  • Gross Margins now forecast at 43%

So, again, Cree has disappointed the market. It is clearly taking longer for customers to run down inventory although the company is making more positive noises about Q4. Shares in SemiLEDS $LEDS are also down in sympathy.
Frankly, this is justified because the pricing pressures and inventory issues are being discussed by the whole industry. The bottom does not appear to be in sight yet and the stock price falls are a salutary reminder of what can happen when the most optimistic of sales forecasts start to falter.

Sunday, March 20, 2011

Wabtec is a Good GARP Stock Exposed to Increased Rail Spending


Wabtec $WAB is the sort of stock that should be bought in these uncertain times. The company is a provider of a range of products to the freight and passenger transit rail markets. As such, its demand drivers are increased car load traffic and the new production of railcars. The former is usually caused by increased economic activity and the latter by new investment in rail and/or new investment in railroad infrastructure.
Wabtec is the only company on the New York Stock Exchange which has seen its share price rise, every year, for the last ten years. It is highly cash generative and boasts an impressive track record, combining cycle growth and the ability to cut working capital in a downturn. Over the last few years Wabtec has used its cash flow generation to make accretive acquisitions and the business has longer term prospects to expand internationally and benefit from emerging market growth.
Within the last few years in the US, freight has grown strongly whilst transit has been flat and this is largely a consequence of budget issues at transit agency customers. Obama has been asking for additional funding and has been aggressively pushing plans for high speed rail. That said, it is probably better to think of these initiatives (high speed rail etc) as potential upside rather than baking them into forecasts

Wabtec Long Term Growth Drivers

Firstly, increasing urbanisation (particularly in emerging markets) should fuel growth in intercity rail investment. Similarly, greater globalisation and production shifts will encourage the necessity for increased mobility in both transit and freight markets.

Secondly, railways are a more energy-efficient way to move people around. The US is such a huge consumer of gasoline partly because it was built on highways rather than railroads.

Thirdly, railway infrastructural spending is a great way to secure job growth and also encourage greater efficiency in transport.

Fourthly, Wabtec's freight demand should see increases with the expected growth in transport of bulky materials like grains and coal in the US. Not only are food and energy requirements growing, but the US looks set to export more (wheat etc) and this requires transportation to external hubs.

Finally, there is a clear need for ongoing infrastructure investment in railroad networks in emerging markets.

Wabtec is well placed in the service, renewal and replacement market and the continued global expansion of rail networks should see increases in the global fleet. A quick look at sales and earnings growth over the last few years reveals that margins have grown well...

Gross Profit197370427393449490534
Gross Margin18.1%27.2%27.1%28.1%29.8%29.0%29.0%
Net Income85110131115123141165
Source: Company Results, Analyst Estimates, Earnings View

...and as discussed previously, Wabtec does a great job in cash flow conversion...

Operating Cash Flow151143159162176200234
% Net Income178%130%122%141%143%142%142%
Free Cash Flow130122140144155175207
Source: Company Results, Analyst Forecasts, Earnings View

Wabtec Evaluation
 Any stock needs to be evaluated on a risk/reward basis and it is no different with Wabtec. However, this stock represents a relatively safe way to acquire an earnings and cash flow stream. It should be compared to a US ten year note and a risk premium attached to it. That said, if Wabtec hits targets than there is a strong case for it being fairly valued at present...
Source: Company Reports, Analyst Forecasts, Earnings View

...and ‘fairly valued’ is fine because if it hits earning forecasts then the stock price should be able to ‘do its earnings’.
Wabtec was added to the portfolio at $56 with a $64 price target.