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)	2007	2008	2009	2010	2011
New Video Game Hardware	1,073.7	1,668.9	1860.2	1,756.5	1,720.0
New Video Game Software	2,012.5	2,800.7	3685	3,730.9	3,968.7
Used Video Game Software	1,316.0	1,586.7	2026.6	2,394.1	2,469.8
Other	916.7	1,037.7	1234.1	1,196.5	1,315.2
Total	5,318.9	7,094.0	8,805.9	9,078.0	9,473.7

...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)	2007	2008	2009	2010	2011
New Video Game Hardware	77	108.2	112.6	113.5	124.9
gross margin	7.2%	6.5%	6.1%	6.5%	7.3%
New Video Game Software	427.3	581.7	768.4	795	819.6
gross margin	21.2%	20.8%	20.9%	21.3%	20.7%
Used Video Game Software	651.9	772.6	974.5	1121.2	1140.6
gross margin	49.5%	48.7%	48.1%	46.8%	46.2%
Other	315.2	351.6	414.6	405	452.6
gross margin	34.4%	33.9%	33.6%	33.8%	34.4%
Total	1471.4	1814.1	2270.1	2434.7	2537.7

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-10	May-10	Jul-10	Oct-10	Jan-11
New Video Game Hardware	40.9	21.2	25.9	21.7	56.2
gross margin	5.5%	6.1%	8.2%	7.9%	7.2%
New Video Game Software	322.2	174.5	141.7	182.4	321
gross margin	20.6%	20.0%	21.4%	21.7%	20.1%
Used Video Game Software	360.7	274.4	260	250.2	355.8
gross margin	46.4%	48.1%	46.0%	47.4%	44.2%
Other	150.3	100.7	89.2	92	170.7
gross margin	33.6%	34.7%	34.8%	35.9%	33.3%
Total	874.1	570.8	516.8	546.3	903.7

..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.

Virbac Offers Secular and Cyclical Growth

Virbac Looking After Animal Health

Virbac is a very interesting animal health pharmaceutical company and a good stock to research. It offers a good balance of secular growth from companion animals (pets) and exposure to the positive long term trends of food producing animals. I think is a good stock to buy and picked some up recently. It is a good stock to hold within an agribusiness focused portfolio.

For potential investors, Virbac's companion animal segment growth should be seen as trending with general increases in pet populations and, with company specific issues like new product releases and market share grab. Alternatively, the food producing animal segment is more cyclical and exposed to the increasing usage of parasiticides, antibiotics and vaccines in animals. I think this is a good long term trend as protein consumption is on the increase and utilisation of animal pharmaceuticals will help to deal with increasingly concentrated production techniques.


Virbac Revenue Breakdown

Here is a table of percentage of revenue share by geography and segment to the half year of 2010

%	Rev Share	Growth
Europe Companion	34.6	20
Europe Food	15.8	0
N America Companion	14.1	25
RoW Companion	11.1	27
RoW Food	21.7	66

Source: Virbac

Clearly there is a slowdown in European Food market and high feed prices have not helped. However, the good news is that this segment only makes up nearly 16% of revenues and the rest of the world is doing fine. Moreover, there is a clear split between how bovine products (77% of food revenues) are performing and how swine & poultry are currently faring.

The companion market is doing very well with new product launches and a return to economic growth.



Virbac Food Producing Animal Markets

For 2010 Virbac reported 5% organic growth in this segment. As discussed above, emerging markets are doing much better than Virbac's core market of Europe and in particular France. These markets can be seen as cyclical and dependent upon the dynamics of production/price factors in these markets. What is common to all of them (swine, poultry and bovine) is that they are experiencing rising feed costs.

When feed costs rise, supplier's margins get squeezed unless they have pricing power through relatively low production. Ultimately, the price increases tend to cause production expansion. It is a classic commodity price cycle. Here is where we are now with swine...

...and with bovine...

...so it looks like, after a very difficult period from summer 2008 to Jan 2010, prices are very strong. Although feed costs are high, as long as prices are high, margins and profitability can expand. This will encourage future production. There is an unfavourable supply/demand balance in poultry but only makes up a small portion of Virbac's overall sales.

Unless a global economic slowdown ensues, I would expect production expansions in bovine and swine and this has to be good news for Virbac's sales of parasiticides and antibiotics.

Tyson foods recently gave a very upbeat outlook for 2011.


Virbac Companion Animal Market

This segment makes up 60% of sales and revenues in 2010 were up 13.5% organically. I've broken down sales in this segment by product here

%	Rev Share
Parasiticides	30.8
Vaccines	14.6
Antibiotics/Dermatology	14.9
Specialities	12.6
Horses	7.9
Petfood	6.6
Others	12.6

Source: Virbac

Of particular note was the success of Fiproline and Effipro (Europe)which are spot-on and spray products that treat flea and tick infestation in cats and dogs. They were launched in July 2009 and have already grabbed good market share. Virbac has a sales target of E15-20m and sales were estimated at the top end of this forecast. Virbac intends to launch Effipro in the US by the end of 2011.

Of the existing products in the US, sales of Iverhart (heartworms) have been expanding rapidly. Going forward Virbac plans to launch Canileish (canine leishmaniasis vaccine) by the end of 2011 with a European sales target of E25-30m.


Virbac Forecasts

With the new product launches in the companion sector plus a cyclical pick up in the food sector, I think Virbac is capable of hitting analyst estimates and possibly exceeding them. Here is a summary of consensus forecasts

(m's)	2007	2008	2009	2010E	2011E	2012E
Revenue	438.6	443.4	467.4	572.5	612.3	659.4
growth %	9.2	1.1	5.4	22.5	7.0	7.7
EPS (c)	360	411	448	650	707	791
growth %	23.7	14.2	9.0	45.1	8.7	11.9

Source: FactSet Research Systems Inc

At a current share price of E111 this puts Virbac on a forward PE of 15.7x and gives a market cap of E965m and an enterprise value of E998m. Free cash flow generation has also been improving with generation of E23.7m and 42.6m for 2008 and 2009 respectively. On a trailing basis it is E57.6m
I think Virbac is attractively priced for its long term growth prospects and the recent dip could be providing a decent buying opportunity with a target of E129 in mind.



Source:
Virbac 2010 Sales release