Is Gamestop (GME) a Value Play or Value Trap? Quick Pitch

Market Folly has been adding a bunch of new features as of late. We started off with our stock of the week series and now we're going to begin a monthly 'quick pitch' on certain equities that hedge funds have been long or short.

Today's quick pitch focuses on Gamestop (GME): Value Play or Value Trap? The following is from Chris Lau, a SeekingAlpha contributor:

A major shake-up in the way games are distributed is unfolding. Activision (ATVI) and EA’s (EA) entrance in digital gaming is proving to be a winning strategy. EA’s online site, Origin, bypasses traditional sales channels. In the social networking space, Zynga’s (ZNGA) IPO showed investor willingness to take risks. Investors are putting money in the yet-to-be proven model of social networking games.

This leaves one major question: What does this mean for retailers like GameStop?


Hedge Fund Ownership (Or Lack Thereof)

The top holders of GME stock are largely vanilla mutual fund players like Vanguard and Fidelity. While Cliff Assness' quant firm AQR Capital owned a decently sized position as of 2011 year-end, there is practically no major hedge fund ownership in this stock (at least in the top 100 holders).


GameStop Backstory

GameStop has grown throughout the years, and especially after its acquisition of Electronic Boutique in 2005 for $1.44B. In the last few years as the digital downloading of games has proliferated, GameStop touted its knowledge of gaming and its consumers as a competitive advantage.

In recent months, investor pessimism has grown. Shares are 22.91% off from 52-week highs, closing recently at $21.70. The main concern lies in the rising shift to digital gaming from the traditional physical console games.

GameStop has tried to attack this shift head-on and saw over $450 million in digital sales last year. They've mainly offered access codes in stores that allow gamers to download content at home. GME was originally spun-off from Barnes in Noble (BKS) in 2002, yet another company battling digital distribution of content.

GME's management team has set aside money for further acquisitions in digital as they have cash and no debt.


Valuation

At $21.95 per share, GME trades at a P/E of 7.63 (using 2011 EPS of $2.87 that excludes write-downs). By comparison, Best Buy (BBY) traded recently at $22.95 with a P/E of 6.30 (using 2011 EPS of $3.64).


Why the Bulls Own the Stock

Bulls point to fears over digital distribution as being overblown and argue that the digital transition will take longer to play out and won't cripple GME. They feel as though GME has a dominant market position in the industry.

Joel Greenblatt of Gotham Capital runs a Compustat screen to create a 'Value 1000' index for value investors. GME is one of the main companies on that list due to its cheap valuation. Other bulls might point to a cap structure strategy and its cashflow story as compelling reasons to own it. The massive repurchases could potentially place a floor on the stock that can keep shares buoyant even if things take a turn for the worse. And given the high short interest, there's also potential for various short squeezes as these buybacks reduce the float size.

- During the last quarter, GME grew market share to record levels.
- Its expertise allowed the company to create new business models to fill profitability gap
- PowerUp Rewards program (launched October 2010) now has over 17 million members
- Pre-owned digital and mobile business will add $800 million in revenue in 2012
- The company is debt-free
- $500 million stock buyback
- Cheap valuation
- Continued partnerships with publishers to sell DLC


Why the Bears Are Short

Bears will argue that a secular shift to digital distribution of games and the rise of social gaming will lead to the demise of GME ala Blockbuster.

Hedge fund manager Jim Chanos of Kynikos Associates is a notable bear on GME shares as he argues that game publishers like EA are increasingly becoming direct competitors with GME. You can view his bearish presentation on GME here.

He argues that GME looks cheap and will appear cheap all the way down. Just like movies and music, Chanos says that the value of their brick and mortar presence will collapse. GME's counterpart in the UK, Game Group, recently filed for protection from creditors.

And while GME currently thrives on used game sales, that revenue stream could be in jeopardy in the future. It's been rumored that future iterations of Microsoft's Xbox and Sony's Playstation will likely have some sort of "anti-used games measures" built in to the consoles.

One risk that short sellers are cognizant of is that GME could potentially take themselves private or be taken over by private equity. Additionally, the cost to borrow is quite expensive due to the crowded short.

- Fewer packaged game titles are being released
- Short interest has climbed to 41%
- In its recent quarter, GME said physical console category declined faster than projected
- Comparable store sales dropped 3.6% in the last quarter
- 20% decline in hardware sales


Further Talking Points

During the company's recent quarterly conference call, management said that digital receipts are ahead of schedule. They have a goal of $1.5b receipts by 2014.

GameStop's recommerce (buy-sell-trade) for mobile devices, electronics, and tablets started in 2011. The company believes it can resell items like Apple iPads, assuming 5% trade-ins annually and a 12-18 month upgrade cycle. Sales would account for $200m by 2012 and $600m by 2014 which you can read about here.

GME forecasts growth that is reliant on physical games, hardware, and software. The short-term problem for the company is that a lack of new consoles in 2012 will pressure margins. GME's loyalty program must attract a higher proportion of digital sales.

Hot titles like Grand Theft Auto, FIFA Soccer, Call of Duty, and Max Payne 3 may be a catalyst for higher growth. These catalysts aren't necessarily reflected in the current share price and management kept only a conservative forecast for these releases.


Conclusion

GameStop (GME) is a company that dominates in its traditional space of selling physical video games, but it needs to grow-up in the digital world and faces challenges in adaptation. The negative price action in its stock as well as competitors (BBY), suggests that there is further downside. If console makers implement anti-used game measures, GME would have a tough uphill battle. Weak retail sales in electronics and heavy competition make this a stock to avoid at this time.


Thanks to Chris Lau for his contribution to Market Folly in our new 'Quick Pitch' series. If you have an investment write-up you'd like to submit, please click here to email us

Why Hedge Funds Like Mead Johnson Nutrition (MJN)

In our hedge fund portfolio tracking series we noticed that quite a few long/short equity funds added shares of Mead Johnson Nutrition (MJN) in the fourth quarter of 2009. In a recent letter to investors, Dan Loeb explained the rationale behind his hedge fund Third Point's position in MJN and we thought this would be a perfect time to examine just why so many hedgies are fond of this company.

Mead Johnson Nutrition (MJN) completely separated from Bristol-Myers Squibb (BMY) in December of 2009. MJN is a leading infant formula producer and carries the well known brand Enfamil, making it a definitive consumer staples play. The company has a truly global footprint as it garners large market share in North America and the rising world with over 58% of their sales coming from emerging markets. Loeb certainly likes their attractive earnings growth noting that, "once birth rates normalize in the developed world, the company will generate one of the fastest long-term sales and profit growth rates in the large cap consumer staples universe."

What's interesting is that Loeb's hedge fund has labeled this a risk arbitrage investment and sees MJN as a prime takeover target. In his investor letter, he identifies Nestle or Danone as companies that are big enough to acquire MJN. He explains that, "both companies are focused on health and wellness, have acquired infant nutrition assets in the past (Nestle paid 15.7x EBITDA for Gerber and Danone paid 21.7x EBITDA for Numico)." However, Loeb notes that investors might have to wait a while before MJN is potentially acquired as there are always various regulatory, tax and legal complications in the mix. And, he is more than happy to wait given MJN's emerging markets growth. For more of our coverage of Dan Loeb, we recently looked at Third Point's equity portfolio as well as their performance and exposure levels.

Now that we know the basics of the hedge fund thesis for Mead Johnson Nutrition, let's take a little bit closer look at some of the fundamentals. MJN has a market cap of over $10 billion, trades at an EV/EBITDA of 14.7, a trailing P/E of 25 and a forward P/E of 18.7. It has a PEG ratio of 2.26 and a price/sales of 3.5. These figures illustrate how you're paying up for the substantial emerging markets growth this company provides. This is seemingly the definition of a G.A.R.P. (growth at a reasonable price) investment.

Mead Johnson has profit margins of around 14%, revenue of over $2.8 billion, EBITDA of over $760 million, and quarterly earnings growth (year over year) of almost 38%. Insider ownership comes in at just over 6% and shares are trading near their 52-week high of $50.35. And those of you wanting a technical look at the stock can get an instant chart analysis of MJN here.

Overall, it's an interesting thesis from Loeb's Third Point and we'd imagine many other firms agree that MJN is a solid company by itself (high quality business), but is also fair game as a prime acquisition target. Some of the largest institutional owners of MJN shares include Blackrock, Owl Creek Asset Management, hedge fund Paulson & Co, Lee Ainslie's Maverick Capital, Stephen Mandel's Lone Pine Capital, and Dan Loeb's Third Point, among many others. It will be interesting to see if hedgies have continued to add shares of MJN in the current quarter as shares have been marching higher as of late.

Lastly, we make note that MJN has been popping on all sorts of hedge fund related data sets, including Goldman Sachs' VIP list, the list of top hedge fund holdings, and throughout our hedge fund portfolio tracking series. It was by far one of the most added stocks in the fourth quarter by hedge funds. Obviously, hedgies are bullish on MJN and now we have a better look as to why.

Taken from Google Finance, Mead Johnson Nutrition is "a pediatric nutrition company. Its Enfa family of brands, including Enfamil infant formula, is a global brand franchise in pediatric nutrition. The Company’s product portfolio addresses a range of nutritional needs for infants, children and expectant and nursing mothers. The Company markets its portfolio of more than 70 products to mothers, health care professionals and retailers in more than 50 countries in Asia, North America, Latin America and Europe."