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GameStop

The American consumer is supposed to be sitting inside his devaluating house with his pockets turned inside out like rabbit ears for lack of home-equity loans to spend. But sales for GameStop are somehow on pace to surge 26%. Same-store sales, which ignore acquisitions and new-store openings, jumped 15%, 29% and an estimated 35%, respectively, in the first, second and third quarters of this year.

In June 2006 in this column I presented my Game Theory. It held that (deep breath) the giant hardware makers, Microsoft and Sony, were going to take a bath on their overpriced Xbox and PlayStation 3 consoles, and videogame makers were going to struggle until console prices fell, and GameStop would flourish, because it sells used gear and games at high margins, and that would make a bundle until the new stuff caught on. Microsoft and Sony have, indeed, lost heaps of money on the consoles (although consoles represent a tiny percentage of overall business for each). Game makers did a smidgen better than I thought they would, with two out of the three big ones, Electronic Arts and Activision, beating the market. But none of these companies has matched GameStop, whose shares have nearly tripled in price since then.

Wall Street seems to have been caught by surprise at the retailer's recent success. GameStop has beaten consensus earnings estimates by double digits in its past two quarters. That earned the stock a spot recently on a stock screen for companies with plenty of earnings momentum. The screen looks not only for recent upside surprises, but also strong earnings growth in recent years and projections for more of the same over the next several years. See the screen recipe for details on the demands, and use SmartMoney's stock screener anytime to run it for yourself. It recently highlighted eight earnings outperformers from a starting database of 8,000 companies.

GameStop's recent success is being led by new merchandise now that console prices have dropped. In the company's second quarter, sales of new games jumped 49%. New hardware sales soared 87%. Third-quarter numbers are expected Nov. 20. Expect huge growth. "Halo 3," the last installment of a wildly popular game franchise exclusive to the Xbox and Xbox 360, launched in late September. (To give you an idea of its appeal, extreme gamers/nerdlingers can pay $130 for the "legendary" version of "Halo 3," which comes with a helmet.) Not only did the game sell 3.3 million units in its first week, it helped nearly double Xbox 360 September sales vs. August.

Microsoft reduced the price of its best-selling Xbox 360 model by $50 to $349 in August. PlayStation took $100 off its flagship PlayStation 3 model earlier this month, bringing the price to $499. Both companies have been outsold by Nintendo's Wii gaming system, which currently specializes in cutesy games rather than bloodbaths, and which sells for just $250. GameStop's boost from the console price cuts should carry over into fiscal 2008. Profits then are expected to rise 32% on a 15% increase in sales.

Of course, the stock now trades at 35 times earnings, nearly double the market's average. It's up sixfold since I first recommended it in August 2004. The stock has done so well for so long that I'm reluctant to stop recommending it. But I'm afraid it's probably fully priced here. Figure that you can pay 35 times earnings for a company analysts forecast will produce 20% earnings growth, on average, over the next five years. Divide the first number by the second and you get a PEG ratio of nearly 1.8. Alternatively, you can pay around 18 times earnings for the S&P 500 index, and get long-term earnings growth of 10% (a slowdown this year notwithstanding). That's a PEG of about 1.8, too. This column sometimes recommends stocks with high price/earnings ratios, but they're almost always justified by blazing growth projections. In the past I recommended GameStop shares at PEG ratios of 0.8 and 1.1. At 1.8 they're starting to look a little like those consoles used to: worth passing on until you see a price cut.