Game Group

It's been a while since I bought a new share, but I'm seriously considering dipping my toe in the water for the sake of Game Group. They announced their preliminary results today, with the following highlights:

• Operating profit down 28%.
• Revenue down 10%.
• Their CEO and UK Chief Operating Officer are both stepping down.
• For the first 11 weeks of the year like-for-like sales are down 14%.

How could I resist?

Background

Game Group are the market leading game store in the UK with 600-700 stores. They have another 700 abroad, but derive over 60% of their revenue from the UK. They also sell online, but their online revenue is only ~5% of the total.

Prospects

Game faces competition from other games shops (HMV is probably their biggest threat, given that it's desperately replacing its diminishing CD revenue), non-specialist retailers like Tesco and Argos, and online retailers such as Amazon and play.com.

The key question is whether they can continue to trade profitably despite this barrage of competition. They have some points in their favour:

• 20% of their revenue comes from their pre-owned offering, and their gross margin on these sales is over 40%. In this segment they are relatively immune from online and supermarket competition, so it's basically them and HMV.
• Their reputation as a specialist retailer means that they will be a popular choice when buying peripherals - these form 13% of their revenue, and have a gross margin over 30%.
• People may be reluctant to make a very large purchase online, which means that Game and the other terrestrial retailers have an advantage when it comes to new hardware sales. New hardware forms 25% of Game's revenue, with a margin of ~22%.

I think it likely that online sales of new software will continue to increase, which will eat into Game's store-based revenue. But at least some of that growth will go to Game's online business, and they should be able to close stores as they become unprofitable. They may turn into quite a different sort of business over the long run, but I don't think their business model is going to implode anytime soon.

Income

If we're looking at a business in slow decline, it's important to make sure that they are not going to be strangled by fixed costs and tip into unprofitability in a few short years.

Their total gross margin is about 28%. About 80% of that goes into selling, distribution and administration (including about 30% in staff costs), to leave a net operating margin of 5.6%.

Assuming their fixed costs are entirely fixed, then a 10% fall in revenue should result in a 10% fall in gross profit, and that should then carry through into a fall of 50% in their operating profit. Nasty! 10% may even be optimistic, since like-for-like sales so far this year are down 14%.

Clearly there are substantial risks to the downside here.

Balance sheet

Game have a Net Tangible Asset Value of £150m. They have £176m of inventory, but this is more than funded by their £260m of trade and other payables. They have £86m of cash, offset by £40m of debt.

It's interesting to compare their £176m of inventory with their total revenue of £1.7bn. That suggests products sit on their shelves for an average of only 36 days before being sold. Crikey - that's far less than I would have guessed. Suggests they're running a pretty tight ship.

Price

Now we come to the interesting bit. Clearly this is a company facing some significant risks and uncertainty. It will need to be trading at a pretty decent price for it to be worth investing.

Today Game has a share price of 89p, and a market cap of £354m. In 2009 they earned £64m after tax, for a P/E ratio of 5.5. In 2008 they earned £103m after tax, which would mean a P/E ratio of 3.4 - that's unlikely to represent an ordinary year, but shows what is possible if the market picks up a little.

If the game market stages a recovery, then I think Game could achieve post-tax earnings of ~£80m. If that persisted for a couple of years, then uncertainty may recede, and Game Group might be accorded a P/E ratio of 12. That would mean a market cap of £960m and an increase in the current share price of 170%. Add in four years of steadily increasing dividends and the total return would be 200%.

On the downside, a continued decline in revenue could quickly lead to Game making losses. A couple of years of that would result in them running out of cash, and once that happens Game would be staring into the abyss - the shares could easily go to zero.

Conclusion

This is by no means a dead cert, but I think a 200% upside makes it a decent punt.

Update 22/4/10:

Bought this morning at 92.6p. Game now forms a little over 4% of my portfolio.