“There has been a lot of buzz lately that GameStop might be acquired…It reported results that blew away street estimates.” — Bloomberg TV’s In The Loop 3/18/2010

Readers of this blog by now have probably heard us beat the drum about GameStop (GME) being an extremely attractively valued stock, and today we feel somewhat vindicated and will continue to beat that drum following an impressive fiscal fourth quarter report.  The last year has been a difficult one for the video game industry, and as the world’s largest video game retailer, GameStop has clearly fallen out of favor with the market.  Same store sales dropped nearly 8% as spending on consoles was especially weak. 

Critics argue that GameStop will go the way of Blockbuster (BBI), which is teetering on the verge of bankruptcy, because video game sales will increasingly go digital.  The theory goes that bricks and mortar will be an anchor on results and it is only a matter of time.  However, as we see it, there is one extremely important difference between GameStop and Blockbuster: profit.

Recall, if you will, Blockbuster has not turned an annual profit in six long years, and the losses have widened for the last 4.  Even when Blockubster was in its heyday around the turn of the millennium, profits were hard to come by, which doesn’t speak well of management.  In contrast, GameStop reported a fiscal fourth quarter 2010 (ended Jan.) net income of $215.9 million or $1.29 per share, which is better than Wall Street estimates of $1.27 per share.  That means for the year the company earned $2.28 per share, so even after today’s 9% rally the stock trades for 9.5x trailing twelve month earnings.  The midpoint of 2011 EPS guidance comes in at $2.63, which is 15% growth in the next year.  Overall sales grew by 3.1% over the past year, which hardly warrants the catastrophic tone that some have taken towards the video game industry.  Management said they expect a decent rebound in sales growth next year, calling for growth of 4% to 6%.  The midpoint of the guided sales range would equate to $9.53 billion or $150 mln better than consensus analysts’ estimates.

Are the headwinds for GameStop? Of course.  The threat of aforementioned mentioned digital distribution may cut out distributors like GameStop completely, as game developers may connect directly to consumers.  There is growing competition particularly in used game sales from some of retail’s heaviest hitters like Walmart (WMT) and Amazon (AMZN), but as of yet GameStop has effectively managed to maintain and even grow profits in the face of competition.  At least up to this point, gamers like the feeling of physically holding a highly anticipated game purchase and GameStop instantly gives this to them while Amazon and Walmart do not. 

Will a service like Gamefly pester GameStop like Netflix (NFLX) has Blockbuster?  This one is doubtful, in my opinion; games are different from movies in that they are used repeatedly rather than a single use at a time.  One great thing about Netflix is sending a just-viewed movie back in order to get another one that you have been waiting to see.  Gamers however invest time in the game, and while Gamefly will attract some serious gamers looking to test out games for their next purchase, we think it has less appeal for the average gamer and have less of an effect on GME.

By looking at historically normal valuations, it is clear that the market has priced in a substantial amount of downside has been priced into GameStop already.  For example, GME’s price-to-cash earnings of 5.7x is well below the historically normal range of 8.3x to 19.1x.  Furthermore, price-to-sales over the last ten years has historically ranged between .46x to 1.08x, but the current multiple is .37x with sales expected rise in the year ahead.  We currently have an Undervalued rating on GME, and based on the market’s normal valuation of this stock, we think it could trade in the high-$20 without any concern over valuation give current fundamentals.

So, with strengthening fundamentals and an extremely strong balance sheet, we believe long term investors have not missed the up-trend in GameStop after today’s nice bump.  Management has delivered consistent performance and the underlying fundamentals will eventually be recognized by the market.  With the current valuation, it is no surprise to that there have been rumors in the past week of a potential private equity acquisition looming around this company.

The world’s second largest soft drink maker, PepsiCo. (PEP), announced a share repurchase program that could amount to $15 billion over the next three years.  The company had suspended buy backs earlier this year in order to devote capital to their acquisition of their two largest bottlers, which the company estimated at the time would produce cost savings of about $400 million annually (analysts are far more bullish on savings).  Their new plan is to buy more than $4 billion worth of shares this year which will fall under a 2007 repurchase agreement that had $6.4 billion left on it at the beginning of the year.  The board has further authorized a total of up to $15 billion in share repurchases through the year 2013.  A repurchase of this size should be seen as a major vote of confidence from the board especially when considered in addition to the company’s recent 7% boost to its dividend.

Pepsi lead the way in acquiring the vast majority of their North American bottling operations last August; a move that was later mirrored by their primary competitor Coca-Cola (KO) as they recently acquired bottler Coca-Cola Enterprises (CCE).  On the first of March Pepsi official closed on those deals, and now they are making a clear statement that they will aim to maximize returns to shareholder.  The company expects to grow earnings in the current year by 11% to 13%, which equates to an expected EPS of $4.12 to $4.19.  If the company can hit these targets, the new annual dividend per share of $1.92 is well within their reach with a payout ratio of under 50%.

To be sure, the fact that a company announces a massive buyback does not necessarily mean that they will follow through on that plan in its totality, but we still take it as a sign of confidence from management.  As with any stock, there is an element of risk for shareholders, specifically for Pepsi the fact that carbonated beverages volumes have been on the decline for the last several years in North America.  With that said, Pepsi is somewhat more guarded against that risk that is Coke or Dr. Pepper Snapple Group (DPS) because of their stable of non-carbonated offerings as well as their snack foods division being less affected.

Coming into this week we had an Undervalued rating on PEP shares and this announcement only solidifies that stance.  The company is impressively growing earnings and according to some analysts the cost savings from recent acquisitions may be double what the company originally predicted back in August.  Even with the company trading 2% higher on their shareholder friendly actions, they are still trading below their historically normal ranges of price-to-sales and price-to-cash flow.  We think this stock offers good long term value and based on our methodology could easily trade for $71 to $80 per share in the coming months.

Following second quarter results that showed further improvement from a year ago, Thor Industries (THO) stock retreated nearly 8% on Tuesday because it was not as impressive as analysts had hoped.  Thor, manufacturer of recreational vehicles and busses, swing to a profit of $11.9 million or 22 cents per share from a loss of $14.9 million or 27 cents a share last year.  Profit fell short of consensus estimates of 28 cents per share.  Revenue grew a whopping 90% to $430 million, which topped analysts’ estimates by $2 mln.  Considering sales were slightly better than inline, it was higher than expected costs that turned out to be the culprit for Thor’s disappointing quarter.

There is little doubt that the first half of the year has been far better in fiscal 2010 than it was in 2009, as EPS of $.65 per share easily topped the loss of $.18 in the prior period.  A quarter ago, Thor Industries returned to profitability in both RV’s and bus product lines, but the biggest turnaround has been in RV’s.  RV sales in the quarter rose 150% to $335.8 million, which has completed a six month turnaround of $64 million in net income compared to the first half of last year. The company has seen a relatively strong rebound in demand for RV’s (including the brand Airstream), which in combination with generally stable costs has boosted results.  However, the stock has already priced in the improved sales trends trading more than 270% higher than a year ago coming into the day.

According to our methodology, we view THO as Overvalued at the current price level, and the market’s historical valuation suggests the stock is overheated.  For example, on a price-to-cash earnings basis THO has normally traded for 13.5x to 31.8x, but the stock currently trades well above that historically normal range at nearly 40x cash earnings per share.  Now, we do understand that the company is returning to a more normal operating environment, and should see further normalization in the second half of the year.  However, the stock is now trading at not far from the price level achieved in 2006 and 200, when both sales and earnings were far better than they are today.

For long term investors, we would recommend looking elsewhere for a value stock because this one has already pulled away.  The worst days are hopefully behind them now as general economic improvement is great news for this stock (beta coefficient over 2), but it has been bid up aggressively already in the last year.  We will need to see further improvement to the underlying fundamentals or the price to decline below $30 before we consider upgrading THO.

Del Monte Foods (DLM) has extended its steady upwards trend today, but even after the impressive run of 84% in the last year, the stock may have further to rise.  While the stock has been on an undeniable tear, DLM’s fundamentals have advanced in proportion during that time.  We last wrote a note on DLM in December (Del Monte Foods Nearing New Highs and Still Cheap) after their last quarterly report in which they blew past analysts’ earnings estimates by 71% and raised guidance for the rest of the year.  Since that point, the stock has continued to appreciate nearly 20%, but again today they have beaten estimates and lifted guidance once again.

In the past quarter, Del Monte netted $59.4 million or 28 cents per share, which is slightly less than last year.  However, this quarter’s results were hampered by 6 cent per share in refinancing costs, and still they handily topped Wall Street’s view of $.21.  Revenue grew by 8% to $1.01 billion which was nearly doubled the growth rate expected by analysts.  This strong performance has prompted management to substantially lift full year guidance yet again.  Now, fiscal 2010 earnings are forecasted to come in at $1.07 to $1.11 versus previous guidance of $.93 to $.97.  The new forecast includes 11 cents of refinancing costs, whereas the previous forecast had allotted for only 5 cents.  Lower costs and better than expected sales growth are helping to expand gross margins from previous expectations of 10.6%-11.6% to 12.3%-13.3%.  Through the first nine months of the year, DLM has earned $.89 per share which is a substantial improvement to earnings of $.40 through this point last year.

Del Monte is seeing strong growth in both its Consumer Products division (mainly fruits and vegetables) as well as its Pet Products business as both saw sales increase by 7-8%.  However, the Pet Products was the bigger winner in the quarter with operating income jumping 19.3% due to cost controls and unit volume growth.  As for Consumer Products, increased spending offset the sales growth.

Coming into this week, we had an Undervalued stance on Del Monte and we are unlikely to downgrade it following this report.  Sales and earnings growth have consistently been much better than expected.  For example, in each of the last five quarters DLM has topped analysts’ estimates by a fairly wide margin each time.  They are grabbing market share in both divisions and in general costs and debt are falling, which are clear signs of a company running well.  The stock is trading over $13 on Thursday following the earnings release, but based on the current fundamentals we believe this stock could reasonably fetch $14 to $17.  So, value investors have not yet missed their opportunity in Del Monte.

The $300 pair of jeans is alive and well according to the fourth quarter results of True Religion Apparel (TRLG).  Quarterly earnings came in $.59 per share which was four cents better than Wall Street expected.  The better than anticipated earnings came on sales of $92.8 million which was far exceeded the estimates and was 27.1% higher than last year.  As for guidance for the year ahead, True Religion was mixed as they predicted earnings of $2 to $2.10 per share or slightly less than analysts’ expectations of $2.12.  However, revenue guidance called for $360 million which exceeds consensus estimates of $347.7 million.  The market shook off the slightly less positive earnings guidance and TRLG soared more than 18% on Thursday.

True Religion is striking while the iron is hot as they plan to open 27 new stores in the US and one in Canada in fiscal 2010, which adds to the 28 stores they opened over the past year.  These direct to consumer stores are a key piece of True Religion’s growth goals, as formerly they were sold mainly through the sales channels of high-end department stores and boutiques.  At the end of last year, they had a total of just 70 stores, so there would seem to be plenty of room for growth, but a product like this does run the risk at a certain point of losing the “boutique appeal” and cache.

Consumers’ tastes are notoriously fickle, so a brand that charges a premium price for their products must justify that status in the eyes of their customers.  It is a slippery slope for a business that can grow aggressively in near term, but it may in fact hurt their long term prospects.  For now, they are by all indications still one of the top brands for celebrities and the well-to-do, and I won’t suppose that I know much about fashion or how to run a clothing line.  As of the end of January, the stock had more than 30% of float shorted by the market, so some of today’s performance was spurred by short covering.  However, the analyst community is not siding with the bearish case, as stock has become somewhat of a Wall Street darling as the average analyst is quite bullish (average rating 1.3 on 1 to 5 scale according to Yahoo finance).

Financially speaking, True Religion’s growth has been outstanding since its humble beginnings as a public company in 2003.  Sales more than tripled between fiscal years 2005 and 2009, but growth rates have slowed as the company has matured.  At Ockham, we are reiterating our Fairly Valued stance on TRLG as of the most recent quarter’s results and the ensuing share price advance.  The stock is trading near the middle of its historically normal ranges of price-to-sales and price-to-cash earnings.  Based on current fundamentals and the company’s moderating growth, we believe a price of $29 would be a reasonable valuation.