Sell-off Presents Opportunity for +125% Upside

Game on.

The market is overreacting to an announcement today from GameStop (NYSE: GME) that it had trouble competing with Wal-Mart (NYSE: WMT) for holiday shoppers. Holiday sales were flat and GameStop lowered its guidance for the year, which ends in March, to between $2.23 to $2.27 a share. Wall Street had been expecting $2.56 a share.

Investors headed for the exits, driving shares to a 52-week low before closing -14.9% lower on the day at $20.46, or 8.8 times earnings — roughly a third the valuation of the S&P 500 Index.

These shares present an immediate buying opportunity, either for short-term traders or long-term investors. After today’s knee-jerk reaction, expect Wall Street to add value back to this market leader.

Here’s why:

(1.) The holidays hurt because cost-conscious Moms shopped at Wal-Mart this year. Promotions by the retail giant — buy a Nintendo Wii console, get a $50 gift card — worked swimmingly. That said, GameStop still managed to stay flat against the previous year, which was a record for the company. Consoles made the difference this holiday season: GameStop’s hardware sales were off -8%, while game sales actually rose +4%.

(2.) Moms may shop at Wal-Mart on price during the holidays, but gaming geeks shop at GameStop during the year for expertise. The specialty retailer, with a 6,457-store footprint, is a gathering place for gamers, the average age of whom is 35. The market reaches farther than many realize: A quarter of Americans over the age of 50 buy video games.

(3.) One key competitive advantage is used games, which accounted for $2 billion in sales last year and which was the leading category in the holiday period, during which used sales climbed +9.8%. Wal-Mart can cut prices all it wants, but it can’t compete in this segment of the $45 billion worldwide market for video games. Used games sales are very profitable: Last year they accounted for 42.9% of GameStop’s gross profit.

(4.) The estimates for 2011 still look decent, if not great. This is a company with an impressive earnings track record. (See chart.) In fiscal 2011 the consensus estimate is for $2.92 a share, which means the stock is trading at less than nine times trailing earnings and only seven times estimated earnings, even though 2011 is forecast to be an exceedingly profitable year.

GameStop’s results weren’t awful, they simply seemed like really bad news after a decent holiday season. Cathy Smith, the company’s CFO may well have put it best: “It is important to note that this is still the second-highest earnings year in GameStop’s history coming off a record fiscal year 2008.”

With that in mind, these shares are an appropriate play for short-term traders looking for the market to rethink its abrupt sell-off: Investors could buy these shares at open and set a selling price of $24.

These shares may well be appropriate for longer-term “value” investors looking to see the shares return to their historical valuation (14-16 times earnings), which implies a 12-month price target of roughly $45 and upside of +125%.

P.S. Here’s another company that could deliver +100% gains in the coming year: This up-and-coming star operates the nation’s largest in-theatre advertising network in an industry that has been expanding at a +24% annual clip. With operating margins of 45%, it’s one of the most profitable firms in our coverage universe. It’s also one of the most undervalued: The company has gained +16.5% since my colleague Nathan Slaughter recommended it in September — but according to his estimates, it has another +100% to go before reaching its fair value price. This company made his list of Top Ten Stocks for 2010 (it’s Stock #7). Get his full analysis here.