Monday, April 26, 2010

Quicker Paybacks

Before they can make money, companies must make capital investments. But since the future is always uncertain, investments with longer payback periods are often more risky than those with shorter payback periods. This is because the shorter the payback period, the lower the risk that market conditions can render the initial investments obsolete/useless.

One company towards which this idea has a useful application is GameStop (GME), a retailer of new and used video games. As we've previously discussed, the future of the retail video game business model may be very different than it is today. As such, large capital outlays with payback periods many years out would be a risky endeavor for this bricks and mortar business. However, based on the company's disclosures, investors can actually estimate how long it takes for a new store to pay for itself.

This year, the company will spend $75 million to open 400 new stores, which equates to opening costs of just under $190K per store. In addition, it appears as though the company spends about $20K per year per location sprucing up its stores. But the company's annual operating cash flow suggests that the average store generates about $100K annually. As such, it appears as though it only takes about two years for the average GameStop location to pay for itself!

Of course, these are only rough calculations and are likely far from perfect. For one thing, the calculations assume new stores can generate as much cash as existing stores, whereas the markets for new stores are probably not as attractive as the markets that have already been established, which could increase the payback period going forward. On the other hand, there are likely economies of scale such that revenues from new stores can grow at a faster rate than do corporate-level expenses, which would reduce the payback period.

In some industries, investments are made with payback periods many, many years out. (For example, consider how the oil and gas industry operates.) For a company like GameStop, short payback periods reduce the risk that a changing industry can turn GameStop into the next Blockbuster Video. Short payback periods allow GameStop to be nimble and shut down locations that should turn unprofitable, without the large costs that would otherwise be borne by shareholders.

Disclosure: Author has a long position in shares of GME

1 comment:

tscott said...

It is a great business, some new competition from 7-eleven though.

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