At first glance, it seems that GameStop ($GME), which grew rich and famous selling video games, is likely to wither and die as its customers migrate from store-bought disc-based games to on-line play and downloads. But a funny thing seems to be happening on the way to oblivion. Unlike blockbuster before it, GameStop is embracing the future.

Good Numbers

I found $GME through one of my Smart Alpha stock models, which makes sense considering that basic company fundamentals figure prominently in my selection criteria and since $GME has some impressive data-points.

Table 1

A strong balance sheet and strong returns on assets and equity (the five-year averages are depressed by large non-recurring charges in 2013) signal the potential for strong growth in the future. And better still, the stock appears to be attractively valued.

Table 2

To top it all off, $GME is buying back shares, thus providing an additional way (beyond a good dividend) to return cash to shareholders.

Notice what I did not show: growth rates. That’s the Achilles’ heel here. While EPS growth has been O.K. (in the 9% range), sales have been flattish. The growth has been occurring as a result of margin expansion. The reason for this is no great secret: On-line and digital gaming has been on the rise, thus taking market share from sales of physical discs through brick-and-mortar stores, analogous to what drove Blockbuster out of business. Margin expansion is fine for now. But sooner or later, $GME will have to start delivering on the top line.

That raises the possibility that the favorable valuation metrics are more a value trap than a bargain. Yet . . .

A Low-Risk Selection – Go Figure

The Smart Alpha model that selected $GME is one that is designed to limit the likelihood of extreme losses. That seems out of character for a company whose main business appears to be marching toward obsolescence, as we might be reminded by the experience of those who invested in Blockbuster. Is this simply a case of fundamental data not being able to tell us everything?

That might be so. But then again, maybe it isn’t. Philip Morris ($PM) hasn’t vanished and if ever there’s been a business under pressure that’s it. Sometimes, declining businesses take a lot longer to decline than pundits expect and can generate truckloads of cash along the way that can be distributed to shareholders and/or be reinvested into more promising areas. The latter can be dangerous; let’s never lose track of Peter Lynch’s word for diversification for the heck of it; “deworsification.”

$GME checks the first box: It’s generating the requisite truckloads of extra cash:

Table 3

As to what the numbers tell us about future prospects: Table 1 (a profitable low-debt business) and Table 3 (more cash than is needed) tell us the company has the potential to defeat the forces of obsolescence. The Returns on Asset and Return on Equity figures on Table 1 also suggest the company is succeeding. If $GME were marching toward oblivion, we’d already be seeing it reflected in deteriorating returns as well as declines in the primary components of return (margins and turnover). Table 1 shows its not happening in returns. Moreover, margins and turnover have been trending steady- to slightly-up. That’s supporting stable EPS and diminishing the likelihood of a big drawdown (apart from risks related to sentiment-based market hissy fits, which can temporarily whack any stock any time, especially in and around earnings season or Fed meetings – nobody can control for those).

A Work In Progress – The New GameStop

CEO Paul Raines maintains that “Disc-based games will be around forever,” but for all his conviction on that score (sales of the newest-generation consoles are up, and the used consoles/disc business is strong), he’s positioning $GME to succeed well beyond that arena. For one thing, the company is joining in the digital revolution and doing quite well so far. Downloadable content relating to disc-based console and pc games, full-game downloads, points cards for gamer-platform Steam, and it’s own gaming platform Kongregate are already contributing a bit more than 10 percent of revenue and growing briskly. Helping is the company’s large user database and analytics relating to customer habits and preferences.

Recommended by Forbes

In addition, $GME is expanding into adjacent areas, such as Spring Mobile, which has become the largest and fastest-growing reseller for AT&T (T) and Apple (AAPL), the fifth largest reseller for Cricket, and is getting started with DIRECTV. The company recently acquired ThinkGeek, a purveyor of gadgets, apparel, collectibles and so forth that appeal to the same customer base as that to which $GME has been selling. Finally, the company seems well positioned for the next potential gaming wave, virtual reality games for which seem poised to follow a model very familiar to $GME (discs accompanied by downloads and hardware, which most users will have to upgrade in order to run virtual reality).

A Risk-Controlled Selection

Obviously, none of this is a shoo-in. But the relationship between new ventures and the company’s traditional business keeps it out of the diworsification category, and the fundamental numbers are consistent with what we see from successful management teams. Also, nothing, no matter what the historical experience with drawdown, beta, etc. is a sure thing going forward. Every company is vulnerable to business beat-downs (I’m sure stories of once-great powerhouses brought to their knees by competition and technological evolution is so well known, I need not name names). So when it comes to risk control, I’ll bet any time on an outfit that openly recognizes its challenges and shows tangible progress is addressing them. (And good valuation metrics don’t hurt!)