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Investors are hitting the delete button on the shares of video game retailer GameStop (GME). Its fourth quarter results, reported on Thursday, were encouraging enough: both revenues and earnings were ahead of the consensus estimates. For the full year 2017, revenues grew 5% even when excluding the 53rd week, and same store sales increased 5.8%, an impressive feat in an industry where 2% is considered impressive. GameStop generated $325 million of free cash flow for the year and now has a cash balance that exceeds to its outstanding debt.
Despite these results, GameStop’s shares dove 12% on the news, contributing to a jaw-dropping 30% year-to-date decline and a 70% since late 2016. Clearly, something is wrong with the company’s prospects.
What is going on here?
GameStop thrived in the era before direct downloading of video games. Gamers bought the latest video game cartridges and discs at the stores, then loaded them onto PCs or game consoles at home. Gamers could sell back their pre-owned games as well as buy other pre-owned games at sizeable discounts to new games. Not only were the pre-owned games a high-margin business (48% gross margins in 2014), but they drove a tremendous amount of traffic to the stores, which provided plenty of opportunities to sell high-margin accessories. The stores also sold the latest game hardware, driving further traffic and sales.
With high-speed internet in most homes, physical game cartridges and discs are going the way of movie DVD rentals. Online distribution platforms like Playstation, Xbox, Nintendo and Steam provide instant access to hundreds of new and older games with almost no effort or delay. Even the consoles can be ordered online and shipped to the home in two days. Going to a store is a rapidly fading hassle.
To stanch the existential digital threat, GameStop has expanded its efforts to drive traffic with other products, including collectibles, AT&T mobile phones, Apple products (GameStop’s Simply Mac is North America’s largest Apple-authorized reseller, offering a full line of new and pre-owned Apple products and warranty/non-warranty repair services), Cricket prepaid mobile phones and a range of branded accessories. These efforts have shown some moderate success but haven’t produced enough traction to convincingly reverse the secular tide pushing against GameStop.
To bolster its core business, GameStop announced that it is shifting to a retrenching strategy--turning away from expansive new initiatives to re-focus on improving the business they already have. We think this is the right approach, as previous expansions by acquisition have consumed valuable cash without producing much profit. Just as critical, ignoring GameStop’s core franchise would only accelerate its demise. Helping to drive this shift is the company’s new CEO Mike Mauler, who was promoted to replace the recently-deceased former CEO Paul Raines.
We’ve studied the company’s transcripts, dug through the quarterly and annual reports and read many opinions that offer considerable details and rationales on whether this strategy will be successful in stalling and possibly reversing its perceived inevitable slide into bankruptcy. The story checks many of the boxes for “Game Over.” The reality, however, is that no one knows for sure.
What is an investor to do?
The stock market is assuming GameStop will go the way of Blockbuster Video--that its revenues will shrivel away, leaving an unserviceable debt burden.
Its valuation clearly points to this outcome. GameStop shares, at $12.60, trade at 2.0x (not a typo, that’s two times) 2018 expected earnings before interest, taxes, depreciation and amortization, or EBITDA, based on consensus estimates. This is the lowest multiple for any credible company above $800 million market cap on the New York Stock Exchange or Nasdaq. This includes companies that are almost certain to go bankrupt, including debt-laden J.C. Penney that trades at 5.3x EBITDA. With its enterprise value of about $1.2 billion and cash balances that exceed its debt by nearly $50 million, GameStop’s valuation is truly an outlier.
But is this valuation fair? What needs to happen for GameStop to prove the market wrong? We see at least two general scenarios that would produce a rewarding share price:
- Decline is slow, not fast. If revenues fell by 33% over the next four years, with gross margins declining from the current 33% to only 28%, along with other effects, the company could still generate nearly $800 million in cumulative free cash flows over this period. Even slower revenue and gross margin decay, more aggressive cost cutting and lower interest costs from debt paydown would produce higher cumulative cash flows.
With cash balances more than fully offsetting its debt, a slow decline would yield an investor with repayment of most of their investment, while still leaving a going-concern business, in effect, for free. As GameStop is paying out about half of its free cash flow in dividends (now yielding 12.3%), investors would actually receive much of this rather than see it vanish into new spending.
- Company is acquired. GameStop’s net debt-free balance sheet makes this a viable option. BestBuy might provide a natural strategic fit and could finance a potentially $1.8 billion deal (a 40% premium) with some of its $3.1 billion in cash balances. Other large retail or consumer-technology companies might find this business appealing as a marketing and distribution outlet, aided by cost synergies produced by integrating it into their existing operations. Owning Apple’s largest reseller by itself would have real value to many retailers.
Private equity buyers, particularly those focused on retail, could apply both operational and financial expertise to stabilize and expand GameStop’s profitability. Borrowing for the acquisition wouldn’t appear to be a problem: GameStop’s two bonds currently trade at just above par despite the equity market’s grim outlook.
Some alternatives we don’t think will happen: a liquidation or a transformative acquisition. Aside from its $50 million of cash in excess of its debt, GameStop’s other assets have limited liquidation value. Paying off obligations like store leases could add up quickly. We believe the company is more valuable as a going concern.
A transformative acquisition would require pushing its ability to raise funding too far. Combined with the large operational risk of a major acquisition that by definition is outside their expertise, plus the value-draining impact of depleting its cash resources, these hurdles should convince GameStop’s management to avoid a big merger.
Despite the obvious secular challenges, GameStop’s demise is not set in stone. For patient, highly risk-tolerant investors, the shares’ extreme discount offers the potential for outsized returns. The wildly popular video game “Fortnite Battle Royale” would seem to be fitting for what lay ahead for GameStop and its investors.