GameStop: Is this Game Still Worth Playing?

9 minutes

 

GameStop

Recently GameStop (GME) has taken a beating in the market with the release of some very unflattering news. As we all know the stock market is a very unforgiving place.

GameStop came across my radar a few years ago when I was doing my regular screening looking for new opportunities. Until recently I hadn’t pulled the trigger on the company, but after digging into it a little more it appeared to be a great opportunity. In the light of recent news, I am wondering if I made a good decision or walked into a value trap.

I admit I was first attracted to the 6% dividend yield, which was very enticing. In addition to the low P/E ratio, it appeared this was a great opportunity, as well as other financial strengths.

In this article, I will take a look at my findings again and re-evaluate my decision to buy and whether or not to stay in at this point or to sell and just cut my losses.

Retail is a brutal environment and the competition can be fierce. With the recent announcement of Microsoft’s (MSFT) Xbox’s subscription service there has been a lot of concern among GameStop investors in how this will affect the company long-term.

Let’s take a look.

Business Overview

Founded in 1994 in Grapevine, Texas. GameStop operates more than 7600 stores now. These stores are located in the U.S., Australia, Canada, and Europe.

Gamestop’s primary business is selling new and used video game hardware and software. This includes accessories such as gaming consoles, controllers, headsets, and memory cards.

Segments:

 

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Source: GameStop Investor Presentation

 

Video Game Hardware/Software              49.58%

Preowned                                                 22.34%

Accessories                                              7.83%

Digital                                                      1.87%

Technology Brands                                  8.4%

Other                                                       2.96%

 

Obviously, videos make up a very large percentage of their sales with the current numbers being 71.92% of their total sales.

In recent years, GameStop has begun attempts to diversify their business. They have branched out into the consumer electronics business, selling smartphones and tablets.

In addition, they have launched Spring Mobile, where they have recently become the largest owner of AT&T (T) wireless retail stores, outside of At&T.

They also partnered with Apple (AAPL) to open 72 Simply Mac stores, which serve as tech support outlets for Apple products.

They now have a goal of reducing its reliance on video game sales to less than 50% of its revenue. Currently, they stated in the most recent earnings call that revenue from technology and collectibles make up 39% of their sales. So, they are not there yet but they are on the way

In 2016 they saw non-physical gaming revenues of over $2 billion. So while GameStop has changed its focus, they are still tied to the physical gaming hardware, which is now an industry that is in decline.

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Source: GameStop Investor Presentation

In addition to the increase in revenue from sources other than video games, the company recently announce that they will be reducing their store count by 150 stores. By eliminating stores that are underperforming they will cut overheads and other costs and thus far this has worked.

This is not unlike other retail stores, who are all reducing store counts, even mighty Walmart (WMT) is lowering their store counts.

In addition, GameStop also owns a diverse portfolio of video game websites such as Ebgames.com, Kongragate.com, and Thinkgeek.com.

All the changes in direction are a recognition by management that changes are needed if they are going to survive. And they are implementing them, although maybe not as fast as some investors would like.

Business Analysis

First, let’s take a look at some of the numbers that have driven the price down recently.

 

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Source: Intrinsic Value Formula

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Source: Intrinsic Value Formula

With the sales growth pretty stagnant for the last six years and free cash flow stagnant as well you have seen an increase in earnings per share and free cash flow per share rise because of the very aggressive share buybacks that have been instituted.

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Source: Intrinsic Value Formula

As they have reduced the share count it has helped elevate the earnings per share and free cash flow per share, even when the real dollar amounts haven’t grown that much.

Other bad news was released during the latest earnings release. It was revealed that same-store sales for Q4 2016 were down 16.3% and FY2016 were down 11%. In addition, adjusted EPS for Q4 2015 was down 0.8% at $2.38 and for the FY 2016 down 3.3% at $3.77.

Additionally, GameStop guided down for 2017 as well, with sales estimated down 2% and same-store sales down 5% to even. Net income and earnings per share were guided down as well with $320 million and $3.10 respectively, also guiding down were video sales and hardware.

The big news recently was that Microsoft (MSFT) just announced their new Game Pass which will allow you to use 100 of the most popular older Xbox One and Xbox 360 games, all of this for a $9.99 monthly subscription.

In addition to this news, the subscribers will also be able to buy these games at a 20% discount to their retail price.

Of course, this will hit GameStop right in the bottom line because GameStop generates over 30% of its gross profit from older game sales.

We all know that the video game industry is shifting away from physical games and towards downloads, and with Microsoft and Sony moving towards subscription services, this is no surprise.

The surprise was that Wall Street reacted very badly to this news and the price dropped 10% the day of the announcement.

Good news:

The Technology Brands segment achieved its goal of adjusted operating earnings for 2016. It came in at 90.2 million, which was a 216% increase over 2015.

In addition, the Collectibles business was able to meet its revenue target of $494.1 million in 2016.

As we stated before, the company is moving towards a goal of earnings from businesses beyond physical games of 50% and in 2016 they achieved non-physical gaming businesses comprising 36.9% of total adjusted operating earnings.

They also acquired 511 Technology Brands stores, ending the year with 1522 stores and as AT&T’s largest authorized retailer.

Technology’s brand’s sales increased 52.4% for the full year. And adjusted operating earnings grew by 216.4%.

Other good news was that the new Nintendo Switch sold out in the three major shipments they received in a matter of hours.

This is a prospect that most people haven’t considered. The impact of new hardware releases by Sony (SNE) and Microsoft (MSFT) and what that could do for the company over the next few years.

Gamers don’t want to order new consoles online, they want it now or on launch day. And they would rather get it in store than risk waiting for it to be delivered.

Key Risks

GameStop’s race to reinvent itself is the biggest risk that they face. They are competing against bigger, better-capitalized companies like Microsoft and Sony in the realm of digital video game sales and rentals.

There is also the turnaround to consider as well. They are branching out into businesses that are no-moat, highly commoditized ones.

Selling smartphones and tablets didn’t work out so well for Radio Shack, who tried the same strategy before filing for bankruptcy.

In addition, their efforts with the collectibles division are going to run into to difficulties when competing against eBay. They won’t be able to achieve the same kinds of scale or network effects that eBay enjoys.

Plus, their efforts to compete in the digital video game subscription platforms are going to run into trouble. Because of the size of their competitors, their only avenue is to compete on price. Which lowers the profit margins and drives free cash flow down.

All of these efforts could come at the cost of profitability which could be catastrophic in the long run.

The decrease in profitability has pushed the company into increasing their debt to help fund some of the turnaround efforts. And with their junk bond rating of BB in this rising rate environment, it means any increase in debt becomes that much more expensive.

GameStop’s long-term success hinges on its ability to complete the turnaround it has begun. But with the increased reliance on debt to help fund that turnaround, it has led to an increased risk profile for the company.

As the earnings and cash flows continue to decline, the company’s current tactic of taking on more debt to fund its turnaround will result in continued deterioration of its balance sheet. This forces GameStop to pay 6% to 7% interest on its bonds because of its junk bond rating.

If the interest rates continue to rise it could make it extremely difficult to execute its turnaround plans.

The last risk is a major liability that it faces every year, which would be rent payments for the retail stores it leases. GameStop has paid over $380 million per year in rental expenses each of the last three years.

These leases are non-cancellable agreements that will be a drag on its efforts to effect a turnaround.

State of the Dividend

Without a doubt, the dividend is one of the more attractive aspects of GameStop.

They are currently offering a dividend with a yield of 7.29%, which is a reflection of the depressed stock price. The rate of the dividend is $1.52 a year, which is quite generous for a company this size.

GameStop has raised its dividend every year since it started paying one in 2012. The have raised it from $0.80 a share in 2012 to the current rate of $1.52 a share. Indeed, they have raised the dividend 10.4% over the last three years.

Additionally, the payout ratio for the dividend is 44%, which is a comfortable number given the state of the company. This payout ratio gives some comfort that the dividend is in no immediate danger of being cut.

One note to be aware of. As the earnings and free cash flow margins continue to be squeezed with the declining sales, you will likely continue to see rising payout ratios, which could spell trouble for the dividend.

Right now the balance sheet is strong, but it has taken some hits in the last few years. GameStop has sufficient cash on the balance sheet to continue paying the current dividend for two years.

All these factors lead me to believe that the dividend is now not in danger of being cut or suspended. But it is worth keeping an eye on until the turnaround shows more signs of being successful.

Valuation

The past year has been brutal for GameStop with Wall Street just hammering the stock. Shares have dropped 21% for the year compared to the 17% increase experienced in the market.

This has led to GameStop being one of the cheapest stocks on Wall Street, both from a P/E and dividend yield point of view.

The trailing-twelve-month P/E is 6.45, which is substantially lower than their historical P/E of 10.8. In fact, they are now lower than 93% of all specialty retailers.

Currently, their dividend yield is 6.92%, which is quite a bit higher than the company’s historical yield of 3.1%. In fact, it doubles its historical yield. Some of that, of course, is due to the drop in share price in recent times.

Using a DCF based on Free Cash Flow yields a price of $52.32 and a DCF based on earnings yields a price $36.39.

Source: GuruFocus.com

Using the earnings based valuation would give you a 40% margin of safety.

Final Thoughts

There are certainly quite a few points to be made for a bearish case for GameStop, and I am cognizant of those and understand all the points.

Certainly Wall Street reacted very violently to the mostly bad news that came out during the most recent earnings call. In fact, the day of the news reports the stock was down 12% at one point in the day. No one should have been surprised by these results as the sentiment surrounding the company was terrible going into the earnings call.

Ironically, it rallied a few days later and is back to $21.95. And one wonders if it will continue to rally to its earlier heights. As recently as last November it took a similar dive, only to rebound shortly thereafter.

Some points to keep in mind when considering this stock. First, the company doesn’t need to expand and become the next retail giant. The just need to continue to keep their cash flows intact and survive this turnaround.

Second, the turnaround is well under way, with the recent news that the company has begun the change from a video game retailer to a more diversified company.

There has been a lot of focus on the very poor holiday sales that the company reported, but as someone so astutely reported GameStop experiences a holiday season whenever a new console is released. This makes GameStop much more cyclical than your typical retailer and could help explain the poor holiday season sales.

This a profitable company that has demonstrated that it is shareholder friendly with the continued buybacks and the continued dividend increases.

There is some concern about the dividend being unsustainable but the current strength of the balance sheet should allow them to continue the current payout ratio.

These are just a few of the reasons why I remain bullish on GameStop. I am long the company and believe in their efforts to adapt the company to its current situation.

But I am also humble enough to understand that they face an uphill battle and this won’t be easy, but I believe they will accomplish their goal.

I know there is some concern that GameStop is headed in the same direction that Blockbuster once did. And while that is certainly a possibility, I think we should look at GameStop on its merits and the many ways they are developing to unlock value for its shareholders.

GameStop’s future returns will consist of dividends and earnings growth.

        2% sales growth based on analysts reports

        7% dividend yield

        1% earnings growth from share repurchases

Thanks in large part to its very high dividend yield, GameStop could generate 10% annualized returns, even with the very poor earnings growth projections.

Although I am long the company, I am not immune to some of the warning signs that are looming out there. However, I believe the company has begun a turnaround, which is already well under way.

As the company’s price continues to flounder I will take advantage of any dips to add to my position.

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