GameStop: Up 70% Since August, But Still Undervalued

Summary

2020 cash flow projection suggests a 56% FCF yield and 1x Forward EV/EBIT (base case). The stock is extremely undervalued on a cash flow basis.

Base-case 2020 EV/EBIT valuation suggests 109% upside, assuming no buybacks. Expect a massive short squeeze soon.

A lot of consumers still prefer physical games, and new console cycle should give GameStop a lifeline.

GameStop (NYSE:GME) stock got slammed since the past couple of years, due to a secular decline in physical games and with the late stages of the console cycle. The next console cycle should give GameStop a lifeline, and the company is expected to generate between 0 and 0 million unlevered FCF in 2019 and 2020 on an adjusted basis. Although the company is fundamentally weakening, the threat from digital/cloud gaming is low, and it would take years to develop.

Key Catalysts

1. New console cycle and impact of digital downloads

Online/digital gaming segment of the video game industry is exploding. Data from IBIS world shows that online games constitute 65% of the video game industry while physical games, consoles and accessories account for 17%, 13% and 6%. Introduction of mobile games and digital game downloads has stalled the growth of console, physical games and accessories market. I expect digital gaming to proliferate for the next few years, with tech giants eating up incumbent players - Microsoft (NASDAQ:MSFT), Sony (NYSE:SNE), Nintendo (OTCPK:NTDOY), Take-Two (NASDAQ:TTWO) and Activision Blizzard (NASDAQ:ATVI) market share. A decline in demand for consoles and physical games would be a significant threat to GameStop's business model. Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and Apple (NASDAQ:AAPL) recently released Stadia and Arcade subscription-based gaming service. It could pose a potential threat to consoles and video game publishers, thus eliminating the need for physical retail stores.

Although broader industry trends are not in GME's favor, I think that physical games are not going out of fashion anytime soon and console demand will be steady in the future for the following reasons:

  • A vast majority of popular games only serve single-platform play and gamers won't get the same high-quality user experience on other platforms like mobile phones and computers. For that reason, I don't see a direct correlation between digital and console games.
  • Resale value: Physical games and consoles have resale value, and the customer can trade in for cash or points. A digital download sits in the device's disk and cannot be resold. With the upcoming console cycle, consumers would get rid of older consoles/games to get their hands on the newer ones. This will boost GME's Pre-owned segment's revenue. The pre-owned gaming market can survive a recession without too much damage when consumer disposable income declines since they tend to be cheap. Also, IBIS research says 66% of console players still prefer physical copies.
  • DVD-Rental: Redbox (GME's competitor) had about 39 million DVD rentals a month and expected to add 1,500 kiosks to keep up with the demand for physical games.
  • Legacy: Unlike DVDs and cable TV, I think game discs would take even longer to fall out of favor, due to their big file size and consoles with backward compatibility. Streaming services have gained tremendous popularity and forced companies like RadioShack and Blockbuster out of business. Yet, Best Buy (NYSE:BBY) decided to stop selling CDs in 2018, and Netflix (NASDAQ:NFLX) still has 2.7 million DVD customers.
  • Faster than downloading: Digital games take too much time to download high-quality/graphics-heavy games, it could range somewhere between 1 and 8 hrs. Many regions across the midwest don't have high-speed connections, especially in Australia, New Zealand and Europe (excluding Nordic region), where the company has around 1,500 stores.
  • IBIS research claims that "Motion capture technology of certain genres, such as sports and role-playing games, are anticipated to demand motion capture technology at greater rates due to their reliance on humanoid characters. As this software becomes more widespread and decreases animation time, production costs are expected to decrease, and new consoles are expected to be produced and released at a faster speed". This new technology could potentially shorten the console cycle, giving a boost to GameStop's top-line growth.
  • Software sells hardware: The pre-owned segment revenue is tied to the new console systems and popular game releases. The genre of games that companies publish is very crucial. For instance, strategy and role-playing games are popular on PCs, but arcade, sports, shooter, action and adventure games are played on a console since they have controllers, better graphics and visual effects. Unsurprisingly, strategy or PC-related video games only represent 17% of the market (Source: IBIS world).
  • Primary vs. Secondary market: Developing and publishing companies would favor an active secondary market (pre-owned) for games. Using the second-hand vehicle industry as an example, once the customer sells his or her old car (hardware/software), often the revenue goes on to purchase another new vehicle (in this case new video game software/hardware). Thus, console and game software publishing companies have an incentive to release physical games since digital games cannot be resold.
  • Xbox: As digital gaming is gaining popularity, Microsoft decides to scrape the hard disk drive and plans to release a pure digital console. However, the company "received criticism from customers as they wouldn't be able to pick up deals online or buy titles second hand" (Source: Pocket-lint). Although this is not a great scenario for GME, it is worth noting that PS sold more units than Xbox One, Nintendo Switch, and Nintendo Wii U combined.

2. Buybacks and Dividends

GME had 0MM buyback authorization and bought back 8MM (22MM shares or 34% of outstanding shares) at an average price of .11 per share in 2019. The company is left with 3MM - could potentially repurchase another 30%-40% of outstanding shares (from 67MM total) at the current market price.

The same argument was made by Dr Michael Burry (best known from the Big Short movie). Management seems pretty confident on a rebounce next year and returning cash to shareholders:

"Simply speaking, I think it's a view to the fact that we believe our stock is undervalued and we think that's an appropriate and prudent use of capital to return that capital to our shareholders via the buyback. And I'm just going to re-emphasize that last point. We buy back stock because we fundamentally believe that our stock is trading at a discount and we're very confident as to where our stock is headed given what's going to happen in 11 months. So we're very, very confident at that bounce back. We're very confident that all the work that's being done right now, around expense structure around margin structure is going to pay off in the form of profit flow-through when sales return and we're certainly going to." (Q3 earnings call).

I think the recent dividend cut would increase the possibility of a heavy buyback very soon. However, sell-side analysts had shown a bitter taste when the management scrapped dividends for 2019.

  • Telsey Advisory Group: "Removing the dividend is likely to lead to a rotation in the investor base and further pressure shares."
  • Loop Capital Markets: "The elimination of the quarterly cash dividend sends a worrisome signal that management has lost confidence in the company's cash flow generation ability."

Reducing dividends will free up cash for the firm and would allow the management to focus on strategic initiatives and cost cutting. A buyback can help boost EPS, and the company can pay less dividend per share with lower shares outstanding, potentially saving M a year. However, SA author Vince Martin says that the management might not execute some or all of the remaining buybacks due to the refinancing of 9MM senior notes due in 2021. Vince makes an interesting point in his article (GameStop Reaction: Scion's Bull Case Has 2 Key Stumbling Blocks):

"Given a business that is likely in decline (and almost certainly will be treated like the bond markets as a business in decline for the next 18 months), and what appear to be minimal physical assets, refinancing is going to be difficult".

With a lot of uncertainty ahead - secular industry tailwinds, inventory liquidation (from store closures) and working capital headwinds - management would probably buyback a small number of shares and halt dividends until the end of 2020.

If management does initiate an aggressive buyback, it will cause a massive blow for the shorts. As of 11/28/19, 67.24M shares were short, out of 61.4M float, a whopping 113%. It is very absurd for a company that claims 36% retail gaming market share (IBIS), has a strong balance sheet, TTM net interest coverage of 4x and trading way below tangible book value per share. This could well be a mother of all short squeezes.

3. Cost cutting and new initiatives

From the recent earnings call, management said: "Of the 0MM profit improvement goal, we know that roughly half go that will be delivered in the form of expense reduction while the other half coming from product enhancements". Management is well over 50%+ complete with expense reductions and expected to execute by the end of 2021.

With the flexibility in operating leases (post-FY22 commitments are under 0 million), underperforming stores can be closed quickly with minimal lease break or termination fee. The company recently closed non-performing stores in the Nordic region that would add MM in run-rate EBITDA.

The company is taking initiatives to enhance its brand image amongst its existing customers. The Power Up rewards loyalty program increased customer enrollment and led to more frequent visits. Although Digital segment revenue only accounted for 2%-3% revenue, it generates 88% gross margin, and the company saw a "triple-digit increase in buy online pick up in-store transactions." (Q3 earnings call)

Collectibles segment revenue increased by 11% (FY2017 to FY2018) and 3.1% (Q42018 to Q42019). The new e-sports strategy should further contribute to collectibles and accessories segment revenue growth. In an effort to bring people back into the stores, the new e-sports themed store concept would engage and enhance customer experience, and it could portray the new stores like the local church of gaming. The success of this strategy is still unknown since a lot of casual e-sports events take place online; a perfect example would be Fortnite. The new e-sports/retro store strategy sounds super niche- targets explicitly a community of hard-core gamers. Although the long-term success of this strategy is unknown, for the year 2020, it should give a nice boost to the collectibles and accessories segment's revenue and gross margin growth.

Valuation

  1. Projected 2020 Unlevered FCF

2020 FCF Forecast(Author's 2020 FCF Projections)

Assumptions to arrive at 2020 FCF (feel free to download the model in the supporting documents section below):

  • Revenue/Gross Margin: 2019 revenue is based on the average sell-side analyst estimates. For the hardware, software and pre-owned segment, I've used the previous consoles cycle (2013-2014) growth rate to project out 2020 revenue. Also, used slightly optimistic assumptions for accessories, digital and collectibles, in line with management's e-sports initiative.
  • Operating Expenses: Based on management guidance (-100MM savings) and the historical percentage of sales.
  • Tax rate: GME has tax loss carryforwards, the actual tax will be lower than 21% (probably negative for 2019). However, I have used 21% as a conservative measure.
  • D&A: Projected based on the percentage of sales basis and took into account lower CAPEX spending (-85MM) for 2020.
  • Change in NWC: For 2019, I accounted for the large AP payout during the Q1 2019 that had a negative impact on NWC. Although projecting out NWC is a challenging task, -0MM change in 2019 NWC, I believe a conservative measure. For 2020, I've utilized historical AP days, AR days, inventory days and other CL as a percentage of sales to project out 2020 NWC.

Base-case scenario produces an expected FCF yield of 56%, using the current market cap of the company. For GME's case, EPS estimates alone won't provide us with a clear picture of where the company is heading. I believe that the base-case assumption - 7M 2020 FCF is highly conservative and it could be well above 0MM with a lower/negative tax rate and positive NWC (through negotiating better contracts with vendors and suppliers). Assuming the management doesn't buy back shares in 2020, base-case estimates show FCF per share of .09.

2. Risk-Reward Analysis

Bull Case Base Case Downside Case

2020 EBIT: 6 Multiple (EV/EBIT): 1.5x TEV: $ 1,044+ Cash: $ 100 Market Cap: $ 1,144 Shares Outstanding: 50M Share Price: $ 22.88 (316% from current price .50)

(Note: Assumes 17M buyback of outstanding shares)

2020 EBIT - 8 Multiple (EV/EBIT): 1.5xTEV - $ 717+ Cash: Market Cap - $ 767 Shares Outstanding - 67M Share Price - $ 11.5 (9% from current price)

(Note: Assumes no buybacks)

2020 EBIT: 5 Multiple (EV/EBIT): 1.5xTEV: $ 292+ Cash: $ 50 Market Cap: $ 342 Shares Outstanding: 67M Share Price: $ 5.2 (-6% from the current price)

(Note: Assumes no buybacks)

  • EBIT projections are from the FCF model above. The EV/EBIT multiple of 1.5 (below 5-yr avg EV/EBIT multiple of 7x), I believe it is a highly discounted multiple that compensates for uncertainty around 2020 FCF projections - threat of digital gaming, success of cost-cutting, new initiatives around margin improvement, lower disposable consumer income, and lower demand for new consoles and physical games.

Risks to GameStop's Business Model

Cloud: Sony recently signed a deal with Microsoft to outsource its infrastructure business and help the company establish a cloud-based gaming service (similar to Google Stadia, Apple Arcade and Microsoft's xCloud). If all the legacy games are offered through the cloud with a subscription, it questions the existence of GME.

Declining Secondary Market: Gaming retailers aren't purchasing older titles from distributors, instead directly buying it from customers and selling it on. Game manufacturing and publishing companies could offer older titles online at a much lower price to retain these consumers.

Liquidity: If downside scenario (from 2020 FCF model) turns out to be the case, GME wouldn't be able to refinance 2021 debt maturity and could potentially be pushed into bankruptcy or restructuring.

Closing Remarks

Just like the movie streaming market, digital streaming/cloud gaming could take years to develop. I think consumers would still trade-in old games against the new one, since physical games are faster than downloading, have legacy support (backward compatibility) and resale value. I agree that GameStop doesn't have a strong business model and operates in a disruptive industry, but the company still has gas left in the tank, and it can produce enough cash to sustain itself for next few years.

Supporting Documents

GME_2020_FCF_Yield_FCF_Projection_.xlsx

Disclosure: I am/we are long GME. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Initiated a long position on Aug 13th at .36.

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