May 2 2019 - Time For GameStop To Use The 'Konami Code'

Summary

GameStop must utilize the entire 0M share buyback as soon as possible which would save them nearly M a year in dividend payouts.

GameStop should immediately issue a Rule 10b5-1 trading plan that allows them to continue to repurchase shares through the blackout period.

Earnings per share should top .50 in 2020.

Management must focus on immediate SG&A savings.

A rental subscription program would be game-changing.

Thesis

GameStop (GME) can free up nearly M in cash a year and increase EPS by over 40% by completing the already authorized 0M share repurchase. GameStop has also announced a 0M net-net profit improvement plan that could increase EPS by .00 to .40 (depending on the number of shares outstanding). However, GameStop announced they don't expect the initiative to have a material impact until fiscal year 2020. We believe the improvements can and should be realized much sooner.

Even if net income were set to decline 30% in fiscal 2019 (much worse than any current projections), GameStop could realize an EPS increase of 78% to .80 a share if the share repurchase is completed at current price levels and if just M in SG&A savings could be realized in fiscal 2019. By fiscal 2020, EPS would top .50 on the back of the full 0M net-net profit improvement plan and if multiples expand from 4x to only 10x earnings, shares could top .

The Original “Konami Code”

Never heard of the "Konami Code"? The Konami Code, "↑, ↑, ↓, ↓, ←, →, ←, →, B, A, Start, Select" was a cheat code that provided 30 extra lives in the Contra arcade came from the 80’s. Surprisingly, over 30 years later, it remains one of the most well-known cheat codes and lives on in new games as well as in movie references. Why? Because gamers are nostalgic.

There could not be a more fitting connection to GameStop.

While GameStop’s business of physical game sales is under fire and unloved by market participants, gamers (customers) might not see things the same way. The idea that streaming will replace 100% of physical games seems absurd. Gamers are nostalgic. A physical game brings a connection that can not be replaced via digital media. To some degree, streaming or downloading a game is akin to having a collection of photographs on a computer in place of a physical collection of stamps or baseball cards. It’s not the same! Who wants to buy their kid a “download code” for their birthday or for Christmas? It’s not memorable!

We have no doubt the GameStop bears are doubled over in laughter at this point. “Listen to this guy,” they’re saying, “he’s living in a fantasy world, there’s no future for physical games.”

We could reference Redbox, which was bought by Apollo Global Management for .6B in 2016 when the market was convinced that streaming would completely replace DVD purchases and rentals. In 2017, it was reported that Redbox had an average of 39 million DVD rentals a month (despite 60% of Redbox users also having a Netflix subscription), and that Redbox would be adding 1,500 kiosks to keep-up with consumer demand. It is unsurprising that Apollo was rumored to have significant interest in purchasing GameStop.

We could reference how survey after survey show the preference for physical games (when it comes to consoles) versus digital games. The most recent edition of Nielsen’s annual US Games 360 Report shows that only 34% of console gamers prefer digital downloads over physical games. When analyzing GameStop it is so important to separate console games from total software sales. As of 2017, it is true that 79% of video game sales are digital and that trend has continued from only 20% in 2009. However, this includes smartphone apps as well as in-game purchases. Similar to someone having a Netflix subscription and using Redbox – just because someone spends money on mobile games and in-game purchases doesn’t have any direct correlation to how much they’re willing to spend on console games. As we noted, of those that purchase console games, 66% prefer physical copies.

A thorough read of the Nielsen survey shows that emotional attachment to physical games and concerns over the longevity of digital purchases top the list of reasons of why console gamers prefer physical copies, not the often-cited storage and speed barriers. Physical games will not disappear in the next decade. That said, internet speeds in rural areas are certainly an issue that will take decades to resolve, further supporting the future of physical games.

The biggest risk to physical game sales are the removal of disc drives from the consoles. Are Microsoft, Sony, and Nintendo really going to produce consoles that prevent a portion of the population from being able to play them at all? We think that seems far-fetched – even ten years from now.

As long as disc drives exist, so will a strong selection of physical games that gamers will continue to purchase and then trade-in at GameStop. In fact, Sony (SNE) already announced that the PS5, likely to be released in 2020, will “still accept physical media; it won’t be a download-only machine. Because it’s based in part on the PS4’s architecture, it will also be backward-compatible with games for that console.” The compatibility news means that demand for used games will continue. There is no chance that Nintendo (OTCPK:NTDOY) and Microsoft (MSFT) will not follow their lead. It is also worth noting the PlayStation 4 has more units sold than the Xbox One, Nintendo Switch, and Nintendo Wii U combined. Given that the last major consoles were released in 2013, we think it’s safe to say the next generation of consoles will buy GameStop another 10 years of solid cash flow.

There is no question; however, 2019 will certainly be challenging as consumers may hold-off on hardware purchases and major software developers hold-off on new game releases in anticipation of the next generation of consoles in 2020.

Fortunately, it simply doesn’t matter for GameStop, because they can just press “↑, ↑, ↓, ↓, ←, →, ←, →, B, A, Start, Select” and more than double their stock.

GameStop’s “Konami Code”

While GameStop’s actual Konami Code is not a sequence of buttons like in the old arcade games, it will be just as effective as someone tripling their lives from 15 to 45 in Contra.

GameStop’s Konami Code is the repurchase of shares.

GameStop has already authorized a 0M share repurchase plan. With the price of GameStop currently trading at less than a share and a market cap of less than 0M, the market is handing GameStop the “power-up” of the decade. If GameStop does not utilize as much of the 0M authorization as possible this quarter there will need to be an immediate change to the board of directors. There are rules for share purchases that, due to the unusually late Q4 earnings report, give GameStop only 20 trading days before the end of Q1 (May 3rd) to repurchase shares. They can only purchase up to 25% of the average daily volume which is currently at 4,458,441 and has been increasing daily. GameStop should have easily been able to purchase at least 1 million shares a day, and with an average share price of around .50 they should have utilized at least 0M of the 0M authorization. That is the minimum that shareholders should accept. However, there is no reason that a competent board could not purchase even more.

GameStop needs to immediately issue a Rule 10b5-1 trading plan. This will allow them to make pre-planned purchases that could utilize the entire 0M authorization, even during the blackout period, prior to releasing Q1, 2019 earnings. The board could have also made block trades (once a week) with no limits (such as the 25% rule) on the number of shares included in the block. We notified Investor Relations of this last week and were told that our message was passed along internally.

GameStop ended Q4, 2019 with .624B in cash. In early April, 0M was used to pay-off debt maturing late 2019, which leaves GameStop with .274B in cash with long-term debt of 1.6M that matures in 2021 with a 6.75% interest rate. As GameStop is a cyclical business, we expect a cash burn of about 0M in the first two quarters of the year before cash accelerates back up in Q3 and Q4. This leaves GameStop with at least 0M in cash that they can use immediately and on top of other significant sources of liquidity.

There is absolutely no reason for GameStop to not utilize the entire 0M authorization. In the next section we will explain why shareholders must push for immediate board changes if significant buybacks are not performed.

Importance of Share Buybacks

GameStop pays a dividend of .52 which amounts to an annual cash payout of approximately 5M on 102.27M shares outstanding. If GameStop repurchases 0M worth of shares at an average price of .50, they will have repurchased about 31.58M shares, bringing total shares outstanding down to 70.7M.

Why is this so important?

GameStop only has to pay the dividend on the total amount of shares outstanding. Therefore, if shares outstanding are decreased by 31.58M then GameStop retains M in cash annually. On a 0M share purchase, this represents a per annum return of 16%. GameStop had free cash flow in 2018 of 2.7M. The amount of cash available for share repurchases or capital expenditures would increase nearly 21% YOY by completing the share buybacks which would also make the remaining dividend payout even more sustainable. If the M in saved cash were to be plowed back into annual share repurchases it would continue to provide additional savings each year.

Share repurchases also increase the amount of earnings that flow through to each shareholder. While we do not have any 2019 guidance yet, we can take a look at 2018 to see what the difference would have been. In 2018, adjusted net income was 8.4M which resulted in earnings per share of .14 on 102.27M shares outstanding. If shares outstanding were reduced to 70.7M then the earnings per share would have increased to .09 (an increase of over 44%), because a greater amount of the net income flows through to each shareholder.

Fiscal 2019, without question, will be a tough year for GameStop, which we will explain shortly. However, even if net income were to fall 30%, to 3M, earnings per share would actually increase to .16 year over year, with the share repurchases, before taking into account any SG&A savings.

This logic is predicated on current share prices (which we obviously find far too low). The leverage inherent in buying shares at this price goes away as the price rises, leading to our sense of urgency that management act promptly with respect to share buyback. Put differently, what other investment could generate the kinds of returns we have illustrated, with the kind of confidence associated with investing in your own, well-known, current business?

New CEO

The addition of an outsider as the new CEO, George Sherman, is a welcome development. He has previous experience at Advance Auto Parts, Best Buy, Target, and Home Depot. He must take immediate steps to address pre-owned sales as we will highlight soon. Additionally, we hope he takes immediate steps not only on share buybacks, but also on SG&A costs. As an outsider, we believe he has much greater leverage to accomplish these objectives than the previous CEOs. As we will soon highlight, SG&A is out of control.

eSports Strategy

GameStop has recently announced their foray into eSports with a combination of multiple partnerships. GameStop plans to host hundreds of eSports tournaments nationwide as well as to develop new content to enhance players skills in the games they like to play. In fact, this has already begun online. GameStop intends to bring in a new pro player each month to put on a clinic. April’s clinic is on Fortnite which includes 8 videos on different skills players can master. As you can see from the website, GameStop is leveraging this by encouraging players to purchase digital currency, the Fortnite game and collectibles, as well as accessories related to Fortnite.

We believe this is a solid strategy akin to a well-known Home Depot initiative. Fixer-uppers go to their stores to watch an expert demonstrate how to set tile (or whatever the project is). They then buy not only the tiles, but also the tools and accessories the expert used. We believe that players will watch these videos and will want to own the same accessories as the professionals/teachers they are learning from. GameStop needs to leverage the online piece to also include in-store clinics in addition to the prize-tournaments they are planning. Together, these initiatives should drive sales of other merchandise, physical games, hardware and trade-ins.

Impact of New Console Releases

Microsoft and Sony are expected to release new consoles soon; most expect a 2020 launch, 7 years since the launch of a major new console from either of them. This will hurt 2019 sales, but we expect will be a huge boost to 2020. When the last consoles were released in November of 2013, GameStop’s hardware sales increased by 30% which in-turn led to increases in pre-owned and accessory sales. The next major console cycle will drive significant revenue increases for GameStop.

Historical Sales Mix, Revenues, and Gross Profit

We looked back through each fourth quarter release (such as this example) of revenues and gross profit by category and calculated the percent change from the prior year. These tables we created are shown below (52 weeks ended February 2, 2019 exclude technology brands):

*Excludes Technology Brands

*Excludes Technology Brands

What does this show us?

First of all, while not a calculation shown in the tables, 2019 compared to 2013 shows a revenue decline of only 6.8% with gross profit down 13.9%. Interestingly, gross profit at GameStop increased for 5 consecutive years prior to last year! From a revenue and even gross profit perspective, this is hardly a business that is in major decline.

In fact, some of the figures are eye-popping. Video game hardware sales have actually increased 33% from the fiscal year ending in 2013, and they have even increased 2.2% from the fiscal year ending in 2014 which includes the first several months of sales from the last major console releases. Video game accessories have flown off the GameStop shelves and have grown double digits nearly every year with last year representing the fastest growth rate yet at 22%. Better yet, the gross profit for video game accessories increased 22.5% which means that despite a 22% increase in sales, margins actually increased.

In fact, according to this report, 2018 sales of consoles, portable game devices, and accessories totaled .5B. This means that GameStop’s hardware and accessory sales of .7B represents a 36% market share! Do consumers have other choices? Certainly, but they seem to be overwhelmingly choosing GameStop for these purchases. Clearly, GameStop has a major competitive moat and is a destination store for the purchase of hardware and accessories despite a multitude of other options, including Amazon (AMZN).

GameStop bears rely heavily on the idea that digital downloads and streaming will be the death of the business model. We noted earlier why we don’t think that is true, and an analysis of the numbers show that sales of new video games have declined, but not nearly at a rate proving a mass exodus from physical game sales. In fact, while new video game sales fell 5.1% last year, they are only down a total of 1.8% over the last two years. A 1.8% decrease of new video game sales over two years doesn’t ring any alarm bells for us.

Meanwhile, digital sales have grown the last two years, with margin growth continually outpacing sales growth. The revenue declines for digital for the year ended 2017 are only due to the mid-2017 sale of Kongregate, which was a web gaming portal. While digital makes up a small percentage (7.4%) of total gross profit, when combined with new video game sales the decline over the last two years falls to just 1.1%. We don’t know what percent of digital sales are full-game downloads, but we wonder if the very same game purchased through digital sales is helping offset the decline in new video game sales. Our point is the bears should think more carefully about their assumption that streaming games will disrupt GameStop’s business model. Especially since GameStop's gross profit margin on digital sales is over 88%.

The Tech brands, mobile, electronics, and other category for the last fiscal year represents primarily Simply Mac sales (since we excluded Technology Brands), and they experienced a collective decline of 18.7% in revenues this past year. Simply Mac sells Apple products and performs Apple certified warranty and repair services. While the decline is large, Simply Mac is the smallest category, and makes up less than 5% of GameStop’s total gross profit.

Collectibles have been a huge bright spot, and key information about 2018 results were very poorly communicated. Collectible sales grew 59.5%, 28.8%, and 11.2% over the last three years. Gross profit margin on Collectibles is also very high, over 32%. Collectibles now represent over 10% of GameStop’s gross profit. GameStop bought the collectibles business in 2015 for 0M. Last year the gross profit on collectibles was over 0M. Clearly, this was a great purchase for GameStop and they expect sales to continue to show double digit growth in 2019.

That said, the growth rate of the Collectibles business revenue appears to be declining, as it fell from 28.8% to 11.2%. However, during the earnings call, Robert Lloyd, the COO and CFO stated:

“Our collectibles business, which now exceeds 0 million in revenue, increased 3.1% in the quarter and 11.2% for the year. Excluding ThinkGeek.com, which is a small piece of the collectibles business and has been restructured due to profitability challenges, our growth would have been 12% for the quarter and 18.3% for the full year.”

In other words, excluding ThinkGeek.com, the gross profit growth rate would have been 18.3% instead of 11.2%, and it has been restructured and will no longer be a headwind going forward. That is at least a M difference (probably more) and on 70.7M shares outstanding could add back .17 a share, after-tax, in 2019.

We’ve saved Pre-owned sales and gross profit for last for a reason. Clearly, this category has not been performing well lately with a 13.2% decline in revenue and 17.1% decline in profitability from the prior year, which is the largest single-year loss in our review. Pre-owned gross profit makes up 35% of the total gross profit, thus is a significant category for GameStop. The new CEO must determine why pre-owned sales tanked in 2018. GameStop has a 36% market share on hardware and accessory sales, and only minor declines in the sale of new video games. This is not a digital or streaming issue: Buyers are coming into the stores to do an array of other business. Perhaps the eSports initiative will help, but George Sherman’s number one priority aside from share repurchases and SG&A savings should be stabilzing this business. The margin on pre-owned sales is 43%.

Collectibles are a meaningful and growing category that may be set-up to benefit the most from GameStop’s shift to eSport partnerships. Collectible offerings should be a major part of each store and they should also be aligned with the prize tournaments that are being planned. If gamers are heading to a GameStop store for a Fortnite prize tournament, then the manager of that store must make Fortnite collectibles front-and-center and well-stocked the day of the tournament.

This now brings us to the root cause of GameStop’s woes, and it’s not streaming, or digital sales, and certainly not a broken business model. GameStop is not Blockbuster. We’ve disproved all of that by looking at the sales figures as well as market share figures.

So, what is plaguing GameStop?

It is SG&A.

Look at these custom tables we created for SG&A and gross profit less SG&A using the same sources as our other tables: