Feb 12 2020 - GameStop: The Fallacy That Digital Shifts Will Dwarf Console Sales

Summary

Annual console sales (by units) have fallen over 50% from 2008.

Bears are inaccurately comparing 2012/2013 to 2019/2020.

GameStop has material real estate holdings.

A debt refinance or proxy battle could result in a historic short squeeze.

I wasn't planning to write another GameStop (GME) article so soon, but I felt compelled after reading a recent article by a fellow contributor.

As I've written articles on GameStop and Rite Aid (RAD) in the past, I should point out that on 12/27/2019 I sold a sizable chunk of RAD at .50 and doubled the position of GameStop in the DOMO Concentrated All Cap Value Composite at .50. The portfolio now has over 419,000 shares of GameStop.

The most recent bearish article on GameStop was well done and factual with an emphasis on comparing console cycles. In particular, the author compared the 2012/2013 console cycle to the current console cycle of 2019/2020. This comparison has been a frequent point for bearish Seeking Alpha authors. However, as I am about to point out, it is flawed, because it is based on the wrong facts.

I have written previous articles about GameStop and have gone into great detail about how it was GameStop's inability to control cost that has hurt the profitability of the company and not the shift to digital. For example, as I noted in a previous article:

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.

GameStop had (has) a cost problem, not a sales problem. The current fiscal year is bad, there is no doubt about that, but I will focus this article on the trap of comparing the upcoming console cycle to the previous console cycle.

The recent article written on Seeking Alpha suggested that the next console cycle will not save GameStop, because it is the shift to digital that is killing GameStop.

The author makes three points:

Note fiscal 2012's comparable sales were down 8% versus an estimated 20% for fiscal 2019. Put differently, the current revenue trough is notably both deeper and longer than in 2012 because of the secular shift to digital.

Point: GameStop comparable sales are down an extra 12 points due this console cycle due to a secular shift to digital.

Here note that 2013's comparable sales increased a relatively low 3.8% and global sales remained well below 2011's. Interestingly, while low margin console sales drove growth, both the new software and pre-owned categories saw declines.

Point: The last console cycle upgrade only increased same store sales by 3.8%, and did not help new / pre-owned software sales. Therefore, we should assume GameStop will only get small bounce this time around as well.

Again, total global sales in 2014 have not reclaimed the 2011 level. Comparable store sales were up similarly to 2013 at a relatively weak 3.4% and new video game sales continued to lose significant ground.

Point: Even the following year, GameStop same store sales only increased 3.4%; therefore, we should assume the next console cycle will not help GameStop much.

Comparing 2019 To 2012 Same Store Declines

It is true, GameStop performed much better in 2012 vs 2019. However, a big reason for that is due to GameStop's "Other" segment. In the 4th quarter of 2012, GameStop's same store sales actually only decreased 4.6%. However, that's because GameStop had a 60.3% growth in digital receipts and 0 million of mobile sales offsetting weakness in the core business.

It would make more sense to focus on GameStop's core business by stripping out "Mobile and Consumer Electronics" and "Other." Instead of total sales falling from .55B to .89B (a 7% decline) they would have fallen from .084B to .167B for a decline of over 10% with same store sales down over 11%. However, there is another little quirk in this data...

2012 had a 53rd week and when over 40% of sales occur in the final quarter of the year, it has a large impact. If you exclude the 53rd week, sales would haven fallen to .054B for a decline of over 11.3% with a same store decline of over 12.3%.

Is 2019 same store sales worse than 2012? Yes. However, a 7 to 8 point difference in same store sales is a lot different than a 12 point difference! Is digital responsible for the extra 8 points? There's no doubt that digital has hurt GameStop's pre-owned business. However, there's one more thing to consider. During the late 2000s and early 2010s the United States was in the Great Recession and even 2012 is referred to as "The Growth Recession of 2012." Fast forward to 2019 and the U.S. economy is on fire. I believe there is an argument to be made that the sale of pre-owned consoles and games is likely to be a lot more popular during a Great Recession vs a Great Boom. Unfortunately, we can't specifically calculate the impact; however, I think it's worth noting and undoubtedly has had some impact.

Lastly, I believe once the final numbers are in, that we will see that unit sales of consoles fell more in 2019 than 2012. In fact, unlike the last console cycle, the PS4 has not had an official price cut since 2016! Additionally, PS came out with a Super Slim PS3 in September of 2012 with a retail price of only 9 which helped to stabilize console sales. In fact, Video Game Hardware sales only fell 16.7% for GameStop in 2012 which only further points towards the importance of console sales in driving the other categories.

Why Did Same Store Sales Only Bounce 3.4%-3.8% In 2013/2014?

The idea that the last console cycle only led to a 3.4% and 3.8% increase in same store sales is really the the crux of the bearish argument. Bears believe that the last console cycle did not result in a major increase to new software sales or pre-owned sales. Therefore, why should it save GameStop this time around?

There are several things to consider here.

First, while the "Mobile and Consumer Electronics," Other," and "53rd Week" in 2012 helped to moderate the decline of the core business in 2012 they similarly resulted in a moderation of the growth of the core business in 2013 and 2014. Stripping these out would have nearly doubled same store sales growth from the 3.8% that was reported.

Perhaps still not what we would expect from a new console launch, but certainly a lot better than what was reported. So, why wasn't growth even better?

First, the PS4 was not backwards compatible. Sony has confirmed that, at a minimum, the PS5 will be backwards compatible with the PS4. Rumors are that the PS5 may actually be backwards compatible all the way to the original PS. Similarly, the XBox was not backwards compatible to the XBox 360. Microsoft has already confirmed that the XBox Series X will be backwards compatible with the XBox One.

Have no doubt. Backwards compatibility is not only key to pre-owned sales, but it also provides even more incentive to purchase a new console. If a person can buy a used game from 2003 and use it on a 2020 PS5, that's going to interest a lot of people.

Getting back to why growth in 2013 was not better, we must force ourselves to think critically about why the sale of a console is important to a retailer like GameStop. For every console that GameStop sells, several things happen:

1) They have the potential to become a Power-up Rewards Member.

The PowerUp Rewards program was launched in 2010. Here are the annual membership numbers as of the end of each fiscal year:

2011 16 Million PowerUp Rewards Members
2012 22 Million PowerUp Rewards Members
2013 34 Million PowerUp Rewards Members
2014 40 Million PowerUp Rewards Members
2015 46 Million PowerUp Rewards Members
2016 50 Million PowerUp Rewards Members
2017 37 Million PowerUp Rewards Members
2018 40 Million PowerUp Rewards Members

2) They are likely to buy new and used accessories for the new hardware.

3) They are likely to purchase new software for the new hardware.

4) If the new hardware is backwards compatible, they are likely to purchase used software for the new hardware (which has a much higher profit margin for GameStop).

The next generation of consoles will boost pre-owned in a way that the previous generation could not. While Digital sales may increase, the existence of all the previous physical games will create a bottom in the pre-owned category.

OK, that's nice, but why are these 4 points important or relevant to the 2013 console cycle?

The Previous Console Cycle Did Not Increase Console Sales!

GameStop bears (and perhaps even bulls) have always focused on hardware revenue instead of units sold. Therefore, they believe the console cycle won't help GameStop in 2020, because an increase in hardware revenue did not help them that much in 2013.

They are wrong.

Very wrong.

They believe this, because they made the mistake of looking at sales figures in dollars instead of in units. As we have already established, the benefit to GameStop in selling consoles... is to sell as many consoles as possible, because each console sale results in the sale of items from other categories.

I believe the following chart will be eye-popping for both GameStop bears and bulls:

Year Number of Consoles Sold (In the United States)
2007 25.60 Million Units
2008 32.17 Million Units
2009 30.77 Million Units
2010 29.38 Million Units
2011 26.04 Million Units
2012 19.73 Million Units
2013 16.89 Million Units
2014 16.11 Million Units
2015 15.52 Million Units
2016 13.17 Million Units
2017 16.69 Million Units
2018 16.70 Million Units
2019 Hardware (Dollar) Sales fell over 20% in 2019. Assuming < 14 Million Units

Source of Data: Statista

From 2008 to 2019, annual console sales in the United States have fallen over 50%.

As the most recent bearish article on GameStop pointed out, same store sales in 2013 and 2014 only rose 3.8% and 3.4% (something not entirely true as we worked out earlier). The author then uses this as the primary data point to "prove" that it is the shift to digital that is killing GameStop rather than a decline in hardware sales.

However, if we examine actual unit sales of hardware, the picture is much, much different. The bump that GameStop received in 2013 was primarily because the hardware was being sold at a much higher price and GameStop was also able to make a much higher margin on the new consoles. However, that doesn't mean that GameStop actually sold more consoles, and that is the shocker! Accessory sales fell over 8% in 2013. If there was an actual boom in the number of consoles sold, that number just wouldn't make any sense.

Fortunately, we can make sense of GameStop's 2013 report by analyzing the data above from Statista. From 2012 to 2013, console sales fell over 14% and then fell another 5% the following year, in 2014. Not only was there not a bump in the number of consoles sold, there was actually a material decline.

In fact, console sales in the United States fell every single year from 2008 to 2016.

What happened in 2017?

The Nintendo Switch was launched on March 3, 2017.

There is no question. Digital has hurt GameStop. However, it is the decline in console unit sales combined with mismanagement of the store footprint (cost and SG&A) that is the real reason for GameStop's decline.

Don't let the GameStop bears fool you. The 2020 console cycle will be nothing like the 2013 console cycle. The launch of the PS5 and the XBox Series X will be game-changing and the annual unit sales of these consoles will very likely top 20 million a year in the United States. They are revolutionary top of the line products that are very different from the previous launch.

In fact, in 2014, you can research many articles questioning why the console sales were so poor. One article points out the following:

As one veteran games developer, who has worked in the industry for more than a decade and who pointed me in the direction of the leaked NPD data, put it: “The PS4/XB1 is the first generation to have technology that is worse than what is already out there. There are 2+ year old GPUs that outperform these boxes, and even budget GPUs releasing now in the 0 range outclass these machines. If you buy the highest end GPU on the market now, you have almost 3x the performance of these machines, and we are at the start of the generation. This is unprecedented.

The PS4 and XB1 were not revolutionary consoles. They were not backwards compatible. They were not powerful. They didn't have top of the line graphics.

The next generation of consoles are completely different and once they are officially revealed we may discover even more reasons why they will likely fly off the shelf. As noted here, but here are a few quotes on the PS5:

The PlayStation 5 will run off a custom-built version of the third generation AMD Ryzen chipset, packing in 8 cores with the company's new Zen 2 architecture and Navi graphics. It’s a system that will be able to support ray tracing – a performance-intensive lighting technique that has previously been the reserve of expensive high-end PC GPUs, and which we now know will be "built into the GPU hardware" for the PS5.

Sony has also talked of the console setting a new “gold standard” in immersive, 3D audio, particularly for those using a headset whilst playing. (Some leaked patents, too, show off some intense ventilation design for handling all that processing power.)

The PS5 will also support screen resolutions of up to 8K – far higher than the standard 1080p HD of most people’s televisions, let alone that of the increasingly popular 4K. It’ll also work at 120Hz refresh rates, allowing for super-smooth movement in games. These are incredibly performance intensive specs, so we wouldn’t expect a game to hit these standards regularly (not to mention requiring an expensive TV that will support them), but it’s good to see what Sony is aiming at.

Perhaps the most interesting element of the Sony build is its commitment to using SSD storage. The solid state drive in the PlayStation 5 will again be a custom-built piece of hardware, and Sony has already been showing off its technical prowess with a demo of its existing Spider-Man PS4 game. On PS5 hardware, the game is able to race around an incredibly-detailed New York City at incredibly high speeds without any delay in geometry loading or texture streaming, something that would never be possible on PS4.

We've got some new tidbits on the next DualShock controller too – though there's currently no official 'DualShock 5' branding. A blog post by PlayStation said that haptic feedback technology would replace last-gen "rumble" features, while "adaptive triggers" will be able to recreate different levels of resistance for different weapon loadouts or types of terrain you might be navigating in-game.

There are a few key pieces of data here as well. Specifically, "these are incredibly performance intensive specs..." In other words, there's no way a game taking advantage of this technology could be streamed. When people see what these games offer, they're going to want to buy the consoles. Furthermore, the size of these games are going to be massive which means that physical versions may gain in popularity (or at least stabilize).

Secondly, note that the controllers may also be revolutionary. Does anyone know when the "rumble" technology in the DualShock controller first game to America?

May...

Of 1998!

With the new controllers, users will feel the actual sensation of pulling back an arrow on a bow. Combined with the immersive 3D audio (by the way, the lack of an audio upgrade from the PS3 to PS4 was also a major complaint), people are going to want the new controller and that means massive accessory sales for GameStop.

We should have the full details on the PS5 by the end of March, if not much sooner, and it may also include details on new virtual reality hardware to pair with the PS5.

2017

Well, so much for a short succinct article!

At this point, it doesn't make sense to not cover 2017 - the only year in the past 12 years that annual console sales in America actually increased.

In 2017, console sales increased from 13.17 million to 16.69 million (a 26.7% increase) that was due to the March release of the Nintendo Switch.

How did this impact GameStop?

Sales of video game hardware increased 28.3%. How did that compare to 2013? In 2013, video game hardware sales increased 29.7%.

However, the Nintendo Switch was only 0, and that is precisely the point. Sales figures in dollars do no matter. All that matters is the number of units sold.

In 2017, all due to just the Nintendo Switch, new video game software rose 3.6% (the first increase in over at least 5 years) and video game accessory sales jumped 15.9% (they fell 7.5% in 2013 and 8.4% in 2014).

In 2017, net sales rose 7.3% and same store sales rose 5.8%. If we strip out "Other" the net sales rose 8.5%.

Imagine that... in a year where more consoles are sold, same store sales jump, new video game sales increase (despite the supposed shift to digital), and video game accessories sky rocket (and this was before Fortnite became popular).

Just imagine what will happen if we go from 13 million consoles sold a year in America to 20 million consoles for the next couple of years.

Perhaps GameStop bears will attack here and try to point out that pre-owned still fell 4.6% in 2017. That's true, it did. However, the Nintendo Switch was a brand new console with no pre-owned library of games. This is precisely why the PS4 and XB1 did not help GameStop in this category back in 2013, and precisely why 2020 and 2021 will be different.

GameStop Real Estate Holdings

GameStop Texas PropertyGameStop JetI've covered the balance sheet substantially in the past. However, I did not cover GameStop's actual real estate. As visible in the above screen obtained here by doing a search for GameStop, GameStop has two warehouses and a headquarters in Grapevine, Texas appraised at over million. They also have a corporate jet appraised at over million. In GameStop's last 10-K they also list property in Canada, Australia, and Italy totaling 427,000 square feet.

While we do not know GameStop's current market cap, as we're unaware how many shares have been repurchased this quarter, it is definitely below 0 million. Therefore, we can definitely say, that GameStop's real estate holdings and corporate jet currently represent at least 20% of the current market cap of GameStop. We also know that GameStop will end Q4 of 2019 with more cash than debt. Lastly, we know that inventory is valued at cost and pre-owned has the highest margins (43.4% margin in 2018) which means, even accounting for inventory shrinkage, GameStop's inventory is worth a lot more than what it is listed for on the balance sheet.

Debt Refinance

GameStop has just over 0 million in long-term debt that is due in 2021. However, it's possible that GameStop may have repurchased debt, in addition to shares, during the last quarter. If GameStop were to refinance the debt, it would absolutely crush the short sellers betting against GameStop. Other authors have questioned whether or not GameStop could refinance and have suggested they might have to offer interest rates over 10%. That is preposterous.

One has only to look at Rite Aid (RAD). Even with the recent downgrade of GameStop's debt, the debt still has a higher rating than Rite Aid. However, Rite Aid was recently able to offer current bond holders of their 6.125% 2023 Senior Notes an offer to exchange up to 0M in notes for 7.5% 2025 Senior Notes. The results can be viewed here. There was about .75B in outstanding 2023 notes and bondholders representing .63B (93.18%) of the outstanding bonds wanted to extend the notes out two years to 2025 at the 7.5% rate.

GameStop's bonds mature in 2021 and yield 6.75%. There's absolutely no reason why GameStop should have any issues trying to refinance the current debt through either a new offering or an exchange. Given the current market, they might even be able to lower their interest rate.

According to the WSJ, as of 1/15/2020, there are currently 65.16M shares short on GameStop which is likely greater than the actual number of shares outstanding and most certainly greater than the public float. Additionally, the interest rate that short sellers are paying to short the stock are extraordinary. If the debt is refinanced, there is zero chance of GameStop going bankrupt anytime soon even if bulls are completely wrong about the popularity of the new consoles. Therefore, it could lead to a massive short squeeze that could take GameStop to extraordinary heights.

Proxy Battle

Last year, GameStop publicized an agreement with Hestia and Permit.

Pursuant to the cooperation agreement, Hestia and Permit have agreed to withdraw their director nominations for GameStop’s 2019 Annual Meeting, effective as of the date of the appointment of one of their nominees. They will respectively vote their shares in favor of all of GameStop’s director nominees at the Company’s 2019 Annual Meeting and have agreed to abide by customary standstill provisions. The complete agreement will be included as an exhibit to a Current Report on Form 8-K, which will be filed with the U.S. Securities and Exchange Commission.

There has not been any further public reports regarding this agreement, but the 8-K that was filed and referenced above has further information.

each Investor has agreed to customary standstill provisions, which provide, among other things, that from the Appointment Date until the earlier of (I) the date that is 15 calendar days prior to the last day of the advance notice period for the submission by stockholders of director nominations for consideration at the 2020 annual meeting of the Company’s stockholders

neither Investor will: (A) acquire beneficial ownership, directly or indirectly, in any securities of the Company (or any rights decoupled from such securities) that would result in such Investor owning, controlling or otherwise having any beneficial ownership interest in or aggregate economic exposure to more than 9.9% of the shares of the Company’s outstanding common stock

This is interesting for two reasons. First, it means that the deal with Hestia and Permit is about to expire and although I'm not a lawyer, it appears that would then allow Hestia and Permit to acquire more than 9.9% of the total shares outstanding. Furthermore, it means that Hestia and Permit may come to a new agreement with GameStop in 2020 or they may decide to have an actual proxy battle to replace the board of directors.

It's possible that an announcement of a proxy battle may result in a catalyst that starts a short squeeze. If it doesn't happen immediately though, it may later for technical reasons. In order for over 65 million shares of GameStop to be shorted, there must be massive lending of the shares by the institutions that hold GameStop. When shares are lent to short sellers, the short seller does not receive voting rights; however, the owner of the GameStop shares does lose their voting rights. Therefore, the actual owner of GameStop shares can only vote if the short seller closes their position.

What happens if the institutions decide they want to vote? They have the option to recall the securities that they loan out in order to vote it themselves. If they do this, the short sellers must close out their positions by purchasing GameStop. If every institution that holds GameStop does this at the same time, GameStop could potentially become the largest company, based on market cap, in America.

BlackRock Inc. currently holds over 11 million shares in GameStop and the following is a disclosure that is listed in some of their funds:

With regard to the relationship between securities lending and proxy voting, BlackRock’s approach is driven by our clients’ economic interests. The decision whether to recall securities on loan to vote is based on a formal analysis of the revenue producing value to clients of loans, against the assessed economic value of casting votes. Generally, we expect that the likely economic value to clients of casting votes would be less than the securities lending income, either because, in our assessment, the resolutions being voted on will not have significant economic consequences or because the outcome would not be affected by BlackRock recalling loaned securities in order to vote. BlackRock also may, in our discretion, determine that the value of voting outweighs the cost of recalling shares, and thus recall shares to vote in that instance.

Given that BlackRock Inc. owns about 17% of GameStop's shares, they certainly won't be under the assumption that the outcome would not be affected by their vote.

Fidelity owns over 13 million shares and Vanguard has nearly 10 million shares.

Think it's crazy? You can read here about how something similar happened with Volkswagen (although for slightly different reasons). In a matter of a few days they became the most valuable company in the world, eclipsing Microsoft and Exxon Mobil with a value of over 0B.

Short sellers are playing with fire.

Conclusion

The bull case for GameStop is strong and goes well beyond debunking the 2013 console cycle myth as it pertains to GameStop's sales figures. GameStop has a very strong balance sheet, they have repurchased a significant amount of shares, they have embarked upon a significant cost cutting strategy that includes de-densifying the store base, and short sellers have put themselves in a dangerous position. Additionally, GameStop has significant real estate assets and significantly undervalued inventory. A debt refinance, a new share repurchase plan, or a proxy battle could result in a massive and historic short squeeze.

In regards to the de-densification process. It should be noted that in the 2012 annual report that GameStop mentioned that they would be closing 81 net stores and that using the PowerUp Rewards database they had a unique sales transfer process where over 40% of the sales could be transferred to an existing store nearby resulting in an increased combined profit of 20% or more. Since 2012, the PowerUp Rewards members have doubled while the profitability of stores has fallen. In other words, it is likely that now an even greater number of sales can be transferred and the combined profit will be significantly higher than 20% since the lease of the store that is closing is probably a lot bigger percentage of total cost than it was in 2012.

GameStop made the error of not closing stores earlier, because even to this day, 95% of the stores are four-wall EBITDA profitable even with field overhead. However, with the high sales transfer, closing profitable stores can result in even greater profit due to reduced lease costs and overhead.

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: GME is currently one of the largest position in the DOMO Concentrated All Cap Value Composite. More information on the composite can be found at our website. DOMO Capital Management, LLC ("DOMO") is a Wisconsin-registered investment adviser. Justin R. Dopierala is the President and Founder, and a registered investment adviser representative, of DOMO. Additional information about DOMO is disclosed in our Form ADV, which is available upon request. All information contained herein is for general informational purposes only and does not constitute a solicitation or an offer to provide investment advisory services in any jurisdiction. The investment strategy discussed herein may not be suitable for everyone. Investors need to review an investment strategy for their own particular situation before making any investment decision. We believe the information obtained from any third-party resources to be reliable, but we do not guarantee its accuracy, timeliness or completeness. The opinions, estimates, projections, comments on financial market trends and other information contained herein constitute our judgment and are as of the date of the material, are subject to change without notice at any time in reaction to shifting market conditions and other factors and should not be construed as personalized investment advice. DOMO has no obligation to provide any updates or changes to such information.

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