Aug 3 2020 - GameStop: Why Michael Burry From 'The Big Short' May Be Right

Summary

The transition from physical sales to digital sales is not occurring as fast as the market thinks.

There are multiple rational reasons to buy physical copies of games, instead of digital.

However, companies like Amazon, Best Buy and Walmart are taking a share of the physical sales.

GameStop's future is highly divergent, there are multiple possible scenario's: from bankruptcy in the coming years till cash flows significantly exceeding the current market cap.

Last year contrarian Michael Burry made a massive investment in GameStop Corporation (GME). During the COVID-19 crisis, he increased his stake in GameStop, now his stake sits at 4.3%. Michael Burry said to Barrons in 2019:

'I believe they will have the cash flow to justify a much higher share price.' ~ Michael Burry

I will elaborate on why he may be right because the most prevalent bearish case; that the digitalization of video gaming will lead GameStop to bankruptcy, is overestimated by some. I believe the market, and most investors are overstating the speed of this transition. That's why this cigar butt might have one more good puff.

'We expect GameStop's business will perk up a bit during 2020 and 2021 as the new console cycle, with associated software updates and introductions, finally gets underway.' ~Scion Asset Management

GameStop's business model

Before diving into the thesis I want to address GameStop's business model. I will use the 2018 annual report for this since GameStop thought it was a great idea to stop reporting gross profits split by product category in 2019. They also started reporting their figures into three product categories instead of seven, which is a bit infuriating. In 2018 35.1% of GameStop's gross profit was derived from reselling pre-owned video games, while its share of the revenue was only 29.5%. GameStop has experienced declining pre-owned video game sales for years, this is problematic since it is a lucrative product segment. In 2015 42% of GameStop's gross profits were derived from pre-owned video games. This decline has been partially offset by GameStop's growth in their collectibles segment, however, in 2018 the gross margin rate of collectibles was 33%, while the rate of the pre-owned segment was 43.4%. It is clear that collectibles create a much-needed diversification from the cyclical nature of console releases, however, still, are unable to entirely substitute GameStop's existing lucrative pre-owned business model.

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(Source: Visualized in Excel, data from GameStop IR)

The idea of GameStop's decades-old business model is simple, get people in your store for hardware or accessories and hope they buy some games, preferably pre-owned, while they are at it. I believe GameStop's clientele can be split-up into three different groups. Firstly, people just stopping by accidentally; many of GameStop's locations are in high foot-traffic areas, these people look around and might buy some items. Secondly, lure customers interested in hardware into the store with promotions, and sell them preferably pre-owned video games. And thirdly, it has a loyal group of customers that stop by for a variety of reasons.

However, the digitalization of video games sales has clearly been an issue, historically, GameStop's hardware sales have been strong over the last few years, while pre-owned game sales fell off a cliff. I suspect that this is thanks to the success of the Nintendo Switch. Nintendo (OTCPK:NTDOYsold .94 billion of software digitally, and in total software, sales totaled 168.72 million units, ironically they do not report that number in revenue. It is logical to assume approximately 50% or more of Nintendo Switch's games were sold digitally. I suspect that's why revenues of pre-owned games at GameStop declined between 2016-2018, while hardware remained relatively robust.

GameStop wants customers to buy new games or pre-owned games, and later buy them back so they can resell them again. GameStop lures customers in with hardware, and sells them games simultaneously. Ironically, I believe a case can be made that this model is stronger than most investors think. To elaborate that I will discuss the 'digitalization' of the video gaming world.

Digitalization

Now I will elaborate on why I believe the digitalization of video gaming, especially console video gaming is much slower than most think. Often times authors on Seeking Alpha showcase this magnificent graph to readers to be able to visualize the vast destruction digitalization has made on GameStop's business model. And while it is true that digitalization has cut into GameStop's lucrative pre-owned business model, that transition is much slower than one thinks. Frankly, it is comparing apples to pears. This digitalization includes the rise of mobile gaming and the return of pc gaming, which is great, however, does not affect GameStop.

50538245-15960368351392238.png

(Source: Statista.com)

I have compiled data from Sony's reports that give investors a much better indication at what pace the transition to digitalization is occurring for consoles. This data is much more relevant for GameStop shareholders since as we know GameStop primarily sells consoles, console video games, collectibles and some pc video games. However, the console video games, especially pre-owned, still drive most of the shareholder value. Fortunately, Sony (SNE) releases the full game software digital download ratio of all PS4 sales in its 'supplemental information' report. Clearly, this data is much more accurate since they do not include irrelevant mobile or pc gaming sales, instead, it concentrates on the console market.

50538245-15960437543211.png

(Source: Sony IR)

The so-called 'digitalization' is not occurring at the rapid pace most people think. Customers buy their games after a rational consideration, and sometimes buying digital games is more logical than physical games, however as I will elaborate later that is totally not always the case. Actually, in 2019 two quarters experienced more physical sales than digital sales.

Q4 FY 2019 of Sony is commonly known as Q1 2020 and ended on March 31, 2020. Q4 FY 2019 saw a rapid rise in digital sales, I do believe the COVID-19 crisis, and the consequential lockdown, has raised digital sales in the short term, it is plausible that this is not a long-term trend. Clearly, a transition towards digitalization has occurred, however, much smaller than most might have thought. For example, in Q2 FY 2018 digital sales accounted for only 28% of all PS4 game sales, I suspect that the bears think digitalization is far further. I conclude that customers do not necessarily prefer digital games over physical games, actually, they seem to prefer physical copies. So why would customers buy physical games for consoles, isn't that so 2010?

Physical sales

There are multiple reasons why people prefer physical video game copies:

  1. Firstly, the materialistic element of a physical video game should not be underestimated. People like to collect their games, and people are able to rent out their games to friends. It gives people a sense of control.
  2. Generally at normal prices, physical games are cheaper than digital games. Yet, digital games are generally cheaper during promotions. I believe pricing is the number one thing that drivers customers' decision making. Again if you look at the data from Sony you can see this. During holiday periods that generally have more and bigger discounts on video games, the percentage of digital sales is higher, significantly higher. Most noticeably the summer sale period drives customers towards digital, thanks to the huge discounts. Remember, during a release physical copies are generally cheaper.
  3. People are able to sell their physical copy again, this significantly lowers the cost of playing the game.
  4. The PS4 and Xbox One do not have tons of disk space. The PS4 has a 500gb hard drive, yes, with the opportunity to expand it, but that is expensive. Call of Duty Modern Warfare is 194 Gb for example, clearly, a couple of games can already fill up the basic hard drive.
  5. In some places, the speed of one's internet makes loading big games a daunting task. That's why there are more than 2 million Netflix DVD subscribers, these people do not use the digital platform but instead, get their movies sent physically. Most of the time people prefer this due to a bad internet connection.

These reasons should not be underestimated by investors, a 2018 report from Nielsen states a majority of game consumers fancy owning a physical game, instead of a digital version.

It's more complicated than one thinks

I believe the number of digital sales, relative to the number of physical sales, depends on the game genre and game size. I deem it as plausible that single-player games with vast download sizes obtain more physical sales in relation to digital sales. These kinds of games clearly tick all the boxes of the previous section: most people only play them once so reselling them makes them significantly cheaper, and their download sizes are huge. Also, these are the kind of games that people like to rent out to friends.

50538245-15960437543211.png

(Source: Sony IR)

This hypothesis seems plausible since Q2 FY 2018 saw an incredible low digital/physical rate. God of War was a massively successful single-player campaign released on the 20th of April 2018, this kind of game bodes better with physical sales. However, I believe that promotions, as elaborated earlier, during holiday periods play a bigger role in the fluctuating digital/physical rate.

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(Source: Compiled from respective company reports)

Take-Two Interactive's (TTWO) digital/physical revenue rate was much lower compared to its main competitors. I believe this discrepancy is due to Red Dead Redemption, a single-player game, that consequently oftentimes is played on consoles, this again bodes better with physical sales. Additionally, Red Dead Redemption Two's download size is 90gb, which fills nearly 25% of a normal PS4 hard drive.

Take-Two Interactive is heavily depended on the console market and clearly has a much lower digital share. Other video game producers gain much more sales from games on mobile devices, and generally make multiplayer games, this tends to better fit a digital sale. Interestingly, COVID-19 clearly diminished this effect, Take-Two Interactive became the video game company with the highest percentage of digital sales. It is logical that lockdowns strengthen a digital product that could be bought, and delivered instantaneously, it is a question for investors whether customers will continue to buy the products digitally. Weirdly enough the effect is much smaller at the other video game companies, which does showcase the value of physical sales again. The percentages of physical sales at for example an EA are low, nevertheless, that 20% is still more than a billion dollars of physical sales on a yearly basis.

There clearly is a market for physical video game copies. Video gaming companies want to move towards digital, digital sales have a higher margin than physical sales, however, not all customers want to as well.

Amazon

Amazon.com's (AMZN) dominance in the e-commerce market has given it a significant market share of all physical video game sales. Additionally, Best Buy (BBY) and Walmart (WMT) also sell lots of physical video games. This again cuts away a significant chunk of the market for GameStop.

The future

There clearly is a customer interest for physical games, it's why Sony will sell both a console with and without a disk drive. The Xbox Series X (MSFT) also comes with a disk drive. Clearly, neither Microsoft nor Sony wants to risk losing significant market share by dumping the disk drive, the lost revenue would outweigh the lower costs. Still, the PS5 and Xbox Series X will have much better-storing capabilities, the Xbox even has a 1 terabyte drive built-in, with the ability to expand the size even more. This might lower physical sales going forward.

GameStop has been moving to collectibles to grow its gross profit, however, this clearly cannot turn around GameStop alone. Currently, the market is very pessimistic about GameStop's prospects. Its market cap is only 5.15 million, with a price to book value of 0.60. Bulls hope that a new console cycle grows the inventory turnover of GameStop which would increase profitability.

50538245-15960994017303758.pngGameStop's historic EBITDA for an entire year significantly exceeds its current market cap and comes very close to its enterprise value. GameStop historically loses money during the first quarters of 2020, ironically, the lockdown has severely lowered its cash burn. In 2019 Q2 GameStop experienced a 5.0 operational cash burn, now it only burned .3 million. That's why its trailing twelve months cash from operations is actually positive at 1.2 million, approximately million less than the current market cap.

Clearly, the valuation is incredibly cheap and that's likely why Michael Burry bought tons of shares.

A vote of confidence

Lately, insiders have been buying GameStop shares. Currently, nearly 14% of GameStop is insider owned.

50538245-15960996128476694.pngWhile famous investors and insiders are buying huge amounts of shares, investors are shorting GameStop more and more, even when the stock price already fell 90% and management performed a massive buyback program. There was a short moment in time that more than 100% of all shares outstanding were short.

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Currently, the company has 0 million dollars in cash and cash equivalents, its long-term debt equals 8.9 million. Historically its fourth-quarter generates a majority of the operational cash flow, in 2019 it was 1 million for example, however, with Sony and Microsoft estimated to release consoles in that quarter, I suspect operational cash flows in 2020 to be even higher. It is very likely that this quarter alone will generate more free cash flow than the entire market capitalization of GameStop. In 2019 free cash flow was 4 million and the current market cap is 2.92 million. Considering the company does have more cash on hand than long-term debt, that does make the company an interesting value opportunity.

Shorters may be in for a lesson on asymmetric risk/reward, if GameStop is able to impress even the slightest, shorters will be scrambling to cover their positions.

Takeaway

Michael Burry's bet for GameStop may still be working out. He believes the company future cash flows exceed the current valuation, consequently, it is a value play. From my analysis readers can conclude that GameStop is fighting multiple juggernauts: on the one hand distributors like Sony, Microsoft, EA and Take-Two Interactive prefer digital sales since those provide higher margins. On the other side, Amazon and Best Buy are growing its presence in physical video game sales. That's why it is a gigantic question mark whether it can continue to be profitable, while competitors squeeze its existing business from two sides. However, I do believe that GameStop's current valuation has the potential for tremendous upside, Michael Burry's thesis that GameStop can generate high sums of cash in the next couple of years seems adequate, nevertheless is highly dependent on the evolution of the video gaming market. Shorters are clearly the one with the most to lose.

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