Aug 11 2020 - GameStop: Shorts Win As COVID-19 Quarter Confirms Model Is Broken

Summary

Despite significant additional cost control measures during the quarter, decade-low sales drove an adjusted net loss of over 0 million for the period.

The console cycle will provide a demand spike, but secular declines from the digital shift in gaming will prove stronger and more determinative in the earnings trajectory, driving them negative.

As the gaming industry set multi-year records on unprecedented double-digit YoY gains, and despite an e-commerce sales increase of 519%, GameStop’s same-store sales for “open” locations were down 16%.

As the 8th-generation cycle wound down, video game industry revenues rose. Conversely, GameStop’s fundamentals declined, demonstrating the company's woes are due to secular, rather than cyclic, reasons.

Even near historically low valuations and a .00 price point, the stock will fall further when faced with persistent negative earnings and a permanently infinite P/E ratio.

The drama continued to heighten for GameStop (GME) during its second fiscal quarter. The company’s stock remained in the top spot of the NYSE high short interest list as its liquidity concerns continued to grow. At the beginning of June, the embattled retailer announced both its first "COVID-19" quarter results and a 4 million bond exchange offer.

During the Q1 results call, covering February to April, management provided a robust coronavirus update and explanation for its 7 million YoY net sales decline during the period. Some color was provided on asset sales, along with rough guidance and information about costs savings and improved inventory management. Quick on the heels of these material developments, the second week of the month saw activist investors win their proxy fight at the annual meeting. The victory replaced two board members with activist candidates and increased pressure on GameStop’s management to focus more on shareholder return as opposed to the ongoing Reboot Plan.

Sales Cure All

But as with past catalysts, while they do sometimes drive the near-term narrative and the stock price, the positive significance or meaningfulness of the factors are usually exaggerated. Put briefly, GameStop stock price will ultimately be driven by its future earnings. And as a traditional retailer, the earnings over time are predominantly dependent on its top line revenues and not as controlled by cost savings, improvements to the cash conversion cycle or changes in the capital structure.

This concept may seem somewhat counterintuitive, as each dollar of various costs savings appears to pass directly to the bottom line and each dollar of revenue is muted by the cost of goods sold. However, from a relatively low-debt, retail-focused company perspective, the meaty portions of controllable costs are with the field teams and locations. And importantly, attempts to cut coworker and support staff hours and wage levels, reduce headcounts or the full-time to part-time ratio, or close locations and shorten location hours invariably also reduce total revenues in the system and increase strain on the team members.

As one example, GameStop has done well rationalising the store count. In the select financial table below, note that since 2015 over 700 stores have been closed. But also of note, if you divide the total revenues by the store count or look to changes in same-store sales, the attempts to lean the business through closing locations and transferring sales to nearby stores have not produced any noticeable revenue effects or positively impacted earnings.

It should be noted, however, the relatively large overall declines may be masking transfer gains, and the company has more granular insight into how sales and profits transfer from a closed location. In fact, multiple positive remarks concerning sales transfers were made during the Q1 conference call, including:

As we told you in March, we expect our strategic market optimization efforts to result in a similar number of store closures in 2020 as compared to 2019, or roughly 320 stores. However, given the positive sales and profit transfer rates we continue to see, we’re revising that estimate upwards by roughly 100 additional closures.

But it should be noted the company also broke out the various reasons for the substantial decline in the first quarter; concerning permanent store closures, it stated:

... four percentage points [were] attributable to permanently closed stores and foreign exchange headwinds.

Source: Q1 2020 Results - Earnings Call Transcript (link above)

To put the “four percentage” into perspective, the company closed approximately 3% of the fleet during Q1; the USD-to-EUR rate ended the quarter very near where it began, albeit with intervening violent swings due to COVID-19’s effects on the overall markets. The upshot, only a small minority of revenues likely transferred from the closed locations. Further, while the profitability at stores near closures benefited, each remaining store now carries a higher burden of the fixed corporate overhead.

While a number of caveats could rightly be raised, consider the following graph. And note the intuitive and close correlation between revenues and net income. As a general takeaway, net income and, ironically, costs themselves are largely determined by the revenue run rates.

Data by YCharts

Further, while attempts to reorganize the balance sheet and capital structure are important to short-term liquidity, over time these aspects are also most sensitive to the revenues.

Data by YCharts

To partially drive home the importance of sales over cost structure, consider the following key takeaways from the first quarter for perspective:

• Adjusted SG&A was 1.2 million, a reduction of .5 million, or 16%, from the prior-year first quarter, and inventory saw a 43% reduction.
• Net sales were 21.0 million, a reduction of 6.7 million, or 34%, from the prior-year first quarter.
• Adjusted net loss was (3.9) million, or (.61) per diluted share, compared to adjusted net income of .5 million, or .07 per diluted share, in the prior-year first quarter.

(Source: GameStop Reports First Quarter Result)

Despite significant additional cost control measures during the quarter, decade-low sales drove an adjusted net loss of over 0 million for the period. Put differently, it is impractical for GameStop to cut its way to profitability at the current sales volume.

The following select financial data from the most recent 10-K provides a good overview of the declining sales trend over time. For convenience, comparable store data was provided along with changes to store counts. Note the Switch-related “cyclic bump” in 2017 offset over time by the stronger ongoing digital secular shifts. Also note that while the net income figures have not been scrubbed of the large goodwill impairments during 2018-2019, revenues and earnings from the tech brands stores have already been removed so that a good picture of video gaming revenue trends remains.

(Source: Company Annual Report - Form 10-K (p.16))

Future Sales - The Console Debate, Looking Back

When one looks to GameStop’s future sales prospects, nothing is more hotly debated than the start of the upcoming console cycle that begins this holiday season. One can usefully break out the two primary positions as follows:

• The company’s proponents believe the coming console cycle, when coupled with costs control, will meaningfully reverse the declining earnings trajectory, providing time and ensuring sufficient return relative to the current low share price.
• The detractors believe the cycle only provides an upward demand shift, with the secular declines from the switch to direct digital downloads quickly proving stronger and more determinative in the earnings’ trajectory, driving them negative.

In keeping with a long-time detractor position, my general forecast is for a brief and relatively pedestrian high-single to low-double digit growth in total revenues from the upcoming console launches. This is based on an expectation of similar results as we saw with the main 8th-generation consoles and, much more recently, with the Switch. For a more detailed look at the effects of the 8th-generation cycle on GameStop’s business, consider my article “GameStop: The Reasons Not To Believe PS5/Xbox Series X Hype.” The following are two relevant summary points pulled from the piece that highlight the notion that strength in hardware/consoles yields only marginal total gains.

GameStop gained significant hardware share during the start of the previous console cycle. Unit sales were up 56% on a cycle-over-cycle basis.

Despite significant console gains, 2014 full-year consolidated comparable store sales increased by a relatively low 3.4%.

Source: GameStop: The Reasons Not To Believe PS5/Xbox Series X Hype

Further, New Hardware sales grew ~30%, ~17%, and ~1% during 2013, 2014 and 2015 (currency basis inconsistent). When this data is considered with the relatively low 2-4% change in gross profit for the category during the period, it suggests the majority of gains were in units sold and not higher prices. And this is important because unit sales generally drive software attachments. The takeaway, despite relatively strong unit sales, new software sales declined precipitously at the dawn of the previous cycle. (See compatibility discussion below for more.)

The effects on GameStop’s business from the Switch’s introduction make for interesting and often overlooked comparison. Unit sales-wise, the Switch compares very closely to the PlayStation 4 over comparable periods (graphed by VGChartz). Plus, its limited title structure compares better to what we will see with the new Sony (SNE) and Microsoft (MSFT) products as the number of new titles per year continues to decrease (see below).

Following is my description of the Switch launch quarter as written in May 2017:

Sales of Nintendo's (OTCPK:NTDOY) Switch drove a 25%, million increase in new hardware revenues for GameStop in the first quarter. However, the larger, higher margin new and pre-owned software segments continue to see substantial declines, down million and million respectively. Gross profit declines in these physical game segments of a combined million outpaced the million gross profit rise in new hardware.

Source: GameStop Bulls Drop Switch Talk, Look To iPhone 8

While some caveats are needed here as well, the simple lesson of the previous console launches is to expect a temporary and relatively mild upward shift in total company revenues with the majority of growth in the lower-margin hardware category.

Future Sales - The Console Debate, Looking Ahead

Looking to the upcoming cycle, there is much to be excited about concerning the specifications of the PlayStation 5 and Xbox Series X. Their launches should further energize the gaming industry that was already experiencing strong growth prior to the COVID-19 related surge (details below). As the video gaming industry pie grows, so too do expectations that GameStop benefits.

However, there are a number of counterbalancing factors that should mute GameStop’s participation in the coming console cycle demand surge. These factors are generally closely tied to the company’s heavy dependence on physical disk sales, both new and pre-owned. The two tables below are from the Q4 2018 Earnings Supplemental Presentation. Note the importance of the New Software and Pre-Owned categories, both from a percent of revenue standpoint and gross margin dollars contribution.

(Source: Q4 2018 Earnings)

(Note: GameStop did not provide a detailed breakout for 2019.)

58% of GameStop’s gross profit in 2018 and 52% of total revenue were generated from the New Software and Pre-Owned categories, which consists primarily of physical disk sales. And importantly, the Pre-Owned sales generated 0’s of millions in trade credits which subsidized all categories, including Collectibles and the small Digital business; for every buyer, there was a seller who predominantly elected the larger trade credit over cash. As this subsidy withdraws, all categories face steepening declines.

As shown above, GameStop’s business is largely dependent on the sale of full-game physical disks. And GameStop has struggled as gamers increasingly move to full-game digital download. But as important, it is not just how the players buy their games, but what they buy and how they play. Future console-related cyclical gains must be weighed against these continuing secular trends that go beyond just a shift to full-game digital download.

As a highlight to this idea, consider two recent data points from gaming giant Electronic Arts (EA), GameStop’s fourth-largest vendor overall and the company’s top pure-play software provider:

Overall, 49% of our units sold through were digital rather than physical, measured on Xbox One and PlayStation 4 over the last twelve months, and we continue to model underlying growth at 5 percentage points per year.

Physical game sales comprised 84% of our annual net bookings in fiscal 2009, compared to only 20% last year.

Source: Electronic Arts Q4 2020 Earnings Call Transcript - Note: Electronic Arts uses an eccentric fiscal year calendar.

As seen with Electronic Arts above, the large, ever-increasing majority (~60%) of gaming dollars go to subscriptions, battle passes, cosmetics, powerups, and bonus content rather than full-game purchases, especially full-game physical disks. Key notions in understanding this growing digital/physical divide, particularly in context of the coming 9th generation consoles, include:

1. Gamers play fewer games.

From 2008 to 2019, Wikipedia estimates video game titles per year have fallen from 983 to 352.

2. Gamers play each title for longer.

Increasingly, publishers are focused on monetizing ongoing content for a smaller set of hit titles. For example, consider the following from Electronic Arts:

Let's start with Apex Legends. We have a massive global audience continuing to engage in this high-quality free-to-play experience. Apex has tremendous gameplay at its core and we've built it to have longevity as a live service that will continue to drive engagement over time. In our live service, we're delivering seasons of new content, a collection of new content and updates that begin to roll out at the start of each season and continue throughout the course of several weeks and months.

Source: Electronic Arts, Inc. Q1 2020 Results - Earnings Call Transcript - Note: Electronic Arts uses an eccentric fiscal year calendar.

3. Today’s titles have large day-one downloads and storage needs, whether the player chooses physical or digital.

Debating physical versus digital, Richard Devine wrote:

Physical discs might seem like they would have an installation speed advantage - for most gamers, the Xbox can read off the disc faster than it can download the full game from the internet - but that advantage has been mostly scuttled by the massive first-day download patches that have become par for the course for practically every major game release these days.

4. Major diskless games and diskless consoles continue to capture share.

Key games like Fortnite are essentially diskless games. For over a year, Microsoft sold the Xbox One S All-Digital Edition, and Sony recently showcased a diskless PlayStation 5.

5. Backward compatibility will dampen pre-owned supply.

Backward compatibility will drive demand for prior-generation software and remove a reason gamers don't upgrade. Backward compatibility will also "defend" continuing sales of prior-generation software, GameStop's major problem at the outset of the previous cycle. But also important, backward compatibility tends to dampen incentives to trade. Note the following from the last cycle when the new consoles were not backward-compatible:

"The pre-owned and value business declined 1.4% for the fourth quarter and declined 4.1% for the year. The fourth quarter benefited from trades generated leading up to the console launches and grew when factoring out the extra week in 2012."

Source: 2014 Q4 Transcript (p.5)

This cycle, more players will keep their old software.

6. SSD drives will remove the need for data duplication, one factor in game sizes.

Consider the following from Mark Cerny in a Wired article, "Exclusive: A Deeper Look at the PlayStation 5-Haptics, UI Facelift, and More."

"If you look at a game like Marvel's Spider-Man," Cerny says, "there are some pieces of data duplicated 400 times on the hard drive." The SSD sweeps away the need for all that duping—so not only is its raw read speed dramatically faster than a hard drive, but it saves crucial space. How developers will take advantage of that space will likely differ; some may opt to build a larger or more detailed game world, others may be content to shrink the size of the games or patches.”

This nuance will partially offset the increase in file sizes enabled by the speed and power of the new consoles, ameliorating growth in download times for digital delivery.

Lastly, concerning the console debate, Bloomberg recently reported Sony has significantly increased production of the PS5 so that initial holiday supply will be approximately 10% more than initial PS4 sales in 2013. Describing the report, Sherif Saed wrote for VG247.com:

Mass production of PS5 began in June, and Bloomberg says around 5 million of that 10M initial bloc is expected to be done by September. This first batch will supply the allotment at launch and into the holidays. The other 5 million will be finished between October and December, meaning they’ll end up at retailers in the first quarter of 2021.

By comparison, 4.5 million PS4 units were shipped to retailers in 2013, and it took until June 2014 for that figure to reach 10 million. Assuming there’s enough demand to justify this increase in production, PS5 sales may be stronger out of the gate compared to PS4.

This large increase in supply versus Sony’s original plans is a gamechanger for GameStop and likely allows unit sales on par with 2013. But as with all positive catalysts we have discussed, its meaningfulness or impact must be weighed. Importantly, as shown above, the 8th-generation cycle proved disappointing for GameStop. A similar supply is likely to yield similar results; cyclical gains will be outpaced relatively quickly by the secular digital paradigm shift.

GameStop, the Games Industry and COVID-19

To a large degree, GameStop’s inability to meaningfully participate in the growing digital paradigm described above was demonstrated by the results seen during the company’s February through April first fiscal quarter. Leading up to the results, market researcher NPD showed “Videogame sales log best March in 12 years” and “Videogame sales surge to April record amid lockdowns.” At the same time, GameStop was included in a New York Times article titled “Americans Keep Clicking to Buy, Minting New Online Shopping Winners.” The feature was picked up, amplified and, to some degree, misinterpreted among company proponents and the press. Writing at Business Insider, senior tech correspondent Ben Gilbert opined:

Online sales at GameStop rocketed over 1,500% between March 1 and April 10, according to market analytics firm Earnest Research, speaking to the New York Times.

Moreover, GameStop's market share of online sales spiked.

In January, GameStop's online sales occupied a tiny fraction of the overall market, with Apple and Best Buy dominating. By late March, GameStop's share of online sales were topping both companies by a wide margin.

(Source: "Online sales have spiked over 1,500% at struggling video game retail giant GameStop, according to a new report," Business Insider, May 16, 2020)

But, of course, this narrative was upended when GameStop pre-released the COVID-19 quarter results on June 4th and revealed a half a billion dollar YoY revenue decline for the quarter. Key nuances included:

Excluding stores that were closed during the first quarter as a result of the COVID-19 pandemic, comparable store sales are expected to decline in the range of approximately 16% to 17%.

Net (loss) income is expected to be in the range of (2) million to (2) million… [including] approximately million in non-cash tax charge.

(Source: GameStop Announces First Quarter Fiscal 2020 Preliminary Results)

As the gaming industry set multi-year records on unprecedented double-digit YoY gains, and despite an e-commerce sales increase of 519%, GameStop’s same-store sales for “open” locations were down 16%.

GameStop’s online business, simply defined as using the internet to facilitate store pickup or ship from store, and digital business, which is primarily the sale of currency cards, are relatively and absolutely small; its digital category represented just 7% of gross profits in 2018.

Conversely, when one thinks of online and digital gaming from an industry-wide standpoint, the meaning is dissimilar to the aforementioned GameStop vernacular. Online and digital means full game downloads in conjunction with the dominant and growing subscriptions, battle passes, cosmetics, powerups and bonus content segment. From this viewpoint, GameStop is not participating. Blake Jorgensen from Electronic Arts explained:

The closure of physical retail has not yet affected the sales of full games, with sales actually above where we would expect them to be at this time of year. This suggests that people who want a game are finding a title in our catalog, and downloading a digital copy or ordering a physical copy online. In addition, the shift to digital since the last recession reduces both the impact of store closures and of inventory risk. Physical game sales comprised 84% of our annual net bookings in fiscal 2009, compared to only 20% last year.

Source: Electronic Arts Q4 2020 Earnings Call Transcript (link above) - Note: Electronic Arts uses an eccentric fiscal year calendar.

The lesson of GameStop’s first-quarter collapse is not just as another example where the significance of a positive catalyst was overstated. The key takeaway is the company’s inability to participate in industry-positive catalysts in general and what that means for its participation in the upcoming console cycle specifically. Further, a portion of the market share being lost by GameStop during the COVID-19 crisis, i.e., its customers who chose digital, won't return meaningfully to the company’s physical trade credit ecosystem.

Takeaway: The Cycle Myth and the Digital Divergence

Consider Electronic Arts’, Activision’s (ATVI) and Take-Two’s (TTWO) revenue growth in comparison to GameStop’s as the 8th-generation consoles aged. And note that these companies are three of its six largest software providers. Sony and Microsoft are not included in the comparison because they are not primarily in the video game industry. Also, it would be partially unfair for this comparison to look at Nintendo, whose cycle began more recently with the launch of the Switch in 2017.

Data by YCharts

Note in the graphic above, over the past several years as the 8th-generation cycle has wound down, the video game industry revenues have risen significantly. This demonstrates the myth of the cycle and is evidence that GameStop’s recent fundamentals declines are not due to cyclic console reasons, but rather due to secular digital ones. Or more exactly, the secular trends are most predominant.

	FY 2016*	FY 2017	FY 2018	FY 2019	Q1 2020
Adjusted Net Income (M)	1	3	8		(4)

(Source: Compiled from company website. *[unadjusted for Tech Bands sale])

The coming console refresh will only be a cyclic “bump” in the secular slope that is driving GameStop’s full-year earnings negative. And most importantly, even near historically low valuations and a .00 price point, the stock will fall further when faced with persistent negative earnings and a permanently infinite P/E ratio.

Contributor's Note: The author is currently Top Analyst for GameStop at estimize.com and has been publicly bearish on the stock since April 2017 and a price. He is also a long-time Power-up Rewards Member and picked out his first gaming console, an Atari 400, at EB Games (now merged with GameStop).