Oct 12 2020 - Agreement With Microsoft Shifts Sentiment
GameStop confirms joint press release with Microsoft includes a revenue sharing agreement.
Agreement kills short seller thesis on GameStop business model.
A Sony revenue sharing deal may be imminent.
A GameStop announcement on the future of the European operations may be imminent.
Shares short increased from 66.41M on 9/15 settlement day to 68.63M shares as of 9/30 settlement day.
Revenue Sharing Agreement with Microsoft
On October 8th, GameStop (GME) and Microsoft (MSFT) released a joint press release announcing a multi-year strategic agreement. The investment media initially focused on the enterprise elements of the agreement rather than the commercial elements. Microsoft will benefit by equipping GameStop associates with Microsoft Surface tablets that will allow them to be mobile within the store rather than stuck behind a counter. Microsoft will also standardize GameStop's back-end and in-store solutions using Dynamics 365 which will provide the associates real time information to personalize the customer's in-store experience.
It is important for people to understand that Microsoft likely had a lot of sway in regards to the wording of the press release. Therefore, a lot of people tried to claim that the 4th and most important bullet point to GameStop was likely not relevant since it was buried in the press release. This is absolutely false and shows a lack of understanding surrounding the joint release.
I have officially confirmed with GameStop that the following quote from the press release specifically refers to a revenue sharing agreement:
GameStop and Microsoft will both benefit from the customer acquisition and lifetime revenue value of each gamer brought into the Xbox ecosystem.
Michael Pachter, of Wedbush, detailed how this works:
For example, if a customer signs up for the monthly Xbox Game Pass Ultimate at a GameStop store, we would expect GameStop to receive .50 or so from that monthly revenue stream for as long as the customer continues to subscribe. If instead, the customer signs up for Xbox All Access for /month, GameStop would share .50 per month for 24 months.
Mr. Pachter believes this won't drive "meaningful upside" and that is where I disagree for a number of reasons.
Economics of the Agreement
First of all, we don't know that the revenue sharing agreement is simply limited to a percentage of revenue of the cost of the subscription. It is possible that GameStop benefits from additional dollars that the consumer spends within the ecosystem.
However, focusing on just the example laid out by Mr. Pachter, let's think about the economics of the agreement for a moment.
The X-Box S costs 9 and the X-Box X costs 9. We can see from Q3 of 2019, the last point new hardware sales were broken out, that GameStop had about a 10% to 11% margin on the sale of new hardware. Let's just assume 10%.
This means that GameStop makes about to on the sale of every X-Box S and X-Box X. However, what if the customer instead, opts to pay nothing up-front and take advantage of the All Access X-Box offer?
On the X-Box S the cost is a month for 24 months and on the X-Box X the cost is a month for 24 months. According to Michael Pachter, he would expect GameStop to earn .50 to .50 a month from each sale. Here's the thing, over the course of 24 months, that will total to per sale instead of to . While the revenue stream will take longer to realize, GameStop nearly doubles their margin on the initial sale of the console while still realizing additional profit from the purchase of new games and accessories.
Additionally, most subscribers are likely to extend their Game Pass Ultimate subscription beyond the initial 2 years after the console is paid for. A second 24 month subscription would essentially have the same effect as GameStop selling an additional console over the next two years to the same person as GameStop would realize another per year per gamer over the following 24 month period as the Game Pass Ultimate subscription is a month.
By the way, the X-Box One sold over 48 million units. GameStop is going to sell tens of millions of the X-Box X's. Let's assume though, that they only sell 5 million X-Box X All Access subscriptions to users that then extend the Game Pass Ultimate subscription for another 2 years at a cost of 0 ( a month). (0 * 10%) * 5 million customers = 0,000,000.
That's right. In years 3 and 4 combined, if just 5 million customers extend the subscription for two years, GameStop makes 0 million in incremental profit with zero cost involved. That's nearly a quarter of GameStop's current market cap in recurring income at 100% margin!
While some analysts like Seth Sigman from Credit Suisse believes it will not be incremental to potential lost preowned sales, I would disagree. It should be noted that Seth has had a .50 price target on GameStop for some time. Maybe he's missing the big picture?
Microsoft's All Access subscription does not include all games. In fact, many publishers have come out and stated that they would never go to the subscription model, because it just doesn't make sense from an economic standpoint. In fact, these publishers are raising prices across the board by to a game. Not only will gamers not be able to access these games as part of their All Access subscription, the increase in price also makes buying the physical game more beneficial as it increases the trade-in value. It will also encourage others to wait until a used preowned game is available and rejuvenate GameStop's preowned offerings.
What Seth Sigman is missing is that the revenue sharing agreement has no impact on GameStop's future preowned sales. It is giving GameStop a new revenue stream that they never had before, while going forward gamers will be even more incentivized to want to purchase the blockbuster AAA games in physical format from GameStop.
In fact, we may get additional details over time that makes the deal look even better. For example, one of the major reasons why GameStop is essential to Microsoft, Sony (SNE), and Nintendo (OTCPK:NTDOY) is their ability to handle cash transactions. The math performed above for years 3 and 4 doesn't even take into account the fact that many consumers may turn to GameStop to fund their Game Pass Ultimate subscription even if they don't buy the X-Box from GameStop or even if they don't take part in the All Access program.
There still exists a material number of consumers that are still not interested in attaching a credit card to an online subscription and/or may not even have a credit card. This makes GameStop essential in handling these transactions that allow people to purchase digital subscriptions and content. GameStop also accomplishes this through trade-in credits. Therefore, GameStop will share not only in the revenue from the All Access subscription, but also in revenue spent on digital using GameStop's footprint.
This was even recently highlighted by Jim Ryan, PlayStation chief, in an article from last month:
It's interesting, there is quite a nice ecosystem that's sprung up for specialist retail, around selling cash cards for people who don't have a credit card... There's a list of reasons why people need these cards. I don't want to get into the back and forth of the margin discussions between ourselves and our retailers, but we think we've found a way to make that work together.
Which brings us to our next point.
Nintendo and Sony Revenue Sharing Deal
In addition to the investor world and the short sellers, Nintendo and Sony were likely shocked by the GameStop announcement. Historically, GameStop has had a much closer agreement with Sony than Microsoft. Although, the Nintendo relationship has recently warmed-up with the addition of Reggie Fils-Aime (former President of Nintendo of America). This was evidenced on the last earnings call when George Sherman stated:
We receive more than our fair share of Nintendo Switches and we sell those very rapidly.
This is relevant because historically GameStop has not received great allocation on Nintendo products. Going from less than fair share to more than fair share is a material change.
Microsoft's warming relationship with GameStop cannot go unmatched by Nintendo and Sony. Sony and Nintendo cannot afford to have the GameStop salesforce pushing the X-Box All Access subscription to take advantage of the revenue sharing deal at the expense of their products. The success of this generation of consoles will have a lasting impact, especially with the differing strategies being pursued by Microsoft and Sony.
There is little doubt that GameStop and Sony have likely already had discussions surrounding a revenue sharing agreement. I suspect GameStop's coup in getting Microsoft on-board will be major motivation for Sony to finalize something soon before the release of the next-gen consoles next month.
Don't be surprised if we see another halt and news announcement from GameStop in the next 45 days regarding a revenue sharing deal with Sony.
Sale of GameStop European Operations Appears Imminent
I am shocked that none of the major analysts covering GameStop have picked-up on the signals GameStop has been sending regarding their European operations.
First of all, the Milan DC is the only property owned by GameStop that was not part of any sale leaseback.
I wasn't certain until GameStop's last 10-Q, but page 28 lays it out clearly as GameStop completely rewrote their Overview on Liquidity and Capital Resources. Specifically they state:
As part of our previously announced GameStop Reboot profit improvement initiative, we are evaluating future strategic and operating alternatives for certain of our unprofitable operating subsidiaries and business units that operate within our international segments. We currently believe that the aggregate amount of any potential charges associated with the disposition or wind-down of certain operations under consideration, primarily relating to lease and severance obligations and accelerated depreciation and amortization, would not be material to our liquidity, results of operations or financial condition.
In my opinion, this language clearly implies that we should expect a sale of the European segment. This would make a lot of sense for GameStop on a number of levels.
First of all, the value of the European segment would be maximized just prior to the release of the new consoles. While the segment is unprofitable today, it won't be unprofitable for the next two years. This gives GameStop the ability to monetize the asset immediately, and gives the new owner the ability to use the cash flows as they see appropriate.
Second, a sale of the European segment would result in significant SG&A reductions. GameStop would no longer need lawyers or accountants or marketing teams specific to that region of the world which is comprised of a number of different countries. The reduction in business complexity will lead to a material decrease in not only SG&A costs, but also capital expenditures. GameStop will no longer need to spend money on maintaining that store base and the acquirer can decide how best to operate the assets going forward and what the footprint should look like.
While there is no guarantee on the timing of when this may occur, I expect it would have an extremely positive reaction from investors.
Short Seller Thesis is Dead
The short seller thesis was always doomed to failure.
The revenue sharing agreement with Microsoft is the final nail in the coffin for people claiming GameStop is the next Blockbuster. It creates a recurring new revenue stream that will exist for the lifetime of the customer's engagement with the X-Box subscription.
Some short sellers and financial media such as Barron's, have expressed how "perplexed" they are at the increase in stock price of GameStop on the back of the revenue sharing agreement. They don't understand how the deal could bring that much value to GameStop to justify the rise in price.
It's simple. Let me help simplify and untangle it for them. It doesn't.
However, stock valuation is not a vacuum. The increase in GameStop price is not a reflection of the "value" of the strategic partnership, it is a reflection of a change in investor sentiment. GameStop, even at , I would argue even at , is priced for bankruptcy. Cash on hand is worth over a share. Net cash is worth over a share. The market was not ascribing any value to GameStop's future cash flows. As investor sentiment continues to shift and coincides with significant changes in the company's fundamentals in the form of massive increases in profitability and cash flow, the upside for GameStop is tremendous even without a short squeeze.
Kingdom Capital had a fantastic article: GameStop: It's The Cash Flow, Bro that highlights the expected cash flow generation the new consoles will deliver for GameStop. There is no need to recreate his brilliant work, go read it.
If I were a short seller, my biggest concern may actually be one of the exclusion of news. On October 8th and 9th over 153 million shares have traded on GameStop! The SEC requires shareholders of 5% or more of the company's shares to file promptly disclosing any material change in shares, for example:
An acquisition or disposition of beneficial ownership of securities in an amount equal to 1% or more of the class of securities shall be deemed 'material'.
However, acquisitions or dispositions of securities that constitute less than 1% of a particular class of securities may nevertheless be "material" on a case by case basis.
With no amendments filed by Friday night, unless something appears on Monday after the bell, shareholders can be assured that Donald Foss, Must Investment, Hestia, and Ryan Cohen have not yet sold any material amount of shares during the recent run-up and despite massive volume.
According to Ryan Cohen's filing he spent ,896,391.01 to purchase his 6.5M shares for a cost basis of approximately .98. Although we know about most of his purchases, there was a material amount of shares that he likely started purchasing back in early 2019 when my first article came out on GameStop. We know this because his filings show 4,306,295 shares purchased at an average price of .23. This means his remaining 2,193,705 shares had to have been purchased at an average price of .47 which dates his initial purchases back May of 2019 or earlier.
Therefore, he has been deliberating on GameStop for some time, and his lack of selling only further proves his motivations and intent. Ryan Cohen isn't in GameStop for a double. He knows the value of GameStop is worth well more than that. He knows what we longs have always known, which is that...
The longs were always going to win, it was only a matter of time and patience. The only question was how deep would the short sellers dig their own graves.
Apparently, not deep enough...
Short Sellers Continue to Dig Their Own Graves Deeper
According to the WSJ, the number of shares short in GameStop has increased again and is now at 68.63M. This means that as GameStop stock increased from .09 to .09, short sellers increased the number of shares short by 2.22M. The dollar amount of short interest has gone from 4M on settlement day 9/15 to 3M as of settlement date 9/30. As there are only 65.16M shares outstanding, the dollar amount of short interest exceeded the market cap of the entire company as of the end of September.
Additionally, despite the recently announced revenue sharing agreement, it appears short sellers may have increased their positions even further during the last two days as both S3 and Ortex showed an increase in the number of shares short since the announcement.
Short sellers previously had to worry about longs calling in their shares rather than lending them out. While that may still occur at these levels, now the short sellers also have to worry about funds selling out of their positions to take profits. Funds that do not track indexes likely took part in some profit taking last week. If these funds sold to longs that are not lending out their shares, it will be the same as calling shares in. The short sellers they were lending to will be forced to cover and close-out their positions whether they want to or not.
Short sellers also have to worry about a domino effect of new revenue sharing agreements, a potential sale of the European division, a redemption of the bonds, share repurchases, or a potential offer from an interested party.
While shareholders have mostly been focused on Ryan Cohen as a potential acquirer, who better to take on Amazon than Microsoft? Perhaps a Microsoft and Cohen tandem offering is in the future? It's sure fun to speculate!
Almost anything is possible...
Except bankruptcy. Even bondholders currently ascribe zero chance of GameStop going bankrupt by 2023 as both GameStop's 2021 and 2023 bonds now trade above par.
The short seller thesis is dead.
GameStop is not Blockbuster.
Will the short sellers cover willingly at to or wait to be forced out at 0 to ,000?
Get your popcorn ready - this story isn't over yet!