Gamestop Corporation: Every Dog has its Day

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  • GME is a beaten up retailer that has survived for years despite skepticism that a digital evolution will render sales of physical video games obsolete.
  • The company has survived an industry-wide secular decline in large part to its virtual monopoly in used video games which carry very lucrative 50% gross margins.
  • The market is pricing GME as if it had already begun its death spiral
  • Due to GME excessive free cash flow, which allows the company to buy back a significant part of the stock while still distributing a healthy dividend yield, shorters are competing against the clock.
  •  I estimate that the current valuation is pricing in ~10-15 % CFO decline into perputity.
  •  If GME can beat this expectation for the 5 years to come, I see significant upside. E.g. If GME manage to shrink their CFO by ~5 % per year for the next 5 years, I see an 1.5x upside.
  • I want to say GME is a buy, but I’m currently standing on the sidelines because I’m having a hard time estimating how fast CFO will fall.
  • I also see a bearish scenario were the sale of physical video games get completley crushed in the 5 years to come. In that case stockholders can lose up to < 70% of their investment (Losses are somewhat capped as I belive the dividend will be sustainible for at least 2-3 years).

GME is one of the most shorted stocks in the S&P 500 for legitimate reasons. The company’s main busines is cleary dying, as the digital evolution will make sales of physical video games obsolete. The company has accordingly been refered to as “the new Blockbuster” by the Street. The Street is pricing GME as if it had already begun its death spiral. Even if the shorts are right about the long-term outlook for GME, the stock might still prove to be cheap. The combination of abundant free cash flow, a low valuation and a management focused on shareholder value provides an opportunity for significant gains.

What the Bear says

The original short thesis on GME – that the digital evolution will make sales of physical video games obsolete – is well documented. It’s no secret that growth of the internet and high speed DSL and wireless connectivity have been extremely disruptive and even fatal to brick and mortar retailers in categories such as books (Barnes and Noble vs Amazon), recorded music (Sam Goody/Tower vs iTunes) and movies (Blockbuster vs Netflix). It’s easy to draw an analogy between recorded music or DVDs and video games and conclude that GME will meet a similar fate.

The used game model is as of now essentiell for GME’s overall exsistence. The segment comprise about a quarter of GME’s total revenue but almost 40 percent of its gross profit dollar. If you take away the majority of gross profit from used games, GME would need to trim SG&A to remain EBITDA breakeven. If you further assume that rent expense (included in SG&A) is fixed, this cost reduction might be problematic.

Furthermore, used games are more significant to GME than just its gross profit contribution.  Used games create a virtuous cycle.  Used games bring in over $1 billion in trade-in credits that gamers can use to buy new hardware and software.  Without used games, GME would have substantially less customer traffic to drive new game and ancillary sales.

The large threat to GME is that Sony, Microsoft and the game publishers are working together to usurp the used game model. It is well known within the game industry that game publishers like EA and Activision do not like new game sales being cannibalized by GME used games. For the last years publisher are very keen to move into digital sales as margins and taxes will be much more preferable. Even if GME is also moving into digital distribution, this is certainly not going to compete with the publishers as they are pushing their products strict thru the consols. Importantly, games are now available for digital download through Xbox Live and Playstation plus. With Xbox One, gamers would be able to “trade in” games digitally through Xbox Live and receive credits towards future games (downloaded, rather than purchased in retail stores). Publishers are also giving costumers numerous discounts discounts and the availability to download before release date etc to convert as many of the costumer from hardware into digital.

The pros and cons between physical hardware and digital downloads has been discussed to lenght. As I’m not a gamer myself its easier to listen to what the gamers say themselves.

Here is some of the different opinions I have heard.

Pros

  • Save physical space (Saved to cloud etc)
  • Very convinient, don’t have to move to buy it etc
  • Cheaper? No tax
  • Pre-release

Cons

  • Required to download the full game and install it, plus patch (will take time and internet data)
  • Can’t resell
  • Hard to transfer between consols
  • Sometimes required for internet to be launched, problems if servers are down
  • Might lose games if consols breakes down and becomes obselete
  • Alot of people enjoy collecting physical games.

Summarizing its seems obvious that the future is converting to a more digital enviornment. The more interesting question is how slow this process will take.

What the Bulls says

There are several reasons why technology may not be fatal to GME’s brick and mortar business, or may take longer than the bears are assuming. Not everyone has access to a high speed internet or Wi-Fi connection, and not everyone has a video game console that can accommodate downloads. The majority of GME business comes from the U.S. New research has shown that mobile data users in the U.S. pay far higher data fees and experience slower network speeds than data users in foreign countries. Market researchers at Ookla have revealed new data about the state of LTE mobile internet speeds offered by American service providers.

According to Ookla, Fixed broadband customers has download speeds achieving an average of over 50 Mbps. Mobile internet customers has an average download speed of 19.27 Mbps. Even more disturbingly, while Americans have to suffer through slow mobile data speeds, it has also been reported that US data prices are far higher than in other countries. For example: while German T-Mobile customers pay only $1.19 per Mbps for their LTE connections, American customers using Verizon’s service had to hand over $4.05 for the same amount of data.

Unlike downloading a song to an iPod or a book to a Kindle, downloading a full sized video game to a gaming device can still take a long time and may use a very large amount of storage.  At present, large Xbox One games are 40-50 gigabytes. Being 4k ready, it would be feasible for an Xbox game to easily be 100+ gb, especially considering there is likely to be a virtual reality component to the new set. Assuming present internet infrastructure on average gives most consumers fairly long download times. This might not be an optimal solution for the average consumer on the day of a hot release, with all gamers accessing the same server at the same time to download the same game.

While I expect download speeds to continue to increase, and storage costs to continue to fall, the games themselves will continue to grow as well.  Game developers are more focused on improving the gaming experience than optimizing the code to facilitate downloads. Over time however, I would expect downloading technology to replace some of the hard copy sales of games.

Physical games also have a perceived trade-in value of ~$20 which lowers the net cost of a new ~$60 game to ~$40, making it cheaper than a full-priced $60 digital equivalent.

Latest updates

With the emergence of next generation consoles and new technologies, most of the bull case impediments have/will been removed. First, new consoles can now store a greater number of titles , well more than what the average gamer owns at any one time. Second, both Sony and Microsoft have deployed pre-loading software this summer, enabling customers to download games at their leisure well in advance of the official release date but get instant access at midnight. As a result consumers can bypass the antiquated experience of standing in line outside a store for hours. Third, both Sony and Microsoft are regularly offering $10-15 store credit for games purchased through their online platform. Such discounting, among various other promotions , disintermediates the perceived $20 trade-in value of a physical copy while further locking customers into a publisher’s digital ecosystem.

As an example, for the month of December PlayStation Plus subscribers can download free copies of the following:

  • Injustice (currently $19.99 new and $17.09 used at GME)
  • Secret Ponchos (PC game not sold by GME but $14.99 on Steam)
  • Hitman HD Trilogy ($19.99 new and $17.09 used at GME)
  • Deadly Premonition ($39.99 new and $17.99 used at GME)
  • Final Horizon (Not available elsewhere)
  • Titan Attacks! (PC game not sold by GME but $9.99 on Steam)

Keep in mind that this represents just one month and that over the course of a year subscribers get access to a tremendous number of titles, many of which they would have otherwise purchased in a store. These offers appeals the most to aggressive used-game consumers, those who constantly purchase and resell used titles, by providing them with a massive catalog of older games that they can download fromchoose from to download.

This scant coverage also applies to the latest efforts by Sony and Microsoft to push digital subscription adoption even further. Sony has been beta-testing a streaming service called PlayStation Now, which is a cloud gaming service. The platform allows users to pay for access to a selection of original PlayStation 3 titles on either a per-game basis or via a subscription, with playstation 4 games comming to playstation now sometimes in 2017.

Thus, rather than purchase a used game from GME for ~$10 and resell it later for ~$1, this service allows budget conscious customers to pay $10 for the same experience minus the physical hassle. In all likelihood, both companies will officially launch streaming subscription services sometime next year, giving consumers instant access to immense back catalogs of titles. These services will appeal the most to GME’s best and most reliable used game customers, who will transfer their highly lucrative used game purchases permanently to digital. In short, this is the used video game industry’s equivalent to Netflix. Summurazing, streaming is the inevitable future for games as hardware will become obselete. How fast this shift will happend is however the real question to answer in this case.

Unlimited data? If Data caps roll out as more common through household ISPs, it’ll stifle digital distribution plans for video games as they grow in size. As far as data usage, it looks like PS now averages about 10 mbps, so about 4 Gb per hour. That’s only about 60 hours of PS now gaming a month on a 250Gb/month plan, assuming you or anybody else in your household don’t use internet for something else.

As of October 2015, there were 58 wired broadband providers in the US that used data caps, among them major wireless cell phone providers such as Verizon Wireless and AT&T.[3]

Playstation now has got terrible respons from customers. Playstation now is before its time.

Valuation

To be continued…

GME management are well aware of the shift in the business. As a result the company has successfully started to diversifying away from its main business via Springmobile, SimplyMac, and ThinkGeek (along the way becoming the largest AT&T mobility retailer in the US). As of 2016, non-physical gaming represented 36.9 percent of operating earnings. The next two-five years will be crucial in transforming the business away from its core into Technology Brands and Collectibles. It’s my opinion that sales declines will still be unavoidable, and gross margins will take a hit, but the interesting question is if the sale decline will be faster than whats priced in. As its nearly impossible to say with precision how fast the digital revolution will continue and with what magnitude it will affect GME, the long term investor should aim to buy with margin of saftey. I will therefor use very conservative assumptions in my valuation.

 

GameStop is currently reviewing its property portfolio and when possible closing unprofitable stores.

Very stringent cost controls and a sensible and phased reduction in store count will be key.

Anyway, payroll cuts are very unlikely for right now. We’re pretty much at the bare minimum as it is: ~87 hours are required to operate at single coverage for the week, and most stores (in my district) only receive 118 (which is +31). That’s broken up by 44 SL + 32 ASL + 42 Parttime. Reducing this any more would mean staff cuts as well, and would severely impact any store’s ability to train employees. At that point, they’d be eliminating the GA position entirely. All in all, I doubt it’ll go any lower. Though I’ve been surprised before.

We were successful in cutting over $32 million in SG&A from our core business, seating our target for 2016 of $30 million. Cuts came in store expenses including payroll and an infrastructure and back office cost. We are on-track to remove $100 million SG&A cost by the end of 2019.

In 2016, we closed a net of 119 video game stores around the world, ending the year with 3920 video game stores in the U.S. in 2007 internationally. We acquired 511 technology brand stores opened and opened another 72 and closed 97 for a net growth of 486 stores and the year ending store count of 1522. We opened a net 51 collectible stores during the full year and now have 86.

 

 

 

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