Gamestop: Evaluating A Cigar Butt

Gamestop is an excellent company to examine how the past and even current financial statements do not always provide great indications of the value of the business.  Additionally, Gamestop provides an excellent lesson in capital allocation decisions.  Another lesson from Gamestop is an on the ground due diligence efforts can yield effective and quick results.  

Quick round-up of the recent numbers:

2015 2014 2013 2012 2011 2010
Revenue 9364 9296 9040 8887 9551 9474
Operating Income 648 618 657 411 570 663
Operating Cash Flow 657 481 763 632 625 591
Capex 173 160 126 140 165 198
Acquisitions 268 77 96 2 30 38
Shareholder Returned 348 480 389 511 262 381

On a valuation story, GME looks attractive.  Some rough numbers:

  • 105m shares outstanding x $27 stock = $2.835B
  • $350m LT Debt (GME recently issued another roughly $450m debt, which I will exclude because I am using the historical operating earnings and those earnings do not include the results of the recent acquisition).
  • Total EV= $3.19B
  • Operating Cash Flow average over past 5 years: $600m
  • Maintenance Capex: approximately $100m (this is probably a low estimate)
  • EV/FCF: Approximately 6.5x.  This looks good, but….

The numbers look great, but the health of the underlying business is not so positive.  Gamestop management knows that the physical video game business is dying and is actively directing capital towards alternatives.  The investment case needs to answer two questions.

  1. How quickly will the video game business die?
  2. And how effective will the capital allocation of management be in directing the remaining cash flow towards new ventures?

These questions are not difficult to frame, but much more difficult to answer.  There is a lot of digging around in trying to determine the answers to these questions.  I decided to go to a few stores.  I noticed a few hard-core “gamers” and asked them if I could have a few minutes of their time to chat ($20 for 30 minutes can buy a lot of Mt. Dew and doritos).  I did this at 2 different stores with two sets of teenage gamers.  

Why do you shop at Gamestop?  How has your buying decisions changed over the past 3 years? What brings you to the store?  How often do you come to the store?  

The answers were obvious to them, but educational to me.  Cheap diligence and highly informative.

The basic gist of the conversations was that these gamers rarely, if ever, purchase games in Gamestop anymore.  Amazon, Target, Walmart and basically any other place is cheaper.  Online delivery from Amazon is free and usually 10-20% cheaper.  The games arrive the day of the launch.  The only reason they could even think to buy games in the store was if they did not have access to a credit or debit card (a requirement for online shopping).  Old titles were cheaper new at Amazon or Target than those same games are used at Gamestop.  

The primary motivation for going to the stores was show-rooming.  The gamers enjoyed looking around and talking to the employees, who they indicated were very knowledgeable.  Visiting the stores was also a habit, since they used to purchase games there.  But not anymore.  

Gamestop is struggling with this shift and its solution is to buy a lot of retail phones stores.  Lots and lots of retail phones stores.  From 2013 to 2016, Gamestop has acquired or opened over 1500 retail phones stores.  You may recall a similar strategy from Radio Shack.  It did not work there.  

I do not know if the shift will work.  I don’t have an answer to either one of the questions above.  Based on the time I have spent, the shift at the Gamestop stores is happening quickly, i.e. gamers have moved on or will continue to migrate to other areas.  

The decision to allocate capital to the retail phone locations may prove to be intelligent.  It is early and difficult to tell.  I cannot think of one single advantage Gamestop has in running their locations versus other operators.  They are selling goods provided by the manufacturers on standardized contracts to customers who are fairly mobile in their choices.  The options are plentiful, buy online, at AT&T/Verizon/Sprint/T-Mobile store, Best Buy, Apple, etc.  The investment case here is basically that the tail of the retail gaming stores will be longer than the market expects and that the retail phone locations will provide adequate returns going forward.  

This is an easy no for me, for two reasons.  First,  I cannot easily answer the two questions from above.  I just don’t know.  And, I am not sure any additional hours of due diligence will provide concrete answers.  Second, if the market is under-appreciating the long-tail nature of the physical game stores, the stock will go up and I will need to sell.  I cannot envision a scenario where Gamestop, as a retail phone store, will become a compounding machine.  In other words, the business itself could be undervalued at this moment providing near term (1-2 years) appreciation in the value of the company.  However, I see this more as a one-time revaluation of the business instead of a compounding machine that will generate significant equity returns over a long-term holding period.  This may be a high bar for an investment decision, but considering the downside to Gamestop could be significant if the tail of the physical store is actually shorter than the market currently sees (or the retail phone stores turn out to be a mistake), one should require a high margin of safety or upside on the investment.  Neither a strong margin of safety or significant upside is present in Gamestop.  

 

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