Geoff Gannon May 25, 2018

Gamestop (GME): A Risky Stock that Just Might be the Cheapest Billion Dollar Stock in Today’s Market

Member write-up by Vetle Forsland


Business Overview

GameStop is the number one video game retailer in the world, the largest AT&T retailer, the largest Apple products reseller and one of the world’s largest sellers of collectibles. The company had 7,276 stores as of February 3, 2018 all over the world, with over 5,200 of them in the US. They are also one of the world’s biggest buyers and sellers of used games. That means that people buy physical video games from a shop like GameStop, and when they are tired of playing the game, they can sell the game to GameStop at a discounted price. GameStop sells these games at a higher price, which allows gamers to buy used physical games at a big discount to new games. This segment makes up the largest proportion of GameStop’s gross profit, with 32% of all gross profits, but only 23% of sales, as a result of their terrific margins.


The video game segment of the brand had about 5,900 stores as of February this year, whereas 70% of these stores were located in the US. Most of these stores are GameStop-branded, but they also own store brands like EB Games, Micromania, ThinkGeek and Zing Pop Culture. Furthermore, they own Game Informer, which is the leading video game magazine in the world, and is actually the fourth most popular magazine in the world, with over 7 million monthly paid subscribers per month. It’s also the largest digital publication in the world.


GameStop’s “Technology Brands” contains 1,329 AT&T branded retail stores, where they sell AT&T services, DIRECTV service and electronic products. This segment also consists of 48 Simply Mac branded stores which sell and repair Apple products. Their technology brands make up 8.7% of sales and 19.5% of gross profits. It was a part of their attempt a couple of years ago to diversify away from the video game industry, and it has since been deemed unsuccessful as they recently wrote off about $360 million from the technology brands business. GameStop was pressed to decrease the equity value of the investment as they realized phone owners won’t switch models as frequently as in the past, which makes sense; newer phones aren’t evolving as drastically in quality as they used to.


The consensus today is that GameStop’s business – a video game retailer – is redundant in an age of online shopping. GameStop’s flagship “products” have always been hardware like the newest consoles and physical video games. However, PC Gamers have almost exclusively stopped buying physical video games, as only 20% of all PC games were sold in physical form last year. GameStop shareholders fear that the same will happen to console games and consoles. These two segments, if we include their used games segment, made up 57% of gross profit in 2017. So, I guess in an absolute worst case scenario, where all console gamers switch to digital, GameStop will lose around 60% of their value. The stock has fallen 80% since its peak of $60 in late 2013. This write-up will argue why that might be an overreaction.


The Next Step for Physical Video Games

While PC games have long moved to platforms like Steam and Uplay, console games are still widely sold in physical form. EA predicted that by the end of 2017, 40% of all console games would be sold digitally. I haven’t seen any statistics on this (yet) to confirm if their prediction was correct, but time will tell. There are however, a few reasons why a consumer wouldn’t want to buy their console games online.


Firstly, buying a console game digitally is not as easy as buying a PC game online. On PC, Steam’s UI and the fundamentals of a computer (mouse, keyboard) makes it easy to navigate the platform, buy a game, and then play it in a couple of clicks. But, if you have ever bought a game on PS Store, it’s a tad more difficult. You don’t have a keyboard, which is one problem, and in my experience, the UI is far from as good as the one you get on computer platforms like Steam or Origin.


Secondly, consoles have a limited amount of memory, while games are getting increasingly larger in size. For instance, the PlayStation 4 has a memory of 500GB, while the Xbox One has 1,000GB (1TB). In comparison, Forza 7 takes 100GB of space, the newly released God of War is 45GB, and the latest Call of Duty is “only” 45GB (Gamers were actually relieved when Activision released the file size of the latter– that tells you how games sizes have gotten out of control recently). In essence, a gamer cannot have more than 20 games installed on their console at once. That is a big con for many gamers. On Steam, you will often see people (including myself) with close to 100 games, all installed and ready to play. This isn’t possible on consoles. Therefore, there will always be a demand for having a disc you can simply put in and out of the console and play on your command.


Furthermore, large games like the aforementioned require high-speed internet to download. Games are developed in cities, where they have fiber, so developers don’t really take this into account. Rural cities do not have fiber internet, which means slower internet and a longer download time. The average American home has a download speed of around 15 mbit/s (surprisingly fast – there are thousands of homes that rarely get much above 2 mbit/s), which means that it would take eight hours to download one 50GB game. Meanwhile, the average American lives “within a mile” from a GameStop store, to quote company executives. There is also the unreliability of a stable internet connection. So, many people would rather pick up a game at GameStop, and play it right after the payment has been made, rather than wait a day or a night for a game to download. The same goes for buying a physical copy of a game off Amazon. While same-day delivery is possible, most people will have to wait about 2 days for their package to arrive. That’s two days too late for anxious gamers.


Additionally, you can’t resell a digital copy of a game. Once money is spent on a game online, none of that money can be won back through trading. A GameStop buyer could resell the game later, and if they are members of their loyalty program (more on that later), get extra perks from the retailer.


Management and Capital Allocation

As a cash cow, the way management distributes their free cash flow is a vital part of GameStop’s success – or failure. And, of course, as a company that is struggling, management has to be innovative about what to do in order to create value for shareholders. They have made some bold changes in the past, both good and bad. Between 2013 and 2017, the company reduced its GameStop-branded store count in the US by 9%, or 385 stores. This move proved to be largely successful, as profits per store increased from $83,000 to $102,000 in four years.


They also drastically expanded their loyalty program, which means that the retailer understands the importance of building a faithful relationship with their customers. GameStop have grown its PowerUp Rewards program from 7 million customers when it first launched in 2010, to 37 million in 2017. 6.3 million of these members are paying members, which is down by 2 million since its peak in 2011, but flat since 2014. The Elite Pro version (and the most expensive version) costs you $30 a year, and gives you 20% off pre-owned games and accessories, 20% bonus trade-in credit on games, free 2-day shipping, a 12-month subscription to Game Informer and occasional special discounts. The “Pro” version gives you all of that, but instead of 20% on the discount/bonus above, you get 10%. The latter costs you $15 a year. It sounds like a good deal if you’re a frequent buyer of games and gaming accessories. For instance, if you spend $150 on used games in a year, you will have made up the $15 cost in savings. If you’re an Elite member, buying three “new” games make up the $30 cost, as the latest Call of Duty costs $40, after a $10 Elite discount. On top of that, you get points per purchase that can be used towards occasional coupons for pre-owned games. Plus, you get Game Informer, which is a decent magazine if you’re into gaming. As the paying members count has been stable for three years now, I think many gamers agree with me that the PowerUp reward program is a pretty reasonable deal, as long as you buy used games from GameStop a couple of times a year.


In 2015, GameStop acquired ThinkGeek, a novelty retailer that caters to geeks and gadget enthusiasts. The sold products include clothing, electronic and scientific gadgets, unusual computer peripherals, office toys, pet toys, child toys, drinks and candy. These are usually standalone stores, but some stores have a GameStop branded store on top of the ThinkGeek store, where they seamlessly blend into each other. While it would be logical to think people that shop at ThinkGeek already shopped at GameStop too, these stores actually have surprisingly different demographics. Whereas the average GameStop customer is a male in his 20s, the average ThinkGeek customer is a female in her 30s. Therefore, GameStop managed to expand their core demographics without stepping outside of their comfort zone, risking a “diworsification”.


One expansion by the retailer that might be considered a diworsification, is their infamous acquisition of Spring Mobile, and the consequential purchases of hundreds of AT&T stores. In November 2013, they acquired the mobile service company, and then acquired 507 additional AT&T stores in the fall of 2016. Today, they own and operate 1,329 AT&T branded retail stores, that sell AT&T services, wireless products, and consumer electronics products. GameStop spent millions of dollars (mostly raised through assuming more debt) on a segment that has nothing to do with their specialty, video games.


That doesn’t mean I didn’t like the idea. But, the execution was poor. GameStop’s response to operating in a failing industry was to acquire a company in a different sub-segment in the same failing industry. That, in essence, is the definition of diworsification; spreading revenue by going into a new segment as an act of defense. In this particular situation, I think the end result would have been better if GameStop actually acquired something that wasn’t a retailer. I’m not sure what. But GameStop’s management should have foreseen the downsides of owning a mobile service retailer, that we are just now seeing materialize, in the form of a $360 million write-off. Furthermore, those hundreds of millions of dollars spent on AT&T stores could have been spent on paying down a huge chunk of their current $800 million debt. Their technology brands segment isn’t all bad, however. It accounts for about 20% of their gross profits, which means they successfully managed to diversify their profit stream.


Despite that, their capital allocation has been a bit all over the place. They probably tried to do everything they could to stop the stock price from falling despite decent business results. Remember that about 40% of the shares are sold short. So the management would try whatever they could to stop the stock from plummeting. First, they buy back stock – at levels much higher than they are today – that doesn’t stop it. Then, they say they are diversifying. That doesn’t stop it. Then they initiate a dividend and now they are left with a stock with a 12% dividend yield. They probably expected this dividend to put more of a floor on the stock than what we’ve seen. Right now, they are using about half of their free cash flow on dividends, then another 7% on share buybacks and 7% on paying down debt. Personally, I think it would make more sense for these numbers to be flipped, and then spend more cash on acquiring other businesses or expanding its collectibles and digital efforts instead. The capital allocators probably agree with me here too, but they are so obsessed with slowing down a share price in free fall, that their number one priority right now is to please Wall Street.


So, if I somehow knew that GameStop would spend more cash on buying back stocks, paying down debt, and working on improving their revenue streams – I would be more comfortable buying the stock. I know they have talked about improving the non-video game segments of the business. That’s a good start. But right now, while their high dividend yield is attractive, it certainly doesn’t offer the best return on capital for the company itself.


2018 GameStop May Be Like Buying 2013 BestBuy

GameStop stock is absolutely loathed by the market. With a short float of over 40%, the stock price has been in constant decline since 2014. However, while the stock has been in free fall, revenue is actually down only 5%, while gross profits and EPS are both up around 13%, the latter as a result of successful diversifications into high-margin segments like collectibles.

Furthermore, analysts tend to underestimate GameStop’s quarterly performance. EPS has met or beat analysts forecast in 17 of the past 19 quarters as of Q4 2018. The last time GameStop missed on EPS was in Q3 of 2015 – 9 quarters ago. Basically, the stock market is pricing in a disintermediation that MIGHT happen. It hasn’t really happened yet.


We can draw parallels between GameStop today and Best Buy from 2010-2013. In this three-year period, financials for Best Buy were mostly flat, while the stock price fell from $44 per share to $11 per share, or a staggering 75%. Then, it turned around, and the stock is now trading at an all-time high of $78 per share. The interesting part of this story is that nothing significantly changed financially around that time. Additionally, gross profits and revenue is slightly down since the stock price kissed the 11-dollar mark – but the stock price is more than 7 times higher. There is no way that Best Buy was efficiently priced at $40, then three years later at $11, and then again at near $80 in 2018. The market quite simply shifted its viewpoint on the company, from a detested retailer to a market winner, and the stock price reacted accordingly. It is very similar to GameStop. In both cases, you had a retailer with an EV/EBITDA below 5 and an F-score of 5-7 for several years. The only difference is that at some point, Best Buy’s sentiment changed, which caused its multiple to expand rapidly. Granted, they did take some serious actions to turn the ship around, most notably by cutting prices and re-shaping their stores to make it more like an electronic department store,but the comparison is still very valid.


Something similar might happen to GameStop. If we go back to SeekingAlpha write-ups on Best Buy back before the turnaround, we will find headlines like “Best Buy Going to Single Digits”, “Management is Fooling Shareholders”, “No Country for Best Buy” and “It’s All About Internet, Stupid” (keep in mind that the then-CEO has later been praised for his efforts). Comparing this to the GameStop write-ups today on the same website, and you can come to the conclusion that the GameStop sentiment today is awfully similar to the Best Buy sentiment back before the stock turned around.


GameStop Is Cheap On All Measures

GameStop is the kind of stock that will show up on deep value screens. It is trading at an EV/EBITDA of 2.3x, if we exclude their one-time asset impairment. If we include the latter, as it certainly is a notable charge on the company, the stock trades at 4.4x EBITDA. However, in order to look at GameStop’s actual multiple on a historical basis, I think we’re better off by excluding the write-off. After all, a similar charge will probably not occur again. Therefore, the company has a dirt cheap P/E of 3.5, and an EV/Sales of 0.14. The stock also has a FCF yield of 24% and a dividend yield of 12%. That equals a free cash flow of $395 million, up from $394 million in 2016 (a yield of 13%) and down from $484 million in 2015 (a yield of 17%).


All of this makes GameStop perhaps the cheapest billion-dollar stock on the market. Or is it a value trap?


GameStop has an F-score of 6, which indicates that the company’s financial situation is “typical” for a stable company. In other words, it’s a decent score. During the past 13 years, its median F-score has also been 6, while the maximum was 8 and the minimum was 5. Furthermore, EV/EBITDA has consistently been in between 2.6-5, excluding a brief period in late 2016, when it hovered above 6x. What does this tell us?


To give you an extreme example, the market has a Shiller P/E of 32 and GameStop has an unadjusted Shiller P/E of 5.6. And, it’s a leader in what it does, and has the same F-score as an average company in the S&P 500. Usually, you only get Shiller P/E’s below 6 when a company is seriously financially distressed. We can’t say that about GameStop. It’s a huge cash cow, it has about the same amount of current assets as total liabilities, and has net cash. There is no immediate bankruptcy risk here.


In 2017, GameStop reported adjusted EBITDA of $535 million. The average retailer trades at an EV/EBITDA of 10.4x, compared to GameStop’s forward multiple of 2.5x. The latter multiple assumes that EBITDA decreases by 6% in 2018 (GameStop forecasts their sales to decrease from 2% to 6%). The lowest multiple for any retail-segment is for Grocery and Food-retailers, trading at 7.2x EBITDA. GameStop’s revenues have decreased 2% annually over the past five years, while operating profits have decreased something like 0.4%. If we are conservative, and assume that GameStop’s EBITDA will decrease by 5% annually over the next five years, that gives us a 2022 EBITDA of $414 million. Over these five years, if GameStop manages to turn 75% of their EBITDA to Free Cash Flow, the company will accumulate $1,775 million in cash, or about 150% of their current Enterprise Value. In other words, your downside protection is the massive amount of cash GameStop produces. GameStop can spend this money on dividends, share buybacks, paying down their $800 million debt, let cash pile up on the balance sheet, or make a major acquisition. But, in the end, this is money that will go to the shareholder. Even if we assume that GameStop will generate as little as $414 million in EBITDA every year over the next five years, and that their FCF margin shrinks to 65% of EBITDA, the company still manages to build a cash position of $1,346 million, or their Enterprise Value and then some cash.


I mentioned that the lowest multiple for any segment of public retail companies is 7.2x EBITDA. That is almost three times as much as GameStop’s forward multiple. If the market revalues GameStop at something like 5x EBITDA in five years, we get an Enterprise Value of $2,070. That’s a potential share price of $20 per share, or an annual return of 9%. On top of this, they will generate $1,346 million in cash, or an additional $13.2 in cash per share (the share price GameStop is currently trading at). So, in a somewhat positive scenario but with certain conservative additions, GameStop stock will be worth around $33.2 per share in 2022. That’s an annual return of 19.4%.


That doesn’t necessarily mean you will get a 20% return on your money if you buy GameStop today. There are many things that can go wrong with this stock. This downside scenario is widely reported in other media, but even in that case, you get your money back in cash for as long as you hold the stock. You may wonder why I didn’t apply a more “appropriate” multiple for the company; it’s because the disintermediation expectation won’t vanish.  However, the upside potential in this stock isn’t that the market realizes GameStop won’t deteriorate – it’s that the disintermediation doesn’t continue as rapidly as expected, not to the same degree as expected, it remains in a state that is not as undesirable as expected, or GameStop’s diversification effort is more successful than expected. I believe it’s clear that at least one of the above is true, given the diversion between the retailers’ financials and stock price.



GameStop is a great stock to put in a value portfolio of 20 stocks. However, if you are a concentrated investor, I don’t think we can ever be certain enough on the thesis to make it 20%+ of an individual’s net worth. It is a risky stock. It can either make you a lot of money or, you can lose some money. In that sense, it is similar to the previous stock I wrote up on Focused Compounding, Entercom. But while the stock price might decrease, you will accumulate a double digit free cash flow yield which acts as a downside protection. I think Benjamin Graham might have put GameStop in his portfolio, and it would make sense – if there were more dirt cheap retailers out there – to buy a basket of retail stocks like GameStop. But, I doubt someone like Geoff Gannon would buy it when his portfolio is so concentrated.


I will round off this write-up with a fitting quote by Benjamin Graham:


“When investors rejected the stocks of secondary companies, even though these sold at relatively low prices, they were expressing a belief or fear that such companies faced a dismal future. In fact, at least subconsciously, they calculated that any price was too high for them because they were heading for extinction–just as in 1929 the companion theory for the “blue chips” was that no price was too high for them because their future possibilities were limitless. Both of these views were exaggerations and were productive of serious investment errors.”