GAMESTOP CORP GME S
June 07, 2013 - 12:46pm EST by
nathanj
2013 2014
Price: 37.00 EPS $0.00 $0.00
Shares Out. (in M): 119 P/E 0.0x 0.0x
Market Cap (in $M): 2,149 P/FCF 0.0x 0.0x
Net Debt (in $M): -246 EBIT 0 0
TEV ($): 1,904 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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  • Secular decline
  • Retail
  • Misunderstood Business Model
  • High Short Interest

Description

GME is a timely short ahead of new game console announcements at E3 next week. 

GME is a controversial name as evidenced by the high short interests (35% of float) and the number of bullish and bearish posts on VIC and other forums.  The original short thesis on GME is well documented.  That is, GME a value trap being disintermediated by digital distribution.  Yet, the shorts on many value trap names such as GME and BBY have been bludgeoned this year.  Moreover, GME investors are giddy over the growth prospects of a new console cycle.  As a result, GME shares have risen 50% YTD.

So why is now the time to short GME?  While the digital distribution short thesis is still valid, I believe the threat to GME’s used game business is even more significant and imminent.  First, Wall Street is underestimating the importance of GME’s used game model to its overall existence.  Second, Wall Street is underestimating the impact of the upcoming console cycle on GME’s used game model.  Finally, the first two points will become clearer to Wall Street next week as Microsoft and Sony provide details of their new game consoles.  I believe GME should trade below $20/share (> 40% downside).

Previous GME write-ups on VIC provide good background on the company so I’d encourage new investors to take a look.  Here I focus on the key issues confronting GME’s future existence.

Importance of used game model

Used games are vital to GME.  They comprise about a quarter of GME’s total revenue BUT almost half of its gross profit dollar (see Table 1).  If you take away the entire gross profit from used games, GME would need to trim $350m from SG&A to remain EBITDA breakeven.  This amount represents almost 20% of GME’s SG&A.  Further, if you assume rent expense (included in SG&A) is fixed, GME would need to cut almost 85% of its ex-rent SG&A expense to breakeven.  How is this remotely possible?

Wall Street seems to have missed an even bigger point: used games are more significant to GME than just its gross profit contribution.  Used games create a virtuous cycle for GME.  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. Yes, this means the whole GME model would be broken. 

Even in the scenario where GME is allowed to participate in used games but must share the economics with publishers, GME’s model would still be broken.  This is because GME would no longer keep 100% of the profit on used games.  To maintain the same profitability as the current used model, GME must either reduce trade-in credits or raise prices on the used games it resells.  The former option would make trade-in less compelling for gamers, and would generate fewer credits for gamers to buy additional games at GME.  The latter option would drive down the resale of used games because they are now more expensive.

Table 1: Income Statement

$mm

2010

2011

2012

New HW

 $     1,720

 $1,612

 $  1,333

New SW

3969

4048

3582

Used

2470

2620

2431

Other

1315

1271

1540

  Total rev

9474

9551

8887

 

 

 

 

New HW

 $        125

 $    114

 $      102

New SW

820

839

786

Used

1141

1221

1170

Other

453

506

593

  Total GP

2538

2680

2652

 

 

 

 

New HW

7.3%

7.0%

7.6%

New SW

20.7%

20.7%

21.9%

Used

46.2%

46.6%

48.1%

Other

34.4%

39.8%

38.5%

  Total GM

26.8%

28.1%

29.8%

 

 

 

 

SG&A

 $     1,699

 $1,842

 $  1,836

 

 

 

 

EBITDA

838.8

837.4

815.6

  Margin

8.9%

8.8%

9.2%

 

 

 

 

Rent expense

381.9

399.2

394.7

SG&A - rent expense

456.9

438.2

420.9

 

 

 

 

EBITDA - Used GP

-301.7

-383.8

-354.5

  % of SG&A

17.8%

20.8%

19.3%

  % of SG&A - rent

66.0%

87.6%

84.2%

 

Upcoming consoles will upend GME’s business model

Wall Street believes the new consoles from Microsoft and Sony offer hope for a new growth cycle.   Both consoles are expected to launch later this year.  As such, GME stands to benefit as gamers trade in old systems/games this year and buy new systems/games over the next several years.  I don’t disagree with the former, but I don’t believe the latter will help GME.

The bigger problem for GME is that the Microsoft/Sony and the game publishers are working together to usurp the used game model from GME.  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’s used games.  They have been experimenting with online registrations and digital downloads on current-gen consoles as a first step to combat the used model.  The next-gen consoles will take this even further.  Two weeks ago Microsoft previewed the Xbox One and gave compelling evidence that Microsoft will take over the control over the used game ecosystem. For background, please see the following two Wired articles:

http://www.wired.com/gamelife/2013/05/xbox-one-analysis/  http://www.wired.com/gamelife/2013/05/phil-harrison-xbox-one/

Yesterday Microsoft issued a press release detailing how games can be shared and resold for Xbox One:  http://news.xbox.com/2013/06/license.  At first glance, GME bulls are relieved that used games will still be allowed.  However, I believe the bulls are misguided.  GME’s used game model is changing and it’s only getting worse.  Specifically, Microsoft stated that “third party publishers may opt in or out of supporting game resale and may set up business terms or transfer fees with retailers.”  Simple question: why would Microsoft enable this functionality if publishers are not going to adopt it?  

Importantly, games will be made available via digital distribution through Xbox Live on the day of release of the packaged product (vs. 3-6 month delay currently).  This is further evidence of Microsoft’s push into digital distribution, further hastening the demise of GME’s new and used disc game model.  There are obviously more questions to be addressed, but it’s quite clear that the GME’s existing model is only going to get worse. 

There is also another hint from MSFT on what’s to come in a separate (and subtle) announcement yesterday: http://news.xbox.com/2013/06/connected. MSFT is saying you need to authenticate via Internet every 24 hours.  This means every valid game needs to be linked to an Xbox Live account, which implies that you need to acquire (my read: buy) an Xbox Live account link when you buy a used game at GME.  I don’t think MSFT is going to give away free Xbox Live link to every one of its used games at GME.

What we have heard from game industry sources is that ultimately Microsoft would like to create its own used game ecosystem.  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).  Game publishers would get a cut in this scenario.  Where GME plays is still unclear. It’s safe to assume that whatever role GME plays in the new ecosystem, it can only go downhill from the current system. 

Sony has not publicly commented on their used game strategy for the new Playstation.  I do not believe their plan will deviate from that of Microsoft.  Both console manufacturers have been steering towards digital distribution when they launched the PS3 and Xbox 360.  Having their own used game ecosystem (delivered digitally) is the natural next step.  Several game publishers themselves have confirmed this privately as well.  If you need more proof, take a look at Take-Two CEO’s recent comments regarding used games at the Cowen conference in late May: “we are somewhat hopeful that the new consoles will help us participate in used game sales.”

GME’s future (or lack of) will become increasingly evident at E3

What has hurt the GME shorts this year has been an absence of a clear catalyst.  I believe the catalyst has just begun.  Microsoft previewed the Xbox One on May 21st.   Since then GME shares dropped as low as 20% from $39 to $31 before recovering to $35 this week.  Today the stock is up another 7% as bulls rejoice over Microsoft’s still somewhat ambiguous statements on used games. This share recovery would indicate GME investors are still in denial over or underestimating the potential threat. 

GME declined to comment on the new used game model on its May 23rd earnings call, deferring to the console manufacturers.  I believe this is a sign of weakness.  If they know it’s going to be status quo, why not just say so.

Both Microsoft and Sony will reveal even more details on their new game consoles on Monday, June 10th at the industry’s annual E3 tradeshow.  By that point reality should sink in.

Valuation

GME currently trades at 5x TTM EBITDA.   To be conservative, I assume GME can retain some portion of its used business and cut SG&A expenses to get its EBITDA to about 50% of 2012 level.  Even in that scenario, 5x EBITDA gets you to about $18-20/share.

Risks

MSFT and Sony remain ambiguous: I think the cat is already out of the bag on the used game model.  Yet, Wall Street could still misinterpret the ambiguity as positive for GME, as evidenced in recent bounce in GME shares.  I believe this delusion won’t last as details can only get more obvious, especially as publishers will now freely discuss their intention on used games.

Continued share buyback: GME has been aggressively buying its shares over the past few years, but interestingly they’ve slowed down the pace of buyback recently.  In the just completed Q1, they bought back only $25m, compared to $81m in Q4 and $125m in the prior year quarter.  I’m guessing GME is concerned enough about an uncertain future to slow the pace of cash deployment.

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Microsoft and Sony press events at E3

Updated news coverage of used game model for new consoles

Investors understanding implication of used game model for new consoles

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