|Shares Out. (in M):||141||P/E||9.7x||9.0x|
|Market Cap (in $M):||3,613||P/FCF||9.4x||8.5x|
|Net Debt (in $M):||-344||EBIT||663||665|
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The Bear Case
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 (consider Barnes and Noble or Borders versus Amazon), recorded music (Sam Goody or Tower versus iTunes) and movies (Blockbuster or Movie Gallery versus Netflix). It's easy to draw an analogy between recorded music or DVDs and video games and conclude that GameStop will meet a similar fate. As of April 15, 38 million shares (27% of shares outstanding) of GME had been sold short.
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. 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. It takes about 1.5 hours to download a one Gigabyte game over a typical home DSL line that functions at 1.5 Mbps. Many full sized games are in the 5 Gigabyte range, and would take nearly eight hours to download over a 1.5Mbps connection. (There is a chart on gamestop.com that shows download times based on varying connection speeds and file sizes.) 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. GameStop is already participating in the downloading arena, and has indicated that it plans to continue to build out this capability. The most popular downloads on GME's website seem to be ancillary items, such as maps that are added to existing games.
In my opinion, the biggest issue with digital distribution is that it leaves the gamer without a game that he can sell or trade. GameStop has developed a business model with three legs: new games, used games and consoles and other accessories. Unlike book, music and movie buyers, many gamers trade their games in for a credit towards a "new" game. Used games generated $2.5 billion of GME's $9.5 billion of sales in 2010, and $1.1 billion of GME's $2.5 billion of gross profit. Gross margins on the used games are more than double the gross margins on new software. In the bear case, growth in digital downloads wipes out the market for new games and destroys the used game market as well.
I think many bears are underestimating the importance of this trade-in model to the consumer. If a new game costs $60, and a used game costs $10 to $15, GME is selling several times more units of used games as it is of new games. The flip side of this is that the consumer who gets a new game is actually getting 4 or 5 games if they are willing to trade in their game when they get tired of it. Think of a typical GameStop customer, who gets a new game from his parents as a gift, then trades it in a few months later (possibly with a few dollars of cash) for a used game. The cycle can be repeated several times during the life of a game. For a consumer who has more time than money, this is a huge benefit. Downloads cost the same as a "boxed" game, but with a download, there is nothing to trade.
There is competition in the used-game market. Used games can be sold on Amazon and eBay. From a buyer's and a seller's perspective this doesn't provide the same immediate gratification that results from trading in games at the GameStop in the local mall. It is possible that another retailer such as Wal-mart or Best Buy could take the used game market from GameStop. In fact, Best Buy announced last summer that they intended to expand their efforts in the used game arena. On the recent conference call, GME stated that used game sales haven't shown any weakness since Best Buy's announcement. I suspect that the used game market is more difficult to execute well than the new game market, with local differences in inventory preferences and pricing. From my limited observation, gamers seem more comfortable hanging out and browsing in the smaller GameStop stores compared to the bigger Best Buy stores.
Another factor which I believe is weighing on the value of GameStop is its association with Barnes and Noble, which has seen its stock fall dramatically in the past month. GameStop was owned by BKS from 1999 to 2002, when it distributed its shares to BKS shareholders. Three of the company's ten directors have been affiliated with Barnes and Noble, including Leonard Riggio who is both Chairman of the executive committee of GME's board and Chairman of Barnes and Noble. Mr. Riggio sold 3.5 million shares in October, and an additional 1.5 million shares in February. These sales represented over half the 9.1 million shares which Mr. Riggio reported in last year's proxy. Several other insiders also sold smaller amounts of stock in early February, although since similar sales also took place at the same time last year, these sales may be related to taxes on options or restricted stock.
Coinstar recently announced that its Redbox unit would expand its video game rentals to 21,000 kiosks at a price of $2 per day. This announcement has also encouraged the bears. While the game "rental" model may hurt Gamestop at the margin, it is important to remember that most games are played over multiple days, since gamers want to master different levels. A serious gamer may use a rental to "try before they buy", but the value proposition for game rentals versus purchase won't be as dramatic as for movies, which are typically viewed once, and can be returned in 24 hours.
The Bull Case
The bull case rests on the combination of three elements: 1) an extremely low valuation, 2) strong free cash flow, and 3) a management willing to capitalize on the first two elements of the thesis by aggressively buying back stock. I won't comment on valuation other than to reiterate that the company is trading at 4 times trailing EBITDA, 10 times earnings, and 9 times free cash flow.
As GameStop has moved from a high growth specialty retailer to a mature company its free cash flow has steadily increased. The $41 million increase in free cash flow that estimated for 2011 is based on a $28 million decrease in capital expenditures and a $10 million increase in depreciation. Only $3 million comes from increased net income.
2005 2006 2007 2008 2009 2010 2011(Est)
Free Cash Flow 57 134 242 360 377 384 425
Management has adopted a shareholder friendly approach to deploying this excess capital. Unlike many retailers that continue to add stores even when expansion offers limited returns, GME has decided to invest the majority of its cash flow in its existing store portfolio by repurchasing its stock at current levels while funding digital initiatives that may position it to capitalize on the growth in digital downloading when it materializes. GME's $170 million capital budget in 2011 is $10 to $20 million less than depreciation. Only $70 million of the $170 million is dedicated to new stores and store remodels, the remaining $100 million is directed towards GME's digital initiatives and loyalty programs. The 2011 plan calls for 200 new stores in what management calls "underserved" markets and 200 store closings, which management says are primarily from past acquisitions with expiring leases. Pruning 200 overlapping stores (3% of the store base), some of which are in the same malls as remaining units, should provide better leverage on the remaining store assets. As an aside, GME's operating leases are relatively short; approximately half of the leases expire over the next three years. (Most leases have renewal options.)
GME has begun to pay off debt and buy back stock. In 2010, the company reduced long-term debt by $200 million to $249 million, and repurchased $380 million of its common stock. On February 4, management announced plans to spend an additional $500 million in 2011 to reduce debt or repurchase stock. (I estimate that 85% of this $500 million will come from free cash flow, and the remainder will come from the company's cash balance, which was $711 million at year end.) On the year end conference call, GME indicated that it had already spent $118 million to repurchase 5.9 million shares at an average price of $19.88 in the first two months of the fiscal year. (The midpoint of management's 2011 EPS guidance of $2.87 represents an 8% growth from 2010, and does not include any benefit from buybacks in the remaining 10 months of 2011.) Assuming the remainder of the $500 million is used to repurchase stock ratably over the balance of the year GME's 2011 EPS will get an additional 4% boost, and could be close to $3.00. Since share repurchases during the year are averaged into the denominator for EPS, 2011's repurchases will also increase 2012's EPS.
GME's market cap is approximately $3.6 billion and its enterprise value is less than $3.3 billion. If the entire $382 million is used to repurchase stock at current levels, GME could retire an additional 11% of its outstanding shares. At a minimum, this should put a floor under the stock price. Given the 38 million shares sold short (27% of the 141 million shares outstanding at the end of March), things could get uncomfortable for the shorts as the float shrinks. As long as free cash flow is line with the average of the past three years,(which would be about 10 percent below management's 2011 guidance) GME would be able to buy back roughly 10% of its shares each year if the stock price declines or stays the same. Of course, if the stock price goes up, fewer shares will be bought back but shareholders will still be rewarded.
Another potential outcome would be a transaction with a private equity firm. Specialty retailers Jo-Ann Stores and J Crew have recently been acquired at multiples of 7.3 and 8.6 times EBITDA respectively, or roughly twice GME's current multiple. Given GME's $5.95 per share of trailing EBITDA, even a 6 multiple would result in a sizable gain from current levels.
At current levels, GME presents an attractive risk/reward proposition. The market is taking an extremely pessimistic view of the company's prospects. The company is capitalizing on its strong free cash flow and low valuation toessentially go private in the public markets without using any leverage. The principal risk to the thesis is deterioration in the business. The evidence, at least for now, favors the bull case. Revenue for both the new and used game segments grew in the fourth quarter. Free cash flow has continued to grow for the past several years and comparable store sales were positive 1.1% in 2010 after a 7.9% decline in the recession year of 2009. Although gross margins were down slightly in the fourth quarter, they were flat for the full year, and the company more than offset the fourth quarter's gross margin decline with a reduction in SG&A. The company's modest debt and relatively short-term lease commitments give it flexibility to adjust the business if necessary. While overall net income is projected to be flat in 2011, net income and free cash flow per share should grow by 8 to 12% based on a lower share count, and EPS could be close to $3.00. A P/E multiple of 10 would result in a $30 stock price and a 15% return. A leveraged buyout at just 6 times EBITDA would generate a price north of $35.
Execution of the company’s buy-back program puts continued pressure on shorts.
Additional LBOs in the retail sector may highlight the deep value in GME. Several retailers are currently rumored to be “in play”.
GME releases first quarter earnings May 19th.
Each additional quarter of positive comparable store sales and positive earnings growth helps the market to realize that GameStop isn’t the next Blockbuster.
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