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The Royce Funds Jay Kaplan - Gamestop and Our Long Term Contrarian Investment Approach
Posted by: Canadian Value (IP Logged)
Date: November 14, 2013 04:44PM
Because our contrarian approach emphasizes a long-term time horizon, we tend to invest in companies that we believe have the financial wherewithal to withstand out of favor periods. GameStop used trying times to build conviction and expand its core business rather than abandoning its discipline to meet outside expectations.
GameStop is currently the world’s largest retailer of video games. While market sentiment over the past four years was often unkind, our deep knowledge of the company provided the long-term confidence in both its management and business prospects when many were fleeing the stock or selling it short.
We think that our recent experiences with GameStop offer insight into why patience and discipline are such integral parts of our active management approach and investment process.
Portfolio Manager Jay Kaplan shares the history of his close involvement with GameStop.
Our Early Experience and the Importance of the Balance Sheet
In April 2005 GameStop announced that it would be acquiring EB Games. Although we still liked each business (and held shares in both), the ensuing leverage on GameStop’s balance sheet led Jay to exit the stock in June 2005 (not long after the acquisition) while other Royce managers who held shares began to reduce their positions considerably, eventually selling their shares by June 2006.
Understanding the Core Business
The majority of GameStop’s revenues come from their buy-sell-trade model, which involves taking in used games to re-sell at a discount and giving credit in return to be used toward other, usually newer games. Other businesses have tried to adopt a similar model—including Wal-Mart, Best Buy, and Toys“R”Us—but none have enjoyed comparable success.
In addition to generating enviable margins, the buy-sell-trade model has also helped to solidify valuable relationships with gaming publishers. In an increasingly diverse and crowded marketplace, GameStop’s stores generally boast knowledgeable staffers who cater to the needs of its customers while helping publishers with promotion and discovery.
Returning Contrary to Public Opinion
By early 2009 investors were beginning to worry about the demise of console gaming, which led to a decline in GameStop’s stock price. Ever contrarian, we were happy to revisit the stock at prices that we liked, especially as the company once again met our balance sheet standard while also posting attractive returns on capital.
Still, important questions lingered: What were some of the environmental factors—such as the short-term leases the company commonly took on its stores—that Wall Street was missing? What plans did management have to best position the business for an industry rebound, should one occur? Was the stock cheap enough to compensate us for the risk of reacquiring shares? Risk can be real or perceived, and in this case we believed many of the risks were perceived.
A few real risks, however, remained: Would anyone ultimately need a gaming console or would downloadable games make them obsolete, possibly quickly? Would the gaming industry get to a point where users could download a game directly to their consoles, thus removing a physical disc from the equation, which would potentially destroy GameStop’s buy-sell-trade model? Another concern was the rise of casual gaming on mobile devices, which could take share away from GameStop’s core demographic of hardcore gamers.
We were confident that a lot of the market’s concerns were exaggerated (and, for the time being, still are). Download times currently remain much too long to present a viable threat. There is also the possibility of usage pricing on the Internet, which would make, at least at the onset, the distribution of a game via download prohibitively expensive.
Why Meeting with Management is Fundamental to Our Process
From 2009 through late 2012, while market pundits fretted that GameStop would ultimately share the same fate as Blockbuster Video, the company’s share price traded in the $18 to $28 range, roughly parallel to its operating income. Meanwhile, the company began implementing what we considered to be a series of smart moves.
One significant difference we noticed between GameStop and Blockbuster Video early on was that, unlike Blockbuster, GameStop had really short-term leases on its stores. Although the company’s balance sheet was strong, we liked the idea that if things started to go south quickly it could start to exit stores swiftly and not be burdened with large long-term liabilities.
In July of 2010 GameStop began making investments and adding market share through a series of acquisitions. Some of these boosted GameStop’s trade-in electronics business, which kicked off in September 2011. A month later, GameStop was selling assorted Android tablets. More recently, GameStop made a move to boost its electronics business by buying 49% of authorized Apple retailer Simply Mac.
GameStop’s customer loyalty program provided the company with the information it needed to promote its products and services more effectively. This in turn allowed GameStop to rationalize real estate and shrink its store fleet. By knowing where its customers lived and likely shopped, GameStop was able to close stores that overlapped while directing customers to nearby stores, improving the profitability and productivity of those stores that were still standing.
Management made another sensible move—at least in our estimation—in 2012 by returning its free cash to shareholders. Since it was concentrating on consolidating its stores and had strong cash flow in the face of flatlining operating earnings, GameStop understood that it could allocate capital prudently by buying back shares as well as by paying and increasing dividends.
New Consoles, Different Doubts, and Fresh Opportunities
Microsoft and Sony—two of the industry’s biggest producers of gaming consoles—announced early in 2013 that they would be releasing new systems later in the year.
While this breathed a bit of life back into GameStop’s stock price, another set of doubts surfaced about whether the new consoles would continue using optical discs and if existing discs would be compatible with the new consoles. News leaked of a technology that allows consoles to block used discs from playing, which ignited concerns over whether Microsoft or Sony would make use of it in their soon-to-be-issued models. All of this created additional volatility for GameStop’s stock price.
Our faith in GameStop’s core business never wavered. We believed, then and now, that publishers relied on the company’s buy-sell-trade model for their commerce and that the real value for gamers is the ability to trade and receive credit toward new purchases.
GameStop’s Competitive Advantage
Once it became official that the new systems would still use optical discs, GameStop’s buy-sell-trade model gave the company a distinct advantage. Because of GameStop’s loyalty program, it has a hold on supply, demand, and inventory because of pre-orders and waiting lists for the new consoles. While selling new hardware is not a high margin area for GameStop, the company recognizes from previous cycles the potential take-up rate of new software that historically comes with new hardware.
The introduction of new products should also boost GameStop’s core business because many hardcore gamers are likely to trade in old consoles and games to help with the purchase of the new systems.
GameStop’s stock has risen in the past six months as the market has started to catch on to the viability of its model, going from a business that was considered the next Blockbuster Video to a business that looks poised for an enviable 2014.
Recently, Royce has been reducing our position as its weighting in those portfolios in which we hold it has grown beyond what we’re comfortable with (because of the large increase in the stock price).
As active managers with a long-term horizon, we found many characteristics that inspired our long-term confidence in GameStop. Perhaps, most importantly, it was the fact that, despite the negative attention it garnered, the company never abandoned its core business while it also continued to innovate and create shareholder value. This helped GameStop implement strategies that emphasized its successful buy-sell-trade model and allowed it to emerge as a market leader.
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