Recently, GameStop Corp. (GME, Financial) has taken a beating in the market with the release of some very unflattering news. As we all know, the stock market is a very unforgiving place.
GameStop came across my radar a few years ago when I was doing my regular screening looking for new opportunities. Until recently, I had not pulled the trigger on the company, but after digging into it a little more it appeared to be a great opportunity. In the light of recent news, I am wondering if I made a good decision or walked into a value trap.
I admit I was first attracted to the 6% dividend yield, which was very enticing. In addition to the low price-earnings (P/E) ratio as well as other financial strengths, it appeared this was a great opportunity.
In this article, I will take a look at my findings again, re-evaluate my decision to buy and whether or not to stay in at this point or to sell and just cut my losses.
Retail is a brutal environment and the competition can be fierce. With the recent announcement of Microsoft Corp.’s (MSFT, Financial) Xbox’s subscription service, there has been a lot of concern among GameStop investors in how this will affect the company long term.
Let’s take a look.
Business overview
Founded in 1994 in Grapevine, Texas, GameStop operates more than 7,600 stores now. These stores are located in the U.S., Australia, Canada and Europe.
Gamestop’s primary business is selling new and used video game hardware and software. This includes accessories such as gaming consoles, controllers, headsets and memory cards.
Segments:
Source: GameStop Investor Presentation
Video Game Hardware/Software: 49.58%
Preowned: 22.34%
Accessories: 7.83%
Digital: 1.87%
Technology Brands: 8.4%
Other: 2.96%
Obviously, videos make up a very large percentage of sales with the current numbers being 71.92% of its total sales.
In recent years, GameStop has attempted to diversify the business. It has branched out into the consumer electronics business by selling smartphones and tablets.
In addition, it launched Spring Mobile, where it recently became the largest owner of AT&T (T, Financial) wireless retail stores outside of AT&T.
GameStop also partnered with Apple (AAPL, Financial) to open 72 Simply Mac stores, which serve as tech support outlets for Apple products.
The company now has a goal of reducing its reliance on video game sales to less than 50% of revenue. The company stated in its most recent earnings call that revenue from technology and collectibles make up 39% of its sales. So it is not there yet, but is on the way.
In 2016, the company saw non-physical gaming revenues of over $2 billion. So while GameStop has changed its focus, it is still tied to the physical gaming hardware, which is now an industry that is in decline.
Source: GameStop Investor Presentation
In addition to the increase in revenue from sources other than video games, the company recently announced it will be reducing the store count by 150 stores. By eliminating underperforming stores, it will cut overheads and other costs. Thus far, this has worked.
This is not unlike other retail stores, who are all reducing store counts. Even mighty Wal-Mart (WMT, Financial) is lowering its store count.
In addition, GameStop also owns a diverse portfolio of video game websites such as Ebgames.com, Kongragate.com and Thinkgeek.com.
All the changes in direction are a recognition by management that changes are needed if the company is going to survive. And they are implementing them, although maybe not as fast as some investors would like.
Business analysis
First, let’s take a look at some of the numbers that have driven the price down recently.
Source: Intrinsic Value Formula
Source: Intrinsic Value Formula
With the sales growth pretty stagnant for the last six years and free cash flow stagnant as well, there has been an increase in earnings per share and free cash flow per share because of the very aggressive share buybacks that have been instituted.
Source: Intrinsic Value Formula
As the company has reduced the share count, it has helped elevate the earnings per share and free cash flow per share, even when the real dollar amounts have not grown that much.
Other bad news came during the latest earnings release. It was revealed that same-store sales were down 16.3%Ă‚ for fourth-quarter 2016Ă‚ and down 11%Ă‚ for fiscal 2016. In addition, adjusted EPS were down 0.8% at $2.38Ă‚ for fourth-quarter 2016 and down 3.3% at $3.77 for fiscal 2016.
Additionally, GameStop guided down for 2017 as well, with sales estimated down 2% and same-store sales down 5% to even. Net income and earnings per share were guided down to $320 million and $3.10 respectively. Also guided down were video sales and hardware.
The big news recently was Microsoft announced its new Game Pass, which will allow users to access 100 of the most popular older Xbox One and Xbox 360 games for a $9.99 monthly subscription.
In addition to this news, subscribers will also be able to buy these games at a 20% discount to their retail price.
Of course, this will hit GameStop right in the bottom line because it generates over 30% of its gross profit from older game sales.
We all know the video game industry is shifting away from physical games and toward downloads. With Microsoft and Sony (SNE, Financial) moving toward subscription services, this is no surprise.
The surprise was that Wall Street reacted very badly to this news and the price dropped 10% the day of the announcement.
Good news
The Technology Brands segment achieved its goal of adjusted operating earnings for 2016. It came in at 90.2 million, which was a 216% increase over 2015.
In addition, the Collectibles business was able to meet its revenue target of $494.1 million in 2016.
As stated previously, the company is moving toward a goal of earnings from businesses beyond physical games of 50%. In 2016, it achieved non-physical gaming businesses comprising 36.9% of total adjusted operating earnings.
GameStop also acquired 511 Technology Brands stores, ending the year with 1,522 stores and as AT&T’s largest authorized retailer.
Technology’s brand sales increased 52.4% for the full year. Adjusted operating earnings grew 216.4%.
Other good news was the new Nintendo (TSE:7974, Financial) Switch sold out in the three major shipments the company received in a matter of hours.
This is a prospect most people have not considered. The impact of new hardware releases by Sony and Microsoft and what they could do for the company over the next few years.
Gamers do not want to order new consoles online, they want it now or on launch day. They would rather get it in store than risk waiting for it to be delivered.
Key risks
GameStop’s race to reinvent itself is the biggest risk it faces. It is competing against bigger, better-capitalized companies like Microsoft and Sony in the realm of digital video game sales and rentals.
There is also the turnaround to consider. GameStop is branching out into businesses that are no-moat, highly commoditized ones.
Selling smartphones and tablets did not work out so well for Radio Shack, who tried the same strategy before filing for bankruptcy.
In addition, its efforts with the collectibles division are going to run into difficulties when competing against eBay (EBAY, Financial). It will not be able to achieve the same kinds of scale or network effects eBay enjoys.
Plus, its efforts to compete in the digital video game subscription platforms are going to run into trouble. Because of the size of its competitors, GameStop's only avenue is to compete on price, which lowers the profit margins and drives free cash flow down.
All of these efforts could come at the cost of profitability, which could be catastrophic in the long run.
The decrease in profitability has pushed the company into increasing its debt to help fund some of the turnaround efforts. With its junk bond rating of BB in this rising rate environment, it means any increase in debt becomes that much more expensive.
GameStop’s long-term success hinges on its ability to complete the turnaround it has begun. But with the increased reliance on debt to help fund that turnaround, it has led to an increased risk profile for the company.
As the earnings and cash flows continue to decline, the company’s current tactic of taking on more debt to fund its turnaround will result in continued deterioration of its balance sheet. This forces GameStop to pay 6% to 7% interest on its bonds because of its junk bond rating.
If the interest rates continue to rise, it could make it extremely difficult to execute its turnaround plans.
The last risk is a major liability it faces every year, which would be rent payments for the retail stores it leases. GameStop has paid over $380 million per year in rental expenses each of the last three years.
These leases are non-cancellable agreements that will be a drag on its efforts to establish a turnaround.
State of the dividend
Without a doubt, the dividend is one of the more attractive aspects of GameStop.
The company is currently offering a dividend with a yield of 7.29%, which is a reflection of the depressed stock price. The rate of the dividend is $1.52 a year, which is quite generous for a company this size.
GameStop has raised its dividend every year since it started paying one in 2012. It has risen from 80 cents a share in 2012 to the current rate of $1.52 a share. Indeed, GameStop has raised the dividend 10.4% over the last three years.
Additionally, the payout ratio for the dividend is 44%, which is a comfortable number given the state of the company. This payout ratio gives some comfort that the dividend is in no immediate danger of being cut.
One note to be aware of. As the earnings and free cash flow margins continue to be squeezed with the declining sales, you will likely continue to see rising payout ratios, which could spell trouble for the dividend.
Right now the balance sheet is strong, but it has taken some hits in the last few years. GameStop has sufficient cash on the balance sheet to continue paying the current dividend for two years.
All these factors lead me to believe the dividend is now not in danger of being cut or suspended. But it is worth keeping an eye on until the turnaround shows more signs of being successful.
Valuation
The past year has been brutal for GameStop with Wall Street just hammering the stock. Shares have dropped 21% for the year compared to the 17% increase experienced in the market.
This has led to GameStop being one of the cheapest stocks on Wall Street, both from a P/E and dividend yield perspective.
The trailing 12-month P/E is 6.45, which is substantially lower than its historical P/E of 10.8. In fact, it is now lower than 93% of all specialty retailers.
Currently, the dividend yield is 6.92%, which is quite a bit higher than the company’s historical yield of 3.1%. In fact, it doubles its historical yield. Some of that, of course, is due to the recent drop in share price.
According to GuruFocus, using a DCF based on free cash flow yields a price of $52.32. A DCF based on earnings yields a price $36.39.
Using the earnings based valuation would give you a 40% margin of safety.
Final thoughts
There are certainly quite a few points to be made for a bearish case for GameStop, and I am cognizant of those and understand all the points.
Certainly Wall Street reacted very violently to the negative news that came out during the most recent earnings call. In fact, the day of the news reports, the stock was down 12% at one point in the day. No one should have been surprised by these results as the sentiment surrounding the company was terrible going into the earnings call.
Ironically, it rallied a few days later and is back to $21.95. One wonders if it will continue to rally to its earlier heights. As recently as last November, it took a similar dive only to rebound shortly thereafter.
Some points to keep in mind when considering this stock. First, the company does not need to expand and become the next retail giant. It just needs to continue to keep its cash flows intact and survive this turnaround.
Second, the turnaround is well under way with the recent news the company has begun the change from a video game retailer to a more diversified company.
There has been a lot of focus on the very poor holiday sales the company reported, but as someone so astutely reported, GameStop experiences a holiday season whenever a new console is released. This makes GameStop much more cyclical than your typical retailer and could help explain the poor holiday season sales.
This a profitable company that has demonstrated it is shareholder friendly with the continued buybacks and dividend increases.
There is some concern about the dividend being unsustainable, but the current strength of the balance sheet should allow the company to continue the current payout ratio.
These are just a few of the reasons why I remain bullish on GameStop. I am long the company and believe in its efforts to adapt the company to its current situation.
I am also humble enough to understand it faces an uphill battle. This will not be easy, but I believe it will accomplish the goal.
I know there is some concern GameStop is headed in the same direction Ă‚ as Blockbuster. while that is certainly a possibility, I think we should look at GameStop on its merits and the many ways it is developing to unlock value for its shareholders.
GameStop’s future returns will consist of dividends and earnings growth.
- 2% sales growth based on analysts' reports
- 7% dividend yield
- 1% earnings growth from share repurchases
Thanks in large to its very high dividend yield, GameStop could generate 10% annualized returns even with the very poor earnings growth projections.
Although I am long the company, I am not immune to some of the warning signs that are looming out there. I believe the company has begun a turnaround, however, which is already well under way.
As the company’s price continues to flounder, I will take advantage of any dips to add to my position.
Disclosure: I am long GameStop. This article was written by me, but I am not receiving any compensation for its creation from GameStop.
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