Recently I was reading David Weinstein's excellent article on the bear argument for Gamestop (GME), and I took the opportunity to re-evaluate my long position. About 5 months ago I wrote about how Gamestop had received a lot of negative publicity and was priced "for dead" by the market, as many see this company as the next Blockbuster. After all, this is a company that currently has an EV/EBITDA of 3.23, annual free cash flows approaching $500m, and a current market cap of only $2.9B. Clearly the ridiculously low valuation in terms of earnings yield and P/FCF is because the market is expecting substantial negative growth going forward. The general consensus is that the network of ~6000 brick and mortar stores is obsolete and losing ground fast to the transition to digital gaming.
To be clear the risks here are numerous, and clearly the threats longer term to Gamestop are real. If they cannot transition their business quick enough they will be in serious trouble. The company still generates more than 80% of revenue from new and used hardware and software sales in its brick and mortar retail stores. Several recent events have seemingly fueled the bear argument:
- The recent launch of the Nintendo Wii U was more lackluster than many hoped
- A report came out that the new Xbox 720 may block used games
- Holiday sales were below consensus and showed a faster decline than previously forecasted.
One question has been bugging at me though through all of this - what happens if we take out the digital part of Gamestop's business and value it separately? By doing this, we can see what the market is approximately valuing the "dying" part of the business at, to see if it is realistic or overly pessimistic. In this article I will do this dissection, and show how the current price of Gamestop still gives a compelling entry point, as there remains several potential positive catalysts and the downside is minimal since the negativity is more than priced in already.
Valuing the Digital Business
In the most recent 10-K, for FY11 we can see that the "other" category comprised about 13% of sales, however garnered impressive profit margins close to 40%:
The "other" category consists of the digital and mobile businesses, but also includes some accessories, Game Informer magazine, and the PowerUp Rewards program. Digital game revenues in FY11 were about $450m and therefore about 40% of this segment. As Mr. Weinstein pointed out in his article, this should come in around $600m for FY12 (formal results not yet released), which indicates YOY growth in the 30-35% range. Management had stated previously they expected $1.5B in sales by 2015, starting from $450m in 2011. So that is a CAGR expectation of between 35-48% in the next few years depending on if you consider to the beginning or end of 2015. Growth currently seems a bit slower than original expectations, but for sure it is still nothing to sneeze at.
The 18 Wall Street analysts who cover the company are expecting full year EPS for FY2012 to come in at $3.13. Mr. Weinstein had a lower estimate at $3.06 which is near the bottom end of the analysts' range. To be more conservative, lets assume earnings come in at $3.06/share. In FY11, the "other" category made up about 19% of total company earnings. FY12 will be a bit higher, my estimate is 25% - this taking into account the 30%+ growth in digital (and its high profit margins) coupled with the double digit declines in new and used software and hardware sales. Therefore we can estimate that EPS attributed to the other category for FY12 is 0.25 *3.06 = 0.77.
Next step is to estimate an expected growth rate for this stream of earnings. As stated above, the company expects >35% growth until 2015 for the digital business. Beyond that it gets a lot more uncertain (as does any technology related predictions for that matter). Other estimates I have read show the digital game market is expected to grow somewhat slower at a CAGR of 17% until 2016. Clearly the digital business is growing faster than this rate now, but several years out from now it is likely to slow significantly. I will use a long term growth rate of 20%.
Finally, since the digital business makes up only about 50% of the other category currently, and the other parts of this segment are likely to grow much slower (or even not at all) I've assumed near 0% growth for them. This brings me to an estimated annual growth rate of 12% for this earnings stream. Putting it into a DCF:
|Value of "Other" Segment|
|Earnings Growth Rate Next 10 years||12%|
|Terminal Growth Rate||3%|
|Years of Terminal Growth||10|
So What Value Does Mr. Market put on the "Dying" Business?
Gamestop currently has just over $3/share in cash on the books with no debt. So adding that in brings us to $18.05/share. With a current market price of $24.05, this would mean that the entire rest of the business is only valued at $6/share. So lets think about that for a moment. You would need to have expected growth at -21%/annum for the next 10 years to achieve such a valuation starting with the current earnings level:
|Value of Hardware and Software Segments|
|Earnings Growth Rate Next 10 years||-21%|
|Terminal Growth Rate||0%|
|Years of Terminal Growth||10|
This is a very steep decline, and clearly is not what is occurring now. Even Mr. Weinstein predicted a slowdown in declines in FY13 to -2% as the release of 2 more new consoles in the coming Christmas season will provide for much better numbers than this past year. Although more than few years out is quite uncertain, clearly growth will not be this negative in the short term. The market is being very pessimistic in the current valuation given to the company which is not giving a fair value to the rapidly growing digital segment. When you do this (as I've done above), we can see how undervalued the company is, as its traditional business (although declining) is surely worth more than this.
The Bottom Line
Gamestop is being undervalued significantly by the market. Although brick and mortar sales are declining, the next few years this decline will slow dramatically with the long awaited release of new consoles. This will generate some positive buzz and PR for the industry which in itself could bring the company more into favor again. Even if the long term rate of decline is -5 to -10%, this would still value the traditional business in the range of $10.80 to $14/share, which coupled with the cash on hand and growing digital business then I estimate the company is worth between $31.90 -$35/share -- an upside of about 40% from current levels. Even if you think I'm being too optimistic about the company's ability to slow the decline in sales, another aspect to consider is the $4.71/share in tangible book value. Since this is primarily related to physical assets and inventory from retail stores, if you add that to my valuation for the digital business you still arrive at a value between $22-23/share. Since the retail business is still going to generate very good cash flow for at least the next few years this valuation makes no sense.
I predict therefore that Gamestop should see a nice jump in price closer to its intrinsic value, especially if any of the possible catalysts occurs in 2013:
- A Private Equity Deal - I wouldn't be at all surprised to see another private equity style deal for Gamestop, similar as we just saw for Dell (DELL), as the earnings yield and consistent cash flow is definitely very attractive for taking this company private.
- Positive buzz around new Consoles - The launch of the Wii U was a bit of a disappointment, but there are still two more consoles to come. Any positive surprises in sales will cause the stock to jump
- Positive Earnings Surprises - The great thing when a company is so beaten down as this one, is that anytime they have an earnings beat or slightly more positive outlook than the market is expecting, the stock can soar. This is especially true when there is a very high short float. Another company I own which gives a perfect example of this potential is Pitney Bowes (PBI), which saw its price soar close to 20% in 1 day after declining revenues in its mail business showed signs of slowing.
Any of these potential catalysts may not happen, but with management's commitment to paying 100% of FCF to shareholders with high dividends and buybacks, the downside is cushioned further. As the negativity is already priced in, if the low expectations do come in we are likely to see a flat stock price. Case in point is all the recent negative news (Wii U disappointment, holiday sales, etc), and the stock took only about a 10% dip but has since stabilized. The upside potential is certainly much greater than 10%, and this is why I think the risk/reward ratio is still a compelling opportunity on the long side for Gamestop.