First of all, GameStop (NYSE:GME) is not in any immediate danger of going away. The firm has negligible on-balance-sheet debt, and it is a strong cash-flow generator. The pre-owned video game retailer even pays a healthy dividend, and we think the payout is sustainable in the near term. The problem, however, is that GameStop cannot change its business model overnight, and we've yet to see real pressure on the company's used (pre-owned) video game product segment, which generates the vast majority of the company's gross profit. We fully expect GameStop to deliver decent performance in the near term (next couple years), but in 10-15 years, GameStop will either have to completely reinvent itself or go the way of the do-do. This is a risk that current holders may not be acknowledging wholeheartedly with respect to its existing profit mix. Let's talk about why GameStop is fading away, derive its cash-flow-based intrinsic value, and run shares through the Valuentum process.
For those that may not be familiar with our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. GameStop posts a Valuentum Buying Index score of 6, reflecting our "fairly valued" DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technicals. A score of 6 is not terrible, but it is not a 9 or 10 (a "we'd consider buying" rating) either. We include highly-rated stocks in the Best Ideas portfolio.
GameStop's Investment Considerations
- GameStop earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 175.2% during the past three years. The company's economic profit spread is augmented by a financing decision to lease all of its retail stores. Capitalizing operating leases reveals a much tighter spread, but economic-value creation nonetheless.
- GameStop is the world's largest multichannel video game retailer. The firm generates the majority of gross profit from used (pre-owned) video game products. We think a decline in long-term profitability is inevitable, and something that we have factored into our valuation process.
- GameStop has an excellent combination of strong free cash flow generation and low financial leverage (at present). We expect the firm's free cash flow margin to average about 4.5% in coming years. The company has a significant amount of off-balance sheet debt, however, in the form of operating leases. The firm is rapidly reducing its store count as they come off lease (it will close stores in 2014). In 2015, another ~2,300 stores will come off lease, offering the company further opportunities to close underperforming locations.
- Sony (NYSE:SNE) announced the launch of PlayStation Now, a cloud-based service that provides streaming access to PS3/PS4 titles and runs on TVs, consoles, tablets, and phones. That both old and new games can be streamed is a huge blow to GameStop. It is not this platform (by itself) that will lead to the company's fading performance, but the very idea that this is the beginning of a trend that will evolve over the next 10-15 years. The physical game market will shrink significantly over the next decade or so, and while it won't go completely away (much like DVDs are still around), it will be much, much smaller. GameStop may become the Radio Shack (NYSE:RSH) of the 2020s decade.
- Management clearly sees the writing on the wall. The company is rolling out Simply Mac, Apple (NASDAQ:AAPL) specialty stores, Sprint-Mobile AT&T (NYSE:T) dealer stores and Cricket AT&T prepaid stores. But holders of GameStop's equity need to decide if they believe in this reinvention, which may not be enough to support declines in its core pre-owned business. At some point, these new stores will become the majority of GameStop, and they don't even focus on the firm's core competency: games. Let us not forget that Radio Shack has been reinventing itself for at least a decade, maybe longer.
- Though GameStop boasts a hefty dividend yield, risks regarding the elimination of used (pre-owned) game sales and physical distribution could be devastating to future profits. We think this is an important consideration for holders of its equity simply for the dividend payment.
- To get a feel for the severity of profits at risk, during the company's most recently-reported fiscal fourth-quarter results (ended February 1, 2014), 'pre-owned and value video game products' accounted for 36% of total gross profit dollars. For comparison, 'digital' accounted for less than 5% of gross profit in the period.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. GameStop's 3-year historical return on invested capital (without goodwill) is 175.2%, which is above the estimate of its cost of capital of 11.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate. As we stated previously, this performance is unadjusted for the company's leasing strategy, which would increase both 'earnings before interest' and 'invested capital' as rent expense is removed from (and replaced by depreciation; the measure is still before the interest component) the numerator and adjusted PP&E is added to the denominator of the ROIC calculation.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. GameStop's free cash flow margin has averaged about 5.8% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At GameStop, cash flow from operations increased about 22% from levels registered two years ago, while capital expenditures fell about 24% over the same time period.
Our discounted cash flow model indicates that GameStop's shares are worth between $23-$45 each. Shares are trading at $37 at the time of this writing, just above the midpoint of the range. The margin of safety around our fair value estimate is driven by the firm's HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The ValueRisk™ rating also captures the uncertainty of the company's reinvention and the range of fair value outcomes that they inevitably create.
The estimated fair value of $34 per share represents a price-to-earnings (P/E) ratio of about 11.4 times last year's earnings and an implied EV/EBITDA multiple of about 4.6 times last year's EBITDA. These are very attractive measures, but they do not account for the substantial debt-like lease obligations. Our model reflects a compound annual revenue growth rate of 3.2% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -1.6%. The five-year forecast is front-end loaded, augmented by console releases that will favorably impact performance during the next couple years. Our model reflects a 5-year projected average operating margin of 6.7%, which is below GameStop's trailing 3-year average. We're expecting continued gross profit pressure as higher-margin pre-owned game revenue wanes.
Beyond year 5, we assume free cash flow will grow at an annual rate of -1.7% for the next 15 years and 3% in perpetuity. For GameStop, we use a 11.8% weighted average cost of capital to discount future free cash flows. We think the long-term growth reflects GameStop's business model, which is in secular decline. The above-average discount rate also considers the firm's heightened risk profile.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare GameStop to peers Home Depot (NYSE:HD) and Best Buy (NYSE:BBY), among others in the specialty retailing industry. We think the company's PEG ratio is most important, as it is above the industry median, revealing its lack of growth prospects over the immediate forward five-year period.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $34 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for GameStop. We think the firm is attractive below $23 per share (the green line), but quite expensive above $45 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate GameStop's fair value at this point in time to be about $34 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of GameStop's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $43 per share in Year 3 represents our existing fair value per share of $34 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Disclosure: AAPL is included in Valuentum's newsletter portfolios. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.