GameStop (GME) has enjoyed a 36% run since announcing Q2 earnings on August 16. Sell-side firms are bullish on the stock - 10 of 21 analysts covering the stock rate GME a Buy - with a few reiterating their recommendations in recent weeks. Notwithstanding, GME continues to be one of the most heavily shorted stocks in the S&P 500 (37% of float) in spite of its 4.4% dividend yield. Apparently, the fall rally has failed to scare away the majority of the bears. So where is the disconnect?
The purpose of this article is to shed light on GME's historical operating performance and expected earnings in lieu of past and recent trends. The bulk of the article will offer a detailed earnings forecast for Q3 and Q4. While my segment-by-segment analysis will show exactly how I expect management to meet the lower end of its $3.10-$3.30 guidance ($3.13 vs. $3.14 consensus), I think readers will be surprised by some of the assumptions made to get there.
Building on the trends of 2H 2012, I will then forecast FY 2013 and beyond, delineating the timing and nature of my investment thesis in the process. I believe the stock is worth $0 (excluding forthcoming dividends / buybacks), and bulls are playing a dangerous timing game. I also believe, however, that the true inflection point (i.e. the point at which we begin to see single-digit share prices) for GME will most likely come in 2H 2013 / 1H 2014. In the meantime, my 12-month price target of $17.05 predicts a downside of 26% from the current share price of $22.95 - hardly an aggressive target given the recent trading range, but a substantial return for a patient short seller.
[Be forewarned, this is a lengthy article - feel free to scroll to your most relevant sections]
My model predicts basic EPS (excluding one-time items) of $3.13 for FY 2012 on 124.5M shares outstanding, which is near the low end of management guidance of $3.10-$3.30 (although management guides to 128.5M shares outstanding) and in line with current consensus. GME is not a company that tends to surprise: average surprise since 2006 is 8.0%, 3-year historical surprise is 2.7% and 1-year historical surprise is 1.7% (see below), a fact which also informs my forecast.
The table below shows quarterly revenue and gross margin numbers for each of GME's segments through year-end 2012.
|Q1 12||Q2 12||Q3 12E||Q4 12E||2012E||FY growth||Segments (gross profit)|
|Q1 12||Q2 12||Q3 12E||Q4 12E||2012E||FY growth||Segments (sales)|
Let's break down 2H 2012 estimates segment by segment and assumption by assumption.
Revenues: I expect a 30% YoY decline in Q3 and a 10% YoY increase in Q4. New Hardware sales declined 19% YoY in Q1 and 34% YoY in Q2. Q1 sales were buoyed somewhat by the PS Vita launch. No such launches are expected in Q3 and industry hardware sales declined at a > 30% rate in August (a consistent trend through 2012). The Nintendo (OTCPK:NTDOF) Wii U launches in Q4 versus a relatively weak 2011 hardware comp (-20% from 2010). If ex-Wii U hardware sales continue at a 30% YoY decline, GME will need the Wii U to produce ~$270M in sales to achieve 10% YoY growth. At an ASP of $325 (the mid-point between the $300 and $350 SKUs), this assumes unit sales of 830,000 in Q4. Analysts have called for sales of ~4-5M units by March 2013. I expect ~75% of units to be shipped to the U.S. and GME to capture ~25% market share. Variables that could significantly impact this forecast include the popularity of the system, supply constraints and Nintendo's geographic distribution.
Gross Margin: I expect gross margins of 7.0% in Q3 and Q4. This is in line with historical trends.
Revenues: I expect a 15% YoY decline in Q3 and an 18% YoY decline in Q4. Industry-wide sales of new physical video games have declined at monthly YoY rates of > 20% for the majority of the months in 2012. August data showed a YoY sales decline of ~9%, but I view this data point as an outlier given the consistency of the 2012 trend. GME's New Software sales declined 20% YoY in Q1 and 21% YoY in Q2. A comparison of new game launches between 2H 2011 and 2H 2012 suggests little in the way of upward momentum for 2H 2012. GME has launched aggressive promotions in recent months to boost game sales, and I expect a marginal impact.
Gross Margin: I expect gross margins of 21% in Q3 and Q4. This is 30bps higher than total 2011 gross margins and consistent with quarterly and sequential trends. A risk to this forecast is excessive promotional activity in the back half of the 2012, although I believe that management is fairly wedded to its "margin story" and will sacrifice sales growth before margins.
Revenues: I expect a 5% YoY decline in Q3 and a 3% YoY decline in Q4. Used product sales declined 1% YoY in Q1 and 11% YoY in Q2. Given the double-digit industry-wide declines in new physical video games, GME's used products segment has held up relatively well. The sequential trends in YoY quarterly sales, however, indicate a steady decline (over the last 6 quarters-9.5%, 12%, 3.1%, 1.5%, -1%, -11%). After lackluster pre-owned growth in 2010 (3% compared to 18% in 2009), management aggressively (and successfully) scaled its PowerUp Rewards customer loyalty program and achieved 6.1% growth in 2011. The loyalty program, however, is saturated and no longer a driver for pre-owned growth. I fail to see other catalysts, thus the expected declines in Q3 and Q4 (which roughly fit the sequential trend).
Gross Margin: I expect gross margins of 48.1% in Q3 and Q4. This is approximately 200bps higher than combined 2H 2011, but 100bps below the 49.1% margin achieved in 2012 Q1. My assumption gives substantial credit to management's margin story, as 2012 full year margins would exceed 2011 full year margins by 170bps. Similar to New Software sales, any promotional activities present a significant risk to this forecast.
Revenues: I expect a 33% YoY gain in Q3 and a 40% YoY gain in Q4. Sales in the Other category depend on projections for digital, mobile and "everything else." I comment on each below.
Digital: With respect to non-GAAP digital receipts, I expect a 30% YoY gain in q3 and a 45% YoY gain in q4. Non-GAAP digital receipts increased 23% in Q1 and 27% in Q2 compared to annual growth of 56% in 2011 and 62% in 2010. Management has suggested that Q1 and Q2 digital receipts suffered from difficult comps. Specifically, Call of Duty released map packs in 1H 2011 which generated significant digital sales, but no such map packs were released in 2012. The problem with this argument is that Call of Duty has moved to a premium subscription platform ("ELITE") that includes map packs as part of the service, and GME has not been able to generate the same amount of growth selling digital subscriptions to this service. At this point, however, I give management credit for its ability to ramp up digital PC sales (up 38% and 76% in Q1 and Q2, respectively) and improve digital console sales in 2H 2012 until proven otherwise. Actual digital revenues-as opposed to digital receipts (which include the full value of products sold on a commission basis)-were $207M in 2011 (digital revenue for 2010 and 2009 was not reported). Non-GAAP digital receipts for 2011 totaled $453M, which makes the digital revenue figure 46% of receipts. In Q1 and Q2 of 2012, digital revenues as a percentage of digital receipts were 39% and 41%, respectively. The recent trend appears downward from 2011 but stabilized over the prior two quarters, and I predict 40% for 2012. Taken together, my full year digital receipts forecast projects 33% growth ($601M), while my full year digital revenue forecast projects 10% growth ($228M). The former is well below management's target of 50% growth for 2012.
Mobile: I expect mobile revenues to reach $45.1M in Q3 and $124.9M in Q4. My forecast is based on sequential revenue growth ($12.5M in Q1 and $28.8M in Q2) adjusted for quarterly revenue variation and the anticipated ramping of iDevice and tablet offerings to 6000 GME stores by mid-Q4. Management has been aggressive in rolling out its mobile offerings. Mobile products were available in 3800 stores in August 2012, compared to 460 in January, 1200 in March and 2200 in April. Extrapolating to Q3 and Q4, I expect average stores in Q3 of 4100 and the aforementioned 6000 in Q4. I model sales per store at $12,500 (actual sales per store in Q1), which predicted Q2 sales within a 10% margin when normalizing for seasonal revenue variation. I predict total 2012 mobile revenues of $209M, above management's $200M target.
Everything Else: I expect a 15% YoY gain in Q3 and Q4. This sub-segment has the least visibility. My YoY growth assumptions for Q1 and Q2 were -8% and 21%, respectively. On an absolute basis, revenues in Q1 and Q2 are roughly in line with expected seasonal variations (whereas 2011 Q1 outperformed significantly on a seasonal basis). As such, I modeled 15% growth on expectations of more normalized performance, supported by the expectation that GME would continue to build out it its accessories offerings (e.g. headphones and controllers) and casual gaming platform to offset declining game sales.
Gross Margin: I expect gross margins of 39.0% in Q3 and 37.6% in Q4. See below for further explanation.
Digital: I expect gross margins of 60% in Q3 and Q4. This projection is a "filler" modeled from known mobile margins in Q1 and Q2 and historical "everything else" margins. It is also relatively in line with the blended 53% margin rate achieved in 2011. I expect additional margin expansion due to a higher percentage of commission-product sales and ramped up PC digital sales.
Mobile: I expect gross margins of 30% in Q3 and Q4. Gross margins in Q1 and Q2 were 37% and 32%, respectively. Management has guided to at least 30% in the mobile category, and I give them credit for delivering in the first two quarters. I anticipate that a company-wide rollout of the mobile business will lead to some margin compression, as stores added later-presumably-will struggle more than hand-picked "trial" period stores. Without additional quarters to benchmark, however, projecting a more significant decline is difficult.
Everything Else: I expect gross margins of 36% in Q3 and Q4. I modeled Q1 and Q2 "everything else" margins at 37% and 35%, respectively. This compares to pre-digital/mobile era margins of ~34%. Given a choice between historical averages and the margin predicted by the most recent quarters in a business as dynamic as GME's, I choose the latter.
FY 2012 Full Year Forecast:
My FY 2012 full year forecast calls for revenues of $8.851B (-7.3% YoY) and net income of $390.1M (+0.9% YoY). I expect gross margins to improve to 29.8% from 28.1% the year before, and SG&A expense that is 20.8% of sales (60bps above 2011). I forecast that New Hardware sales decline 12.2%, New Software sales decline 18.3% and Used Products sales decline 4.9%, while projecting a 28.8% rise in the Other category.
Key Forecast Takeaways:
If the segment analysis above proved overly detailed, PAY ATTENTION NOW. Distilled to its essence, my 2H 2012 forecast relies on the following key takeaways:
1. Console sales in Q4 will be buoyed by solid demand for the Wii U;
2. Sales of new and used games will pick up, compared to 1H 2012, and margins will not suffer significantly as a result;
3. Digital will miss its 50% growth target, but mobile sales will make up the difference; and
4. Even conceding the points above, management will only hit EPS guidance because of a buyback-reduced share count.
FY 2013 Full Year Forecast
My FY 2013 full year forecast calls for revenues of $10,179B (+15% YoY) and net income of $337.1M (-13.5% YoY). Revenue growth will be driven by expected console launches from Sony (SNE) and Microsoft (MSFT), as well as the continued roll out of Nintendo's Wii U. I expect New Hardware segment sales to increase ~80% YoY and Other segment sales to increase ~12%, while the New Software and Used Product businesses decline 5-10% (I expect that game sales boosts from new console launches will be offset by the secular decline in physical game sales). The new sales makeup combined with slightly lower margins in the non-hardware segments-a result of increased promotional activity-will decrease gross margin by 480bps while SG&A expense remains flat on an absolute basis. FY 2013 EPS is forecast at $2.89 on 115.8M shares outstanding. The effects of any one-time expenses are excluded from the forecast.
Significant Downside Risks
Given recent performance, I expect that any surprise to the upside would be marginal (from a financial - as opposed to share price - perspective). As such, the following represent downside risks that would have a material impact on my FY 2012 and FY 2013 forecasts.
1. Wii U Sales: I give both GME and Nintendo credit for a successful U.S. roll-out of the Wii U. While the Wii system was a hit and revolutionary (at least initially), consumer reaction to the Wii U is difficult to gauge thus far. While the user interface is once again unique, it is not clear if it will have the same sales effect as the original Wii's motion sensor technology. It is also unclear how the rise of casual and mobile gaming will impact a console launch from one of the "Big 3" (many analysts feel that Wii sales have been most affected thus far). A Wii U miss in FY 2012, while hurting the top line, will likely have little impact on EPS given low hardware margins (depending on management's ability to manage operating leverage).
2. New Software Sales / Margin: If sales of new physical video games continue their industry-wide trend of > 20% declines YoY, GME's top line could suffer in the absence of additional market share gains. The Wii U launch should provide some boost to new game sales, but continued 20% declines in Q3 and Q4 are a serious risk. With regard to the bottom line, we could see hyper-aggressive promotions continue into the holiday season. If management chooses growth over profits, the EPS effect could be material.
3. Used Products Sales / Margin: The trend in Used Products sales has been downward, although margins expanded in Q1 and Q2. A downward trend larger than I have forecast-and more in line with the industry wide trend in new physical games-would significantly impact both the top and bottom lines. Moreover, excessive promotions to promote growth would affect my forecast for YoY margin expansion.
4. Digital Receipts / Revenues / Margin: GME did not quantify digital receipts or digital revenues before its 2011 Investor Day in March 2011. At the time, GME announced annual digital "revenues" of $179M and $290M in 2009 and 2010, respectively. Later earnings calls, however, brought out the significant distinction between digital "revenues" and "receipts." The main point being, the former were actually the latter-i.e. what management was reporting as revenues were not actually GAAP revenues, but non-GAAP receipts. These receipts include the full value of items sold on a commission basis (e.g. Xbox Live points cards), when only the commission itself accrues to the top line. GME's $675M digital target is a reference to digital non-GAAP receipts and represents 50% YoY growth. These receipts were up 25% in 1H 2012 (23% in Q1 and 27% in Q2). I model significantly higher growth in Q3 (30%) and Q4 (45%), although below the 50% target. While management remains sanguine in its digital forecast, citing tough 1H 2011 comps, 2H 2012 growth in the 25% range is a downside risk. Moreover, while I care about digital receipts, I am more concerned with digital revenues. Digital revenues as a percentage of digital receipts were 46% in FY 2011, but averaged 40% in 2H 2012. If this ratio declines into the fourth quarter (e.g. more digital products are sold on commission), my digital forecast is at risk.
5. Mobile Revenues / Margin: I forecast mobile revenues of $209M at a 31% margin. This forecast depends upon the following: 1) management successfully ramps its mobile offerings to nearly all its stores by mid-Q4, 2) sales per store remain constant during the ramp, and 3) margins remain at the 30% level for 2H 2012. To this latter point, iDevice sales have significantly higher margins than other "tablet" offerings, which have hardware type (7%) margins. Slowing of iDevice trade-ins will negatively affect my forecast. This sub-segment also suffers from a dearth of historical results from which to benchmark future growth.
6. Everything Else: Management offers limited visibility on this sub-segment and results have been volatile. Continued volatility to the downside will negatively affect my forecast.
7. Share Buybacks: GME began FY 2012 with 135.4M shares outstanding and guided to the $3.10-$3.30 range accordingly. In the Q2 earnings call, management reiterated the same range at 128.5M shares outstanding, but forecasted Q3 earnings at $.28-$.36 on 124.5M shares outstanding. My full year earnings forecast depends on management lowering its shares outstanding to 124.5M in the computation. Projected FY 2012 earnings on 128.5M shares outstanding miss guidance at $3.04.
8. FY 2013: My FY 2013 forecast depends upon the successful launch of game consoles by Microsoft and Sony. If either or both launch in FY 2014, my top line forecast is likely too high. I believe the bottom line will be affected by ~$.10 per share.
Additional Considerations re Management
Management continues to buy back shares. While current shareholders may enjoy the returns, the buybacks also have the effect of boosting EPS. Management initially guided to its FY 2012 EPS range on 135.4M shares outstanding. They now guide to the same range on 128.5M shares outstanding. As mentioned above, I expect the "denominator" in the EPS to end up at 124.5M shares outstanding-or perhaps even lower (currently there are 121M shares outstanding). Without the buybacks (i.e. using 135.4M shares outstanding), my full year FY 2012 EPS forecast comes in well below range at $2.88. This fact informs the P/E multiple used to calculate my price target as well as my longer-term valuation. Declining absolute earnings are negative for both. Additionally, buybacks lower GME's cash position, which I believe will come under pressure sooner than many predict.
Management also has been uncharacteristically inaccurate or vague in its forecasts over the last two years. I mentioned the digital receipts vs. revenue issue above, but there are other examples. Management did not give a FY 2012 revenue forecast after missing FY 2011 revenue guidance. Comps range guidance has moved from (1.5%)-2.0% at the beginning of the year to (2.0%)-(10.0%) today. The pre-owned business was expected to grow in mid-single digits, but has declined ~5% YTD. Similarly, management forecast hardware and software down 5%-10%, and both have declined more than 20% YTD. Despite these results, full year guidance has been reiterated largely as a consequence of the share buybacks.
Investment Thesis and Timing
As mentioned in the opening, I predict that management's ongoing attempts at growth, margin expansion and capital reallocation (e.g. dividends / buybacks) will eventually be exposed as failures as an inflection point is reached in 2H 2013 or 1H 2014.
For the next 12-months, my $17.05 price target reflects a forward P/E multiple of 5.9x and projected FY 2013 earnings of $2.89 per share. The 5.9x multiple is primarily based upon a 12-month extrapolation of the 3-year downward historical trend, but also considers historical and comparable company multiples, as well as share buybacks. GME's 1-year mean P/E multiple is 6.8x and has dipped below 5x in the period. Current P/E multiples for Best Buy (5.5x) (BBY), RadioShack (RSH) (Neg) and hhgregg (HGG) (6.9x) are similarly in line. Buybacks in 1H 2012 totaled 15.4M shares (the impact on EPS is discussed in more detail below), with a $300M authorization still available. While the 3-year extrapolation suggests a multiple of 6.2x, I believe that further compression of ~5% is appropriate given competitor comps, GME's recent historical lows, and management's aggressive buyback policy boosting EPS (versus absolute earnings growth).
In summary, my GME thesis and accompanying price target is heavily weighted toward the following considerations:
1. Digital revenues and non-GAAP digital receipts have slowed significantly in 1H 2012 (25% YoY compared to 50+% in 1H 2011) as alternative digital distribution services become more popular, and I predict GME will fall well short of its FY 2012 50% growth target for the digital segment.
2. Mobile revenue growth and margins, primarily driven by the re-commerce of iDevices (e.g. iPhones / iPads / iPods) and Android tablets, will peak in FY 2012. Current growth will decline with store saturation, margins will suffer as less desirable locations are targeted, and the lack of a competitive moat portends mobile strategy failure.
3. The expected 2H 2013 console upgrade cycle will temporarily boost revenues. The corresponding margin compression, however, will depress EPS, and digital integration features (more storage / platform improvements) will ultimately accelerate the digital shift.
4. Industry-wide sales of new physical games in 1H 2012 declined > 20% YoY. The decline will inevitably hit GME's core new and pre-owned games segments-combined revenue and gross profit of 70% and 77%, respectively-contracting growth and earnings faster than digital and mobile sources can take in the slack.
5. Shareholder friendly dividend and buyback policies will burn cash faster than is necessary and hasten the road to legitimate financial distress.
I value the company at $0 (yes, zero). To those who question how a company with no debt and positive free cash flow can have a negative valuation, I point to the 6,600+ stores and estimated $2B of operating lease obligations. My valuation (as opposed to my target price) is based entirely on a discounted cash flow model that reflects a short-term view of limited growth and a longer-term view of declining sales and higher margins. I project annual sales growth (decline) of 15%, (10%), (15%), (15%) and (15%), and FY 2013 gross margins at 25% increasing thereafter 0, 200, 100 and 100 bps sequentially (e.g. 2017 gross margin of 21%).
Longer term, I do not see a viable strategy for growth in the retail gaming market and believe that GME will struggle to execute a digital strategy so far outside of its core retail competencies. Console manufacturers, online retailers and publishers themselves are better positioned as digital distributors. Lower forecasted margins reflect my belief that the highest margin used gaming sales category will continue its precipitous decline, while lower margin segments such as hardware (which will remain a retail product for the foreseeable future) and new gaming sales (which include in-store and e-commerce packaged sales) will increase on a percentage share basis. Moreover, I expect that current forays into the mobile re-commerce market will be met with stiff competition and ultimately fail to replenish profits lost from physical game sales. Pre-owned mobile hardware has lower margins and a substantially lower turnover (i.e. people own phone and tablets longer) than pre-owned games.
GME is first and foremost a retailer, not a digital distributor. While the company has expanded into digital markets through acquisitions and internal development, the company's digital expansion remains a work in progress. Management points to next generation console launches in the coming year as business boon, but I am less confident in that assessment. In fact, I expect that next generation gaming consoles will hasten the shift to digital distribution. I expect such consoles to have greatly enhanced storage capacities and fully integrated digital ecosystems. Gamers on their couches - never renowned for a propensity to physical activity - will be more than happy to adopt the new digital regime.
Please feel free to question any arguments / assumptions herein and I will do my best to elaborate.