I owned GameStop Corp. (NYSE:GME) back in 2012-2013 and made money despite the then prevailing opinion that GME and Best Buy (NYSE:BBY) would soon be joining Radio Shack among the soon-to-be-irrelevant brick-and-mortar retailers. Last week, GME announced poor holiday sales and a large drop in same-store sales; the stock has dropped more than 8%, and there are a number of posts again predicting the demise of GME. (Just type "is GameStop going out of business" in your Google search, and you will return over 2.5 million results.) But I think these doom and gloom scenarios are missing the bigger picture, just as they missed it with BBY a couple years ago. Since mid-2014, BBY's shares have climbed from the mid-$20s to the mid-$40s. Can GME do the same?
GME's management has been very candid about their dependence on the new releases of gaming hardware and software to drive traffic to their stores, and the change in gaming patterns from physical software products and hardware consoles to digital downloads and mobile platforms. They specifically stated their intention to diversify away from their reliance on physical gaming in their 10-K for fiscal 2015, stating "Our goal is to have 50% or more of our operating earnings for the 52 weeks ending February 1, 2020 ("fiscal 2019") come from sources other than physical gaming," and "We plan to close approximately 200 Video Game Brands stores worldwide in fiscal 2016". How are they doing? I believe they are making good progress.
GME describes itself as "a global family of specialty retail brands". GME has invested heavily in the past two years in acquiring stores and expanding its relationship with AT&T (NYSE:T) to become the largest AT&T authorized reseller, operating stores under both the AT&T and Cricket brands. GME also operates 70 Simply Mac stores, making it the largest Apple (NASDAQ:AAPL) certified products reseller. The Simply Mac stores are developed, with AAPL's input, in locations too small to support a full-scale Apple Store. GME also has opened Zing Pop stores selling collectible pop-culture themed products similar to those found on its thinkgeek.com website. At the end of October, 21% of GME's total stores were non-video game stores, and GME targets a 20%+ IRR for its new store concepts. GME has more than 2,900 stores (about 38% of its total stores) coming to end of lease in 2017 and 2018, giving management significant flexibility in closing, rebranding, or relocating underperforming or redundant video game stores.
Despite the well documented challenges facing the video game market, GME hasn't missed a beat in producing significant cash flows from its business. From FY11 through FY16 (October TTM), GME has generated $1.1-$1.2 billion of EBITDAR every year and free cash flow (cash from operating activities less capital expenditures) has averaged about $475 million per year, most of which has been returned to shareholders through dividends and buybacks. This kind of consistency is usually reserved for consumer staples companies, yet GME's stock price has experienced dramatic movements, often based on the latest same-store sales comparisons. For example, in FY13, GME generated $9.04 billion in sales, $2.99 EPS, and paid a $1.10/share dividend. The stock traded as high as $57.74. For the year just ended, GME will post sales of approximately $9 billion with EPS of about $3.70/share and a $1.48 dividend, yet the shares are trading at less than $23. What's different? The biggest difference is that GME is operating 1,000 more stores than it was in FY13, but has not seen any real lift in total revenues. GME's revenue per store consistently averaged $1.35-$1.40 million for most of the last ten years, but has recently tumbled to about $1.2 million. GME's same-store sales comps have been poor for the past several quarters. Since the Technology stores (essentially everything except the video game and collectibles stores) are not yet included in same-store sales comps, it is obvious that the decline is concentrated in the video game stores, which is why the opportunity to exit leases and convert or relocate stores is important.
What is often lost in the dialogue about GME's declining video game store performance is the fact that the business remains highly profitable. More important, however, is that the new Technology store business is more profitable than the video game store business. A close review of GME's 3Q16 10-Q will show that its Technology Brands comprised only 11% of total sales for the quarter. This 11% of sales, however, produced 22.5% of GME's total gross profit for the quarter. In fact, the Technology Brands produced $159.6 million in gross profit for the quarter compared, more than the $150.0 million of gross profit generated by new video game software. For the past few years, much has been made of quarterly fluctuation in GME's used video game margins and its market share in the new software and hardware segments. While the gaming segments are seasonal, and also dependent on the cycle of new title and hardware releases, I believe it is likely that GME's Technology Brands segment will become an even greater contributor to GME's total gross margin dollars as the stores acquired in 2015 and 2016 gain traction and efficiencies. The Technology Brands businesses produce a gross margin in excess of 70%, compared to less than 50% for used video games, and 25% for new video games. At these margins, a dollar of Technology Brands sales can replace the gross profit generated by two dollars of video game sales. Management appears to be well on their way to achieving their goal of 50% of operating income from non-video game products by FY19.
Yes, the video game market for brick-and-mortar retailers like GME will likely continue to deteriorate, but GME is still the destination for most gamers, as evidenced by the steady increase in sales of accessories and collectibles. Despite soft sales of new game titles, and no new hardware platforms in four years, GME is still showing year-over-year growth in accessories and collectibles. GME has over 55 million PowerUp Rewards members worldwide, and 2017 should see the release of the first new video gaming consoles since 2013-2014. Therefore, I believe there is a relatively long tail on the decline of GME's video game business. This, combined with the ramp up in the Technology Brands segment, and continued growth from accessories, should provide consistent cash flow generation for the next several years.
The market's hyper-focus on same-store sales comparisons and quarterly changes in market share will likely continue to provide opportunities for investors to acquire GME shares at very attractive valuations. I believe now is one of those times. At today's price ($22.76 as I'm typing this), GME is trading at an enterprise value of just over 6x its annual FCF (just under 6x its five-year average FCF), at just over 1x its BV and a 6x P/E with a yield of 6.5% and a well-supported dividend. All of these metrics are consistent with GME's historic low points. I believe investors purchasing shares at these levels will be well rewarded - but be prepared for the volatility surrounding every quarter's earnings release and sales report.
Disclosure: I am/we are long GME.
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.