GameStop: What The Numbers Say

Summary

• GameStop is strategically well positioned as a specialty retailer, but sales growth seems to be a real weakness.
• The market hasn't been willing to pay more than 10 times earnings on average, in the last decade. The P/E is currently at 6.4, thus indicating a 36% discount.
• The company has been struggling to maintain its excellent business operations. It has for instance gone from an average of -1 day to +50 days that cash is tied up.
• Its loyalty program, with 53 million members, is a core strategic asset that can be leveraged for its business expansion. Current market capitalization indicates a value of $40 per member.
• There is ample working capital and free cash flow for future growth, organic and through M&A.

As investors we continuously try to identify opportunities that can provide great returns with a suitable margin of safety. In this article, we analyze if specialty retailer GameStop (NYSE:GME) is currently such an opportunity. By doing a valuation based on the long-term trends in the company's financial statements and by analyzing strategic business conditions, we identify key performance indicators. Based on the assessment of these indicators we try to come to a conclusion if this stock is currently an attractive buy.

Source: investor.gamestop.com

Valuation (+)

GameStop is a multichannel video game retailer that since 2014 has significantly underperformed its industry and the S&P 500 as a whole, as is shown in the graph below. The main reasons for this are: the very strong competition from online retailers like Amazon (AMZN), aggressive hardware promotions by other retailers like Best Buy (BBY) and the ongoing changes in software distribution.

Source: adapted from morningstar.com

To combat the decline in hardware and software sales, GameStop expanded its technology brands offering in 2014 by entering into a strategic agreement with AT&T (T) and Cricket Wireless. In 2015, it moved into the collectibles market by acquiring GeekNet. In 2016 it even entered the indie game publishing category with the launch of GameTrust division. So GameStop understands the need to find new revenue streams, but the market has not reacted. The market price is close to its 52-week and 5-year lows, as is shown in the gauges below.

Source: data from morningstar.com

Dividend is forecast for 2017 to be $1.52, or about 7% based on the current market price, as also shown in the gauges below. For the next year the dividend is expected to grow by 2.6%, with an analysts' consensus (source) of $1.56 for 2018. The dividend has significantly increased since its introduction in 2012, about 80%. Dividend coverage is about 3 times right now. After dividend payment there is still ample cash for growth.

Source: data from morningstar.com

Considering the near to low market price, we use price ratios to get an initial valuation of the company. The price-to-sales ratio (P/S) for GameStop is currently at its lowest in 10 years with 0.3 compared to the current specialty retail industry average of 2.5 and S&P 500 average of 2.1. In general, a P/S below 1 is considered extremely low, but for GameStop the average has been 0.4 in the last 10 years. Based on this, we currently get a hefty 35% discount.

GameStop's price-earnings ratio (P/E) has been decreasing since 2013 and is now at a 10-year low of 6.4 (forward P/E is 6.6). Compare this to the industry average of 43.8 and S&P 500 average of 21.4, we seem to get an extreme discount. However, the company's average for the last 10 years is 10.4. So, a more reasonable calculated discount is about 38%.

The company has been buying back shares for the last couple of years, thus positively impacting earnings per share (EPS). As is shown in the graph below, currently there are about 12% less shares outstanding than there were in 2013. In the same period the shareholder equity has been steady, overall positive signs.

Source: data from finance.google.com

Strategic Review (+)

The aim of the SWOT analysis, as is shown in the matrix below, is to identify the key internal and external factors and to see if GameStop is able to achieve its objectives. We will use this model to identify the biggest strengths and weaknesses of the company and analyse these in more detail.

The key strengths are GameStop's loyalty program, its brands and cash for M&A. Its key weaknesses are its dependency on physical software games, brick-and-mortar model and large suppliers. Online should be a big opportunity for GameStop. Here it can combine retail, content, development and advertising under one global loyalty brand. This way it can combat the biggest external threats from the change to digital downloads and the so-called “death of the malls.”

The definite move to online should be the company's long-term goal. The entrance into the indie game publishing category, with the launch of GameTrust division and creation of the GameStop Technology Institute (GTI) are clear indications that the company has a similar view. Coupled with the existing web and mobile gaming sites, game print and digital video game publications, this will give GameStop a good strategic position.

In the meantime, it needs to leverage its brick-and-mortar business and move away from physical software. This is where most of the threats are. Based on the above SWOT we will dive deeper into the following:

• Sales and earnings: how is the company managing its dependencies on physical video games?

• Cash and debt: is there enough room for growth through M&A?

• Operational performance and inventory: can we identify increased competition and supplier strength?

• Loyalty program: is this a core strategic asset that can be leveraged?

Sales and Earnings (+/-)

As is shown in the graph below, the last five years GameStop's sales revenue was growing steadily on a year-to-year basis. However, in 2016 (ending 2017-01-28) sales revenue dropped to $8.6 billion by 8.1%. This is significant and probably the main reason for the decline in market value. Looking at the cost, however, we see a well-controlled company with cost of revenue moving in tandem with sales. GameStop announced closing about 150 more stores this year, to keep cost under control (source). Operating expenses have increased in 2016, but this is to be expected with the move away from a dependence on physical games sales into other markets.

Source: data from morningstar.com

Because of the share buyback program, the trend for net income and earnings per share is somewhat of a different story. Apart from the negative value in 2012, EPS has been growing in the last 10 years; see the graph below. Its growth has, however, stagnated with the weak 2016 revenue but it is currently way above its 2008 figures, when sales revenue was much lower. The current EPS of $3.35 compared to the 2007 value of $1.75 has increased about 92% in 10 years' time.

Source: data from morningstar.com

According to the company's 2017 guidance of 6/27/17 (source), total sales will be +/- 2%. So for this year, it is expected to stabilize. In the graphs below, we have plotted the detailed sales figures for the last nine quarters to get a better understanding of what is going on.

Source: data from news.gamestop.com

We clearly can see the seasonal sales pattern and the very weak Q4 last year. Hardware, software and pre-owned are declining year-to-year with only hardware Q1 2017 as an exception. Accessories is more stable with some quarters better and others worse than the year before. GameStop had already anticipated this weakness in software sales and has been actively moving away from physical video games since 2010, with a goal of a 50% reduction at the end of 2019 (source). However, software sales have declined 15% in the last two years.

GameStop is currently unable to catch the decrease in physical video game sales with its digital business. To compensate for this, the company has been focusing on increasing its technology brands and collectibles businesses, as can be seen in the graph below. From a strategic perspective this is very smart, leveraging its brick-and-mortar business with its strong omni-channel and reward systems by introducing new physical products that are linked to its buy-sell-trade and hardware refurbishment models.

Source: data from news.gamestop.com

Cash and Debt (+)

GameStop's cash position has been declining steadily in the last couple of years, as shown in the graph below. Currently, there is about $3.08 per share on the books. But if we calculate net working capital by subtracting current liabilities from current assets, we get the total operating liquidity available to the business. This has grown to a solid $675.1 million or about $6.66 per share. Unfortunately, the total debt has also increased in the same period, indicating that the company has been borrowing money to finance its strategic growth. With a current debt to equity of 0.36 GameStop is, however, safely leveraged and well below the industry average of 0.7. Fortunately, a large part of these borrowings is still available as working capital in Q2 of 2017.

Source: data from finance.google.com

GameStop is also going to add to its cash position with its free cash flow (FCF), as indicated by the before calculated 3 times dividend coverage. This is ample cash for M&A. However, as shown in the graph below, operating cash flow (OCF) has been growing very slowly for the last 10 years, about 30%. This is not a very positive sign compared to 92% EPS growth in the same period. The FCF growth, by subtracting the capital expenditures (CapEx) from the OCF, is a little better with 60%. Growth seems to be a real weakness for this company. Hence, the market hasn't been willing to pay more than 10 times earnings on average in the last decade.

Source: data from morningstar.com

Operational Performance (-)

In the latest quarterly report (source) the company prioritizes the spending of the FCF after dividends as follows: technology brands expansion, potential M&A and share buybacks. So, to see how effective management is utilizing its extra cash we look at some of the profitability ratios, as shown in the graph below.

Source: data from morningstar.com

Return on assets (ROA) gives us an idea as to how efficient management is using its assets to generate earnings. As shown in the graph, GameStop's ROA has declined in the analyzed period, but seems to have stabilized at 7.6%. This is also the industry average, so not that bad actually.

Return on invested capital (ROIC) is used to assess a company's efficiency at allocating its capital. It can be an excellent indicator of the size and strength of the company's competitive advantage (moat). Between 8% and 12% can be considered fair, between 12% and 15% good and between 15% and 20% excellent. So, unfortunately, GameStop has gone from excellent to good, with the increased competition from retailers like Amazon (AMZN) and suppliers like Microsoft (MSFT) shrinking its moat.

Cash-flow-to-sales ratio (CF/Sales) shows the company's ability to turn sales into cash. The higher the number the better. Even though GameStop has an impressive (free) cash flow it needs a huge amount of sales with the current 7.5%. But it seems to be improving over time, which is promising.

Profit margin is an indicator of a company's pricing strategies and how well it controls costs. In this case we use operating margin. The average profit margin for the specialty retail industry is 7.8%. As can be seen in the graph below, GameStop is well below this with 6.3%. It appears to be stable for the analyzed period.

Inventory (-)

For a retailer like GameStop, inventory management is key. Therefore we look at the following 3 ratios to determine the company's operational effectiveness:

• Days inventory (DI) is the number of days an average item is held in inventory before it is sold. A high DI implies poor sales and, therefore, excess inventory. As shown in the graph below, this is exactly what is happening at GameStop. Its DI went from an average of 50 to 80 days and since 2015 it seems to be accelerating.

• Days sales outstanding (DSO) is the average number of days that a company takes to collect revenue after a sale has been made. As shown in the graph below this has also gone up in the last couple of years. It is still relatively low and might have gone up because of the increase in online transactions.

• Days payable outstanding (DPO) tells us how long it takes for a company to pay its invoices from trade creditors, such as suppliers. The longer GameStop can hold on to its cash before it pays the bills the better. But again this ratio is moving in the wrong direction, indicating that the company is losing its bargaining position with the suppliers and is forced to pay the bills on time.

Source: data from morningstar.com

Summarizing, in 2007 the company could on average buy an item from a supplier on day 1, have it in its inventory for 51 days and collect its revenue in 53 days before it would have to pay the supplier the next day. Now, on average, it first has to pay the supplier after 37 days, then the item is in inventory another 43 days before it's sold and then GameStop has to wait another 7 days for it to book the revenue. So GameStop has gone from an average of -1 day to +50 days that cash is tied up in inventory.

Loyalty Program (+)

GameStop's PowerUp rewards program currently has about 53 million global members, 36.5 million in the U.S. and 16.5 million international (source). As is indicated in the graph below it has been growing significantly since 2012. Even the last quarter the company added 1 million new members. Even with the flattening of the curve this is still very positive, especially considering the decline in software sales. Compared to Steam, the biggest gaming platform with more than 65 million players around the world (source), this number is still impressive.

Source: data from investor.gamestop.com

As indicated in the SWOT analysis, the loyalty program can be considered a core strategic asset, as GameStop can drive its (online) business expansion around this program. If the company started utilizing advertisement to its full potential and would become more of a media company, we could even say that with the current market capitalization of $2.15 billion, the value of one member in the loyalty program is about $40. This is similar to a company like Twitter (TWTR) that does not make a profit yet, and about 5.5 times cheaper than Facebook (FB).

Conclusion

The main question of this analysis is: can GameStop provide great returns with a suitable margin of safety? If we summarize the valuation of the company we can conclude that the current market price gives us a discount of about 36%. This coupled with the 7% dividend yield, that is covered 3 times by free cash flow, provides an excellent opportunity.

However, these rewards don't come without a risk, they never do. You can see that the company is struggling to maintain its business operations. Key indicators, like sales, profitability and efficiency, are performing worse than before.

But if we stand back a little and look at the opportunities, we see that GameStop is well positioned as a specialty retailer. It has a core strategic loyalty program and understands that it needs to expand its business around this. It's creating opportunities for online with the entrance into the indie game publishing category, web and mobile gaming sites and digital video game publications. In the meantime, it is working hard to keep its brick-and-mortar business profitable. The latter is where the biggest threats currently are for the company.

Looking at the numbers, in combination with GameStop's strategy, one can conclude that management is actively engaged in every aspect of its business, for now and in the future. Therefore, considering the complete analysis, I believe that this stock could create an opportunity for a value investor.

Analyst’s 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.