3 Reasons Digital Downloads Drag Down GameStop

Summary

• File size and download speeds no longer pose a barrier to online download of video games as global fixed broadband averages exceed 40 Mbps.
• As inventory of possible preowned games diminishes, GameStop’s overall profitability rate diminishes because the mix shifts toward the lower profit new software and hardware categories.
• GameStop’s share of sales falls significantly for new games, digital downloads, hardware and accessories, and even collectibles as the $750 million trade-in subsidy withdraws.
• Fewer physical games are published each year and consumers play games longer, reducing inventory for GameStop's preowned category.
• Expect sentiment to worsen as cash flow expectations decline, debt exceeds cash on hand, and questions are raised if both the divided and store remodels can be maintained.

On the digital side of gaming, that's obviously the overhang that drags down the GameStop stock.

GameStop CFO Rob Lloyd – November 2017

When GameStop (NYSE:GME) announced 4th-quarter results at the end of March, both Q4 earnings and revenues beat expectations. But weak guidance, which projected 2018 total sales down 2% to 6%, rattled investors. Share prices fell 10% during the next day’s trade. Down 40% over the past 52 weeks and at a 13-year low, share price had bottomed. During the coming weeks shares regained most of their post-earnings fall.

Market commentary and sentiment shifted and began focusing on GameStop’s apparent deep value. Eighty percent of analysis here at Seeking Alpha turned positive. The following three quotes from Quad 7 Capital’s recent commentary on valuation are indicative of the common perspective:

…we see shares are trading at 4.18 times forward earnings …the price-to-sales is very attractive, currently at 0.38 times forward sales at the conservative end of guidance.

Long-term debt is $817 million, about flat from a year ago. This is high, but not obscene. The company also has $864 million in cash and equivalents and sufficient cash flow to cover all of its liabilities. Moreover, the company pays a bountiful dividend, which is covered, comfortably. The dividend, which has been raised every year, is now offering a yield of 12%.

In addition, not only is it covered from an earnings perspective, but with projected free cash flow for 2018 at $300 million, the dividend payout ratio is still a paltry 50%.

While analysts have keyed in on the strong valuation metrics above, they do also recognize concerns that the shift from physical to digital delivery of games will impact GameStop’s large preowned business. However, the general consensus is that this decline is slow. Consider the following from a George Putman article:

Decline is slow, not fast. If revenues fell by 33% over the next four years, with gross margins declining from the current 33% to only 28%, along with other effects, the company could still generate nearly $800 million in cumulative free cash flows over this period.

And to date, declines have been slow. But is the cash flow safe? Below we will discuss why the shift to digital delivery will accelerate in 2018 - and more importantly, why the secular shift to digital not only threatens sales and margins in the preowned business, but also creates a feedback loop decreasing new software, hardware and collectables sales.

Internet Speeds, Digital Penetration and the Preowned Feedback Loop

For about two years GameStop has provided the graphic below to demonstrate the moat video game delivery has against penetration from online download. The company rightly points to large file sizes and significant download times as a barrier to change. Interestingly, the download speed used for comparison is 10 Mbps. However, average fixed broadband speeds last year exceeded 60 Mbps in the U.S., and more importantly, grew quickly to now exceed 80 Mbps. Estimates for the current global average is over 40 Mbps and likely higher in the game and geek culture generally. Additionally, last year large game creators like Activision Blizzard (ATVI) improved digital launches for major titles by allowing preinstalls in the days leading up to activations, which were staggered globally to reduce server stress. File size and download speeds no longer pose a barrier to online download.

Source: 2017 Leveraged Finance Conference Presentation

Large creators also have an incentive to move to digital rather than physical delivery. Growing digital delivery of core games (versus physical box), along with adjacent live services, continues to shift their total mix toward digital. This phenomenon, highlighted in the charts below, drives an increasing gross profitability rate. Consider Electronic Arts’ (EA) net bookings mix shift and the corresponding gross profit percentages:

Source: Q3 FY18 Earnings Slides (note: Digital includes core game and live services.)

Source: Q3 FY18 Earnings Slides

There are three nuanced takeaways from the imminent transition in 2018 from physical box majority to a digital download majority. As inventory of possible preowned games diminishes, GameStop’s overall profitability rate diminishes because the mix shifts toward the lower profit new software and hardware categories. Additionally, moves to defend the category through promotion drive down the profitability of remaining dollars in the category. Check the following graphic from Q3, preowned is by far the largest and highest profit percent center among the video game segments (outside of digital of course). It is also the category with the fastest declines in both dollars and percent gross profitability. Put more bluntly, GameStop’s profit rate responds inversely to their large game maker partners’.

Source: 2017 Leveraged Finance Conference Presentation

Equally important, the reduction in possible preowned game inventory is removing hundreds of millions of dollars from GameStop’s ecosystem. Company officials have recently stated that they are returning a billion dollars to players through trade-ins. A large majority of these dollars was given as trade credit; in the past the company has stated that three out of four of these dollars go to new game purchases. As this $750 million subsidy is withdrawn, GameStop’s share of sales falls significantly for new games, digital downloads, hardware and accessories, and even collectibles. And note, here too the company is not aligned with game creators, as GameStop receives 100% of the profits from reselling trade-ins of game creators intellectual property.

Last, on the recent conference call CFO Rob Lloyd proposed two connected ideas that further weigh on the preowned category:

Our pre-owned business performed in line with our expectations declining nearly 3% in the quarter and 5% for the full-year. Given the relative newness of the Nintendo Switch, it’s important to point out that it is not yet contributing to our pre-owned business in a meaningful way.

In addition, we’ve seen a shift in the pre-owned business from software into hardware as we see fewer physical games published and sold each year and consumers playing games longer to take advantage of added digital content and in-game transactions.

But will Switch contribute significantly to the preowned business? Concerns immediately surface when one takes a look at the four strongest Switch titles from 2017. Splatoon 2 and Mario Kart 8 Deluxe both have strong replayability and ongoing multiplayer content. The Legend of Zelda: Breath of the Wild and Super Mario Odyssey don’t have as high replayability but are considered library worthy titles. Trade-ins of these titles will be limited. And more generally, to paraphrase Lloyd, fewer physical games are published each year and consumers play games longer, reducing inventory for preowned.

Takeaway

As mentioned in the valuation section above, GameStop does have zero net debt. However, capital expense projections, for 2018 alone, exceed $110 million, as capital intense merchandising resets/remodels are necessary in the video game stores. $150 million is earmarked for the substantial dividend. Prioritizing a small stock repurchase program is planned along with using $75 million of cash on hand in refinancing activities. Maintaining the dividend and zero net debt is carefully balanced on reaching expectations.

Source: 2017 Q4 - Earnings Call Slides

Are expectations realistic? GameStop is guiding down 2018 sales for the video game categories by mid-single digits and some have suggested guidance is purposefully low. But taking the three trends highlighted above into consideration, when coupled with tough 2017 comps driven by the Switch success, even the low end of sales guidance seems optimistic. And recall, the profit percentage from these sales is pressured by the ongoing mix shift away from preowned. Expect sentiment to worsen as cash flow expectations decline, debt exceeds cash on hand, and questions are raised if both the divided and store remodels can be maintained.

Analyst’s Disclosure: I/we 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.