- GameStop exhibits a number of intrinsic business disadvantages.
- The company's financial positioning is progressively weakening.
- GameStop elicits a sell recommendation.
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Over the past five years, GameStop (NYSE:GME) has sustained a significant deterioration in the company's stock price. GME witnessed a more than 70% downtrend, with share prices falling from 2015 highs of $45 to present levels of around $11. Falling share prices come as a result of a number of fundamental weaknesses in GME's business ranging from a changing distribution channel, substantial retail competition, significant competition from online channels, digitalization of games, and strong growth headwinds. GME's unsuccessful bid for a buyout was not exactly a vote of confidence for existing shareholders. Even still, GME offers a 13.52% dividend yield, prompting deliberation over whether or not it's worth it to collect GME's high dividend and wait for growth to resume. This article will provide an in-depth analysis of GME, discussing business vulnerabilities, growth sentiment, dividend yield, and relevant financials.
The preeminent concern facing GME is that digital game downloads will replace physical games that GME has traditionally sold. GME derives an overwhelmingly large concentration of revenues from its legacy video game and tangible hardware sales business. Roughly 81% of revenues come from GME's tangible video games/hardware segment, 11% comes from the technology brands segment, and collectibles and other items comprise the remaining 8%.
GME's legacy video game business encompasses new video game hardware, new video game software, pre-owned and value video game products, as well as video game accessories. The company's large tangible gaming product concentration subjects it to market share erosion as major retailers such as Target (TGT), Walmart (WMT), Amazon, and Best Buy (BBY) etc. offer the same gaming product lines in addition to having much broader revenue diversification. So not only is GME facing market share erosion and margin compression from other retailers, the company also faces a significant online buying dilemma. GME's target clientele is younger individuals ranging from adolescents to people in their 20s and 30s+; GME's intended customers epitomize the convenience-oriented buying culture of 21st-century society. Young individuals are most likely to pursue the most convenient buying options, ex. why go to the store when in a matter of clicks, you can buy and download a game to your computer, game console (Xbox/PS4), or phone? This is extremely problematic to GME as online game purchases result in poor store revenue translations, increased market share erosion, and decreasing revenues. The following statistic is derived from the Entertainment Software Association and demonstrates the precipitous decline in physical format game sales over time.
Not only is there a deviation toward digital game delivery but there is broadened differentiation within the market in which game spending is further distributed across mobile games, tablet games, smartphone games, pc games, browser pc games, downloaded pc games, virtual reality games, and of course console games. Given that GME derives an overwhelming portion of revenues from console games and hardware this may represent a revenue shortfall as gamers are preoccupied with other gaming mediums.
If we look at GME's revenues, surprisingly the company has experienced what appears to be only nominal revenue contraction, in fact, revenues have flatlined at around $9 billion. However, it has not been so much a precipitous decline of GME's revenues as it has been a decade-long lack of revenue expansion. As U.S video game spending increased an astronomical 40% from, $17.5 billion in 2010 to $29.1 billion in 2017; GME did not realize any positive monetary implications, suggesting an underlying weakness in the company's revenue generation model.
While AMZN, BBY, WMT, and other game product retailers have brought negative competitive pressures to the retail space; GME's critical weakness lies in digital game downloads. More and more consoles are offering game downloads instead of selling physical games. The reasoning behind this is that it is much more profitable for game studios and console makers to utilize digital content delivery as it eliminates the need for third-party retailers and also eliminates costly disc reading componentry. Although the trend for newer software, increased digital content delivery, and decline of pre-owned video game sales is worrisome, physical video games will likely not dissipate overnight. Broader revenue contraction for GME will take time to materialize as the company's physical game and hardware offerings definitely capture a segment of the market. Over the past couple of years, GME has witnessed some declines in the company's legacy new video game hardware and pre-owned/value video game products. The company is poised for slow revenue deterioration; however, that could be exacerbated by console developers transition to diskless consoles. Later in 2019, Xbox is rumored to be releasing a console-less Xbox one variation that is considerably less expensive than a disk drive model. The diskless console is set to cost $200, which will be considerably less expensive than current disk drive models. A drastically reduced console price will provide strong consumer incentives to deviate away from physical disk-drive units, providing Microsoft (MSFT) with increased revenue opportunities within its digital game sales segment.
Poor Managerial Oversight
I am not overwhelmingly convinced with GME's operational strategy. Management has made a number of imprudent decisions ranging from an unrealistically high dividend that will likely be cut, wasting liquidity reserves on share buybacks, and a misplaced focus on GME's collectibles segment. GME's current dividend yield, although very enticing at 13.52% is unsustainable based on its free cash flow payout ratio. Currently, the payout ratio sits at 86%, placing significant constraints on free cash flow mobilization toward reinvestments, enhancing the company's collectibles business, or offering new and innovative products that appeal to consumers. It seems that cutting the dividend is a fiscally responsible course of action given that GME's annual dividend payments monopolize a substantial portion of free cash flow, the company has a large debt accumulation of $818 million with a significant $350 million debt payment due this year with limited cash reserves of $455 million.
GME's focus on the company's collectibles segment will be unable to compensate for the revenue shortfall in the physical games and hardware segment. GME still derives 81% of revenues from the company's physical game and hardware offerings while obtaining less than 8% of total revenues from the company's collectibles segment. GME did expand the company's total revenues from the collectibles segment, but growth prospects are unpromising as the collectibles segment is a very limited market and growth has slowed. Collectible product sales grew from $309 million in 2015 to $494 million in 2016 to $636 million in 2017 representing a 29% and 23% respective year over year growth rate increase. Additionally, the propensity of consumers making collectible purchases is much lower than ordinary game purchases. Furthermore, I anticipate GME's margins to face continued pressure as the store implements item bundling programs and continues to pursue collectibles, specialty items, and licensed merchandise in an effort to supplement existing revenues. Something else to consider is that although management expresses solace in the stores' value proposition to customers, the reality is that game/console trade-in programs at GME are very uncompelling, and other retailers such as Amazon have far better pricing.
GME is set to experience a gradual decline as revenues are eroded by game segment differentiation, digital game downloads, diskless gaming, and rampant competition. GME is a business without a competitive moat as it does not own substantial fixed assets, it cannot be as price competitive as other retail firms, and the company is being reduced to an increasingly smaller segment of the gaming market. There are fundamental weaknesses in GME's business ranging from financial difficulties, operational mis-execution, and an unsustainable dividend. Although GME's decline will very protracted, shares are not a buy as there is an unattractive risk-reward proposition and I foresee continually downward stock price movement in the future.
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