GameStop's (GME) current business model is clearly dying (although the speed of its demise is debatable). There is an obvious argument made that even as a dying company its shares have become too cheap to ignore. I think that this is a very superficial take and may distract investors from the true nature of the bet they are making.
Before delving below the surface though, let's take a look at the obvious stuff first. GameStop has $748 million of net cash (cash minus all debt) which is about $7.3/share. Its current market cap is about $888 million at $8.7/share. Which means that the company could pay all of its debt, return to shareholders a sizable amount of money and still have ample cash going forward.
Furthermore, the company is still quite profitable. According to its 2018 10-K it generated about $200 million of FCF and about $298 million of net profits if we exclude their $970 million goodwill impairment charge. Sure, revenue declined about 10% y-o-y but this business isn't closing tomorrow.
So far so good. But for GameStop to make sense as an investment for any reasonable amount of time at least two of the three following statements must be true.
- The company will return a lot of cash to shareholders.
- The company will focus on keeping its legacy business profitable and cash flow generating for as long as possible.
- The company will succeed in diversifying its revenue and will start growing again.
I think that the first point has almost zero chances of being true and that going forward shareholders should expect that GameStop will use every last dollar in its disposal in its fight for survival.
The following excerpts are from GameStop's Q4 2018 earnings call:
Daniel DeMatteo - Executive Chairman
[...] We also want to maintain flexibility to deploy capital toward the value-enhancing initiatives currently under development. As you know, we announced a concrete plan to reduce our debt through the retirement of the $350 million in unsecured bonds due in 2019. I'm pleased to share that at April 4th that process will be completed. We will also announce the new $300 million share repurchase authorization, which will enable us to be opportunistic in buying back shares.
[...] Any thoughts about the dividend, I mean is there any risk to the dividend with the cash flow situation where us in good shape right now.
The balance sheet looks pretty strong in terms of cash, given the divestiture of the AT&T business. We're not giving guidance on cash flow for 2019. Again that's related to the initiatives and various things that George (the new CEO) will be neck deep and frankly when it gets here. So, we're holding off on that. I would say that the dividend is part of the capital allocation strategy that the board will continue to evaluate quarterly as we move forward.
My take is that the board is purposefully vague about capital allocation because they don't want to create any problems for the new CEO that they just hired. Especially because the most likely route the new CEO is going to take is to preserve as much capital as possible for the company's efforts to reinvent itself.
This is easily discernible from the massive bonus the company has awarded the newly hired CEO. The excerpts below are from the company's May 2019 proxy filing (emphasis mine):
In March 2019, the Board appointed Mr. Sherman as Chief Executive Officer, effective April 15, 2019. [...] Mr. Sherman was granted a “make whole” equity award with a grant date value (at the target-level of performance) of $6,000,000 and a 2019 annual equity award with a grant date value (at the target-level of performance) of $4,500,000. Each of these awards consists of 50% time-vested restricted stock and 50% performance-based restricted stock. [...]The actual number of shares that may be earned in respect to the performance-based portion of the awards will vary between 0 to 200% of the Target Shares, depending on actual performance, with any above-target shares being issued at the time that performance is determined.
[...]The time-based portion of the awards will vest in three equal annual installments, on the first, second and third anniversaries of April 15, 2019 (the “Grant Date”), subject to Mr. Sherman’s continuous service with the Company through the applicable vesting date. The performance goals applicable to the performance-based portion of the awards have not yet been determined. [...]To the extent earned, the performance-based shares will vest on the third anniversary of the Grant Date, [...] In each case, the awards are subject to accelerated vesting upon certain termination events set forth in Mr. Sherman’s Employment Agreement.
Essentially the board has given the new CEO a very strong incentive to keep the company alive as long as possible and to try to turn it around. The first and most obvious step in this process is to conserve resources. And in service of this first step, I expect the new CEO to cut the dividend to zero and ignore the share buyback authorization altogether.
The second of the conditions I mentioned above is for the company to try and keep its legacy business as profitable as possible for as long as possible. This is something the company is already working towards and has very good chances of achieving. They have already initiated a cost-savings and operational improvement initiative with the aim of achieving an improvement of $100 million in annualized operating profit. They expect to achieve this by the end of fiscal 2019 and 2020 results will benefit fully from this.
Another factor that helps postpone the demise of GameStop's legacy business is the fact that console makers are cautious in making the transition to a cloud-only business model. This excerpt is from Wired about the upcoming PlayStation console:
[...] If history is any guide, it will eventually be dubbed the PlayStation 5. For now, Cerny responds to that question—and many others—with an enigmatic smile. The “next-gen console,“ as he refers to it repeatedly, won’t be landing in stores anytime in 2019. [...]
[...]the next-gen console will still accept physical media; it won’t be a download-only machine. Because it’s based in part on the PS4’s architecture, it will also be backward-compatible with games for that console. As in many other generational transitions, this will be a gentle one, with numerous new games being released for both PS4 and the next-gen console. [...]
The third condition for GameStop's success as an investment is also the most crucial. The future of GameStop as a company and as an investment rests for the most part on the company's ability to find new, profitable opportunities to expand. It is too early to say if they will succeed in this or not, but they have given us a taste of how they intend to go about it.
Of course, the new CEO has yet to provide us with his view on what course the company should follow. Let's see what we know so far. Excerpt from the company's Q4 2018 earnings call:
Robert Lloyd - COO & CFO
Focused on live video game competitions, eSports is one of the fastest growing areas of the video game industry. While we participated in eSports before, this is a strategic and concentrated effort to broaden our presence in the space in a way that makes economic sense for us and allows us to test, react and implement strategies that can drive more brand awareness and positively affect our extensive retail platform.
Our new partnerships include alliances with Infinite eSports & Entertainment, Envy Gaming and Complexity Gaming, which happens to be one of America's most elite and longest-standing eSports organizations. [...]
[...] By becoming more involved in the eSports space, we're positioning GameStop to be the youth sports league of eSports where we can provide unique experiences for the amateur gamer and help develop and prepare the next-generation of professional gamers. This is a very exciting initiative and we're looking forward to what these partnerships tell us in their first year about the opportunity for us to participate in the industry going forward.
And an excerpt from Bloomberg's coverage about the subject:
[...]The 11,000-square-foot GameStop Performance Center will include a public area where fans can watch matches, as well as a studio and training facility for CompLexity Gaming’s players. CompLexity Gaming, majority-owned by the Dallas Cowboys’ Jerry Jones and real estate investor John Goff, fields teams playing Fortnite and other titles. Financial terms weren’t given.
CompLexity’s players will be able to eat breakfast and lunch five days a week right next to the Cowboys. “This is a big step toward the growth of esports,” said Jason Lake, chief executive officer of CompLexity. “When you get this kind of support it helps legitimize everything we’ve been doing for years.”
The deal ties GameStop, the world’s largest independent video-game retailer, to the world’s most valuable sports franchise, the source of most of Jones’s $6 billion net worth. [...]
[...] GameStop has been looking for new ways to connect with customers who increasingly skip brick-and-mortar stores and buy games online. The Grapevine, Texas-based company sponsored some events last year, including an autograph signing by the Dallas Fuel, an Overwatch League team, that drew hundreds of fans.
“That was a toe in the water,” said Frank Hamlin, GameStop’s chief marketing officer. “Now we’re all in.” [...]
Wrapping it up
At its current ultra-low valuation GameStop looks at the surface as a profitable deep value investment opportunity that is trading below its liquidation value. The reality of the situation though is that GameStop is a company in a desperate search of direction in a rapidly changing sector.
The one side of the coin is that GME has little debt, a lot of cash and its legacy business is still generating profits and FCF. The flipside though is that these are ultimately irrelevant. The key question investors are called to answer is
"Will GameStop's management find a profitable new direction for the company? Will they manage it in a reasonable timeframe?"
Personally, until new information on management's plans become available I will have GameStop in my "wait and see" pile.
What do you think?
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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.