GME - Only Hedged Into Earnings

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About: GameStop Corp. (GME)
by: Truth Finder Investment
Summary

GME lack of visibility allow only a hedged positioning into earnings.

Upside potential is there with attractive catalysts.

BEAR - BASE - BULL Case would show a value range of 0$, 7.81$ and 43$ per share.

Summary

Gamestop (GME) is the largest brick and mortar physical game and merchandise retailer in the US with a total of 5700 stores in 14 countries.

The business segments sell products across new and pre-owned video game systems, software and accessories – for further information, I kindly refer you to the other SA articles or the 10k of the company.

Annualised quarterly Q120 sales were 6.2bn USD and declined around 13.4% quarter over quarter, with same store sales declining 13.3%. Indicating a clear downward trend also over the past quarters. However, especially cash flow generation has a high seasonality and usually GME creates the bulk part in Q4 during holiday shopping season.

While there is around 60% of free-float outstanding shorted, there could still be a potential for a hedged position in the shares due to the high cash flow generating characteristics of the business model and moreover a triggered short squeeze in the case (A) new management mentioning a share buy back or (B) revenue decline is slower than perceived by market participants – current consensus is at -19%. However, a hedged position at least in the earnings disclosure after market close on Tuesday, 10th September 2019 would be recommended. This could be done by positioning with short term puts otm and longer term a stop loss, capping a potential further sell off.

While it is obvious that the business is in a very distressed environment with losing market share to online retailers, as well as a shift towards subscription based gaming platforms, a position could be interesting due to:

1) short exposure as high as 60% in combination with the potential of share-buy-backs,

2) Priced in revenue decline slowing down with turn-around measures by the management.

Assuming three different scenarios with varying top line growth, cost savings as well as a potential share buy-back, the outcomes differ widely on FCF generation, net cash position or a Discounted Cash Flow valuation.

DCF at 15% COE and -1% TV Growth

The float of the company is around 7m shares traded on average which at a share price of 4,5$US would get one to around 32m dollar volume traded.

Overview

Management

Literally the whole management has been replaced during the year 2019. Key roles of the CEO and CFO are briefly outlined below:

CEO

There have been changes of CEO´s in the past years due to various reasons and management has not been highly opportunistic in regard to the potential sale of the company to Sycamore Partners – however, most likely with the right reasons at the time this is difficult to judge. Also past strategic decisions have not paid off in retrospective, as for example the wireless purchase and sale of Spring Mobile shows. But with the appointment in March 2019 of the current CEO George Sherman, an experienced retail CEO will decide on the strategy going forward. Mr. Sherman has been CEO of Victra, a authorized retail for Verizon Wireless US, president as well as interim CEO of Advance Auto Parts and leadership roles with Best Buy, Home Depot and Target Corporation. At this point it is difficult to judge his track record of share buy backs or pay-off of strategic changes with the previous companies as direct decision making is not clear. But with his vita, he should be a good fit for the company.

CFO

Also the CFO James Bell has been with the company only for a short period and it is not clear what the opinion is about share buybacks. Mr. Bell has been the CFO and interim CEO of Wok Holdings and similar leadership positions with RLH Corporation and Coldwater Creek.

From the information given, it is not clear to make a reasonable assumption around the likelihood of a management to announce a share-buy-back. However, with cutting the dividend and a stable balance sheet, it at least marginally is more likely.

Market Overview

The introduction of digital games and subscription services such as Xbox Game Pass, Xbox Live or Playstation Network are putting massive pressure on the physical brick and mortar market. Customers shifting to digital downloading and away from consoles towards mobile gaming. To put some context in regard to market size: in 2008 the UK physical games market, including console, accessories and boxed software generated 4bn GBP worth of sales, while in the year 2017 this figure has decreased ot only 1.75bn GBP.[1] For a value proposition, it would be recommended to deep dive into release dates and the market in general. In case you have additional input/ specific knowledge about the current development or good sources, I am happy to read your comment.

Investment Thesis

Without doubt, the retail market is under high pressure due to competition of online sales capturing increased market share as well as a changing underlying market such as the switch from physical games to digitalized games. Keeping this in mind the thesis is not primarily about a turnaround, that more likely will destroy shareholder value with the capital allocation towards defensive measures that projected IRR will fail. It is about the potential to purchase a business valued at net-cash below the market capitalization and attractive, increasingly probable catalysts as described above:

1) short exposure as high as 60% in combination with the potential of share-buy-backs,

2) Priced in revenue decline slowing down above consenus estimates.

Valuation

DCF - Outcomes:

Discounted Cash Flow until 2024FY with 15% COE and -1% TV Growth Rate

Revenue Growth/Decline Assumptions:

Revenue Growth Assumption

The revenue decline takes into account previous seasonality and annualises the impact.

Operating Free Cash Flow Assumptions:

OCF Outcome Capex and Depreciation is relatively stable going forward and does not assume massive investment by management. Moreover, there is the same movement in working capital for the remaining quarters.

Assumed Cost Savings:

Cost Savings GME

Management noted there will be 100m in cost savings - which I assume will crystalise in all three cases.

EPS per share:

Earnings Per Share

The EPS per sahre varies a lot for the Bull case as there is a backed-in assumption around share buy backs. The scenario would assume 50% of authorised capital being bouthg back this year with an additional 50% next year at various prices above the current share price.

FCF per share:

FCF per share

Liquidation Value per share:

Lidquidation Value per share

Assuming 100m of Liquidation Cost, full crystalisation of liabilities and only 50% of inventory resale value, etc., the liquidation value is not very attractive for either of the cases. Meaning in case of further deterioration of the business, one could not recover part of his equity value. A stop-loss order is therefore strongly recommended.

Net debt/ Cash per share:

Net Debt/ (Cash) per share Please note that the negative value indicates a net cash position. This shows a slightly better picture compared to the liquidation value - mainly due to the composition of net debt not including all liabilities. The assumptions around the claim of creditors in regard to different line items could vary widely. The liquidation value therefore is the better to try to figure out the bankruptcy protection of one´s investment.

Catalyst

Share Buy Back

A share-buy-back would be the most favourable option for everyone with a long position in the stock and could strike a great balance between potential management efforts for a turnaround of the business as well as returning cash to those shareholders that had losses on their books and are inclined to keep their shares.

The economics are quite tempting. Currently, at a market capitalization of 450m $US and outstanding shares of 90m, with the authorized capital of around 237m$USD management could tremendously reduce shares. With 60% of the float outstanding being shorted, a buyback of around half of outstanding shares could not only increase EPS favourable, but also lead to a short-squeeze. Moreover, it would signal the shareholders that management is highly focused on all stakeholeders of the business.

Buy-Out of the Company

Even though there has been an attempt by Sycamore Partners to buy GME in 2018, I think this is a rather unlikely event as a potential suitor would need deep pockets with a strong vision of store usage going forward. Maybe an online retailer could use the stores for pick-up of last-mile products or a concept that is defined by physical presence.

Positioning

Hedged Position into Earnings:

In regard to a potential purchase of the stock, I would recommend to purchase otm short term puts at strike of 4$US and at a premium of around 6% (as of Friday, September 6th). Total fixed hedging cost would come to the premium of the option while the downside would be capped at 5%, with an entry price of 4.2$US. However, this should vary depending on the specific purchase price.

At the time of the writing of the article I am not sure about the potential execution and availability of liquidity of those exact options. Please leave a comment in regard to better suggestions/insights. However, at this point YahooFinance gives me the respective quotes as following:

Shareholding with Stop-Loss

I strongly recommend any shareholding to combine with a stop-loss order and to be careful about earnings dates in the future.

Any inputs are greatly valued in the comments.


[1] 12 months that transformed UK games retail

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.