- There has been rising demand for video games as people are forced to stay inside in the wake of the global pandemic.
- The whole sector will benefit, and GameStop is not isolated from this positive trend. Nonetheless, the stock still trades at a low valuation.
- Video games are a recession resistant industry, as they can provide solace in difficult times at an unparalleled value.
- Investors should focus on the attractive fundamentals, not on the short interest, the activists, or prior console cycles.
As the impacts of the global crisis continue to become clear, the stocks of many industries and sectors have been re-rated to reflect the direness of the situation. Retailers, in particular, have been hard hit, as reflected by the increasing number of bankruptcies from companies like J.Crew and J. C. Penney (JCPNQ). In this environment, it is not simply enough to have a low valuation based on past results for a company to be investable. The world has changed and so have people's behaviors, at least for the foreseeable future. While the discretionary nature of apparel has become quite apparent when individuals are stuck indoors or are out of a job, the same cannot be said for video games. In tough times, video games provide a much needed respite from the calamities of life. Few retailers are better positioned to benefit from this trend than GameStop (NYSE:GME), the largest video game retailer in the world. While GameStop seems to unfortunately be quite a magnet for negative press, one should focus on what matters: the fundamentals of the business. While companies like Take-Two (TTWO) or Nintendo (OTCPK:NTDOY) are priced for success, GME continues to trade at a bargain-bin valuation. In this light, it is quite possibly the best value play to take advantage of the tailwinds in the gaming industry.
In this article, I will first delve into the macro trends for the industry as a whole and then analyze GameStop's position in the grand scheme of things, considering factors like the last earnings report and catalysts in the remainder of 2020.
Tailwinds for the Gaming Industry
First, let us look at how the video gaming industry as a whole has fared in March and April. According to the NPD group, "March 2020 tracked spending across video game hardware, software, accessories and game cards totaled $1.6 billion, gaining 35 percent when compared to the same time period last year. This is the highest reported spend for a March month since the $1.8 billion achieved in March 2008." April also had great results, with "tracked spending across Video Game Hardware, Software, Accessories and Game Cards totaled $1.5B, 73% higher when compared to a year ago. This is a new record high in reported spend for an April month, eclipsing the $1.2B generated in April 2008." I could probably spend a whole article just analyzing the rest of the data that Mat Piscatella reported on for those two months, but the main point I want to focus on is that these results illustrate that demand for video games is rising in the current environment. This does not require fancy forecasting for what the next console cycle will result in, nor does it require a deep-dive into what happened in the last console cycle.
Every scenario is different, and it is extraordinarily difficult to extrapolate with one dimensional analysis. Consider the Wii, which was released in November 2006. From the first 3 years after its release in 2006, the Wii had explosive growth, selling almost 26 million units in 2009 alone. The console then experienced comparative declines but still impressive numbers until 2013, when the Wii U was released. Interestingly enough, the Wii still sold more units that year than any year in the Wii U's lifetime. Investors who simply expected the Wii U to perform in a parabolic manner as its predecessor did and invested in Nintendo in 2013, they would have had middling returns for over 3 years until there was surprising optimism in the stock over the eventually immaterial impact of Pokemon Go in 2016. Fast forward to the latest Nintendo console, the Switch, and we can see that Nintendo had learned its lessons from the Wii U and hit a home run once again, selling over 55 million units since release.
What I want to drive home is that the success of every console is driven by a myriad of factors, and not just the tech specs of the console itself or how long it's been since the last console release. Note that the highest Wii Sales figures were in 2008 and 2009, in the midst of the great recession. When times are tough, people turn to video games for a number of reasons, and it's not just stress. The unemployed also need ways to pass the time, and games also provide a sense of accomplishment and productivity. This is no more clearly exemplified than by the success of Animal Crossing New Horizons, which was the best selling video game of March. When individuals cannot even leave their homes, Animal Crossing provides a regular routine of tasks to complete, progress in the form of an ever improved island, and seasonal events to liven up an otherwise stale quarantine. It's not just about escapism, as I've oft heard, but also the feeling of achievement and productivity. This need is something that is unique to video games, as spending hours watching TV or streaming Netflix (NFLX) can often make one feel the opposite of productive. Given people who derived this kind of achievement in the past from activities like sports can no longer do so under quarantine, there is demand from non-gamers and gamers alike. Remember that video games performed admirably in the great recession even as people had access to other forms of entertainment like movie theaters and sporting events, so given the circumstances now, I am quite bullish on gaming in general for the near future. I emphasize that this is not because of 'console cycles' but rather because of a myriad of factors, most notably that there is an inherently strong demand for video games given the state of the world as a whole at the moment.
What about Digital?
You might be wondering, what does this mean for GameStop? Isn't digitization eating GameStop's lunch? Why can't anyone order from Target (TGT) or Amazon (AMZN)? While it is true that digital sales in general are growing, and that there are other retailers that sell video games, that does not mean that GameStop will not continue to take a piece of the pie. For the digital argument, I will summarize some of the main points I've made in earlier articles. One, the medium itself allows for reselling and also makes for better gifts. Two, digital copies take up space on one's console and could take far longer to download depending on one's internet connection. Three, and this is big: physical games are the ultimate collectible. When one considers how collectibles as a category have grown, it makes little sense that gamers will cash out for Funko (FNKO) Pop figures for their favorite gaming characters but somehow skip out on owning the actual game itself in physical form. For highly anticipated releases, special editions of games are almost guaranteed to sell-out even in the pre-order phase, an example being the Collector's Edition of The Last of Us Part II. This edition costs over $100 more than the base game itself, all for effectively a bunch of knick-knacks to the layman, and yet still sold out weeks before the game's release.
I acknowledge it is not simply enough to argue that physical has an advantage in theory, but also in practice, and a concerning data point is indeed that digital sales continue to grow relative to physical sales. While it is difficult to quantify the exact changes over time as there is not complete visibility into 1st party digital sales at Nintendo, for example, one should consider what digital sales actually mean. They can include more than just base games in consoles, such as Mobile games and DLC. As more and more games have post-game content through DLC, one should definitely be careful not to construe the trend as more people substituting purchases of physical copies of base games for digital ones. An example is Super Smash Bros Ultimate on Nintendo Switch, in which one would have to pay up $55 to get all the fighters available. As Smash has quite a devoted player-base, it would be a reasonable educated guess that Nintendo is getting a large chunk of digital sales from this game alone, especially compared to 10 years ago when games they released had no DLC. My hypothesis is more that digital as a category has a place alongside, not against, physical sales.
Furthermore, something mentioned in the 2019 yearly results was that GameStop has begun "testing digital revenue sharing with key partners." While there is not much additional color on this in the report itself, we can see now what GameStop meant by this by simply visiting their online store. Two of the main banners on the front page are for Sony (SNE) and Nintendo's latest digital promotions: Sony's Days of Play and Nintendo's Summer Game Sale. While these promotions would have traditionally been marketed directly by Sony and Nintendo to their customer base, it does seem the companies have struck a deal with GameStop to serve as a middle-man as well. As George Sherman mentioned in the earnings call, publishers benefit by being given access to GameStop's large loyalty base of PowerUp Rewards members. If GameStop can get consumers in the habit of purchasing even digital titles from them with incentives from the rewards program, the company can turn the headwind of digital growth into a tailwind.
What about other retailers?
Ok, so physical games may be around for a while. But why visit GameStop when one could go to Target or Amazon? For one, GameStop has plenty of exclusive merchandise and often has special pre-order bonuses like a pin set for the new Paper Mario game coming out in July. Second, GameStop is the only multi-national retailer focused entirely on video games, so naturally, their selection of games is hard to beat. Lastly, the PowerUp Rewards program is actually a great deal for gamers, and buying games at GameStop is actually a very economical option, even if one prefers to buy new games. The points are nice, but the main appeal is the $5 monthly certificate that can be redeemed with no minimum on almost anything in store. For an annual fee of $15, a member gets over $60 in benefits. This is beneficial for both the customer and GameStop, as it incentivizes a customer to make at least 12 purchases a year and the customer can get discounts on brand new releases that otherwise sell for full MSRP at release in other retailers. As one can now redeem their certificate online, the value is still there even in the midst of the pandemic.
Also note that while other retailers like Amazon and Walmart (WMT) do sell digital copies of games as well, they do not appear to be participating in the digital promotions I mentioned earlier, illustrating the unique relationship GameStop has with publishers. While I am on the topic of vendor and supplier relationships, I would like to point out that if GameStop were to go the way of Blockbuster, this would be a negative event for publishers as well. If suppliers are forced to deal with an increasingly limited number of retailers, this limits their bargaining power and increases concentration risk should any catastrophe befall any of them. As Reggie said when he joined the board, "The gaming industry needs a healthy and vibrant GameStop."
Lastly, I would like to emphasize that there is a lot of press concerning GameStop and to focus on what matters for the company as far as an investment is concerned. Consider the short interest. Consider the activist investors and the proxy contest. Now consider that we may very well be in a recession. And consider the last earnings. Out of these, really only the last two should affect the investment thesis in any meaningful way, and as I mentioned earlier, an economic downturn is actually bullish for GameStop. The short interest might result in a squeeze, but whether that happens or not does not change the value proposition. The proxy battle, while exciting symbolically, should not meaningfully affect the company either. If the nominated directors from Hestia and Permit win, they still only hold 2 seats in the board. Even if they can enact change, I am not convinced that they will move the needle much. If they lose, then the two returning directors will retire in a year anyway. Ultimately, both the board and the activist investors see value in the business's fundamentals and that is what one should focus on.
Focus on the Fundamentals
Looking to the fundamentals, the business has no liquidity issues, with approximately $570 million in total cash as of May 2nd, including the $135 million drawn down on the revolver. The company also plans to end the second quarter with total cash and liquidity between $575 million and $625 million. The strong cash position has been thanks to an intentional reduction of inventory over the last year. The debt should also be manageable at $419 million maturing in 2021. The bonds have been trading at a discount as of late, and unfortunately, it does seem that buybacks of debt has been minimal. However, while this was a missed opportunity, the debt exchange offer may fulfill the same purpose. This will push debt obligations away from the short term and free up cash for profitable ventures like preparing for the next console cycle. However, not all the news was positive, as there was an operating loss of ($108.0) million in the quarter. In addition, "after including the impact of stores that were closed for the majority of the quarter due to the COVID-19 pandemic, comparable stores sales decreased by approximately 30%." On its own, this is certainly disappointing and took me by surprise, given the trends in the industry mentioned earlier. Upon deeper inspection, given the conditions and context, the results are not as catastrophic as they appear. I had not anticipated such large sales drops given the 1500% increase in online sales YoY in April for the company that the New York Times mentioned. Taking into account that GameStop has an incredibly large store fleet, and that a large number of locations were closed in April and May, these results are more reasonable.
Also consider that many operating stores were curb-side pickup only and operating with limited stock. Supply chains of all industries were affected by the pandemic, and given the high demand for gaming hardware, this would have further impacted GameStop's ability to meet demand. While the Switch has certainly been the most popular, all the consoles have been short in supply, and GameStop is essentially sold out of all of them online as of this writing. Thankfully, GameStop has also sold most of its Switches through bundles, not only disincentivizing hoarders but also improving the size and margins of sales. If many of these buyers are also new customers, as Sherman alluded to, they may very well continue to purchase games from the company for the rest of the year.
A small point I do want to mention regarding GameStop's clientele is that many may be forced to patronize GameStop specifically because it has a physical presence. Believe it or not, at least within the US, there are a sizable percentage of adults who do not have bank accounts or are underbanked, around 25% as of a study in 2017 by the FDIC. In addition, only 75.5% of consumers had at least one credit card as of August 2019. This is a population neglected by Amazon and the digital storefronts of publishers. For these consumers, GameStop serves an important purpose, as they may only be able to pay in cash. If they did want to purchase from the Playstation Store or Nintendo eShop, the easiest option would be to go to GameStop and purchase the credits in cash. Given the company's large physical presence, few retailers can match the convenience and ease of stopping by the local GameStop. Unfortunately, as GameStop had only accepted credit cards for most of the time that stores were open for curbside-pickup, these customers were effectively closed off from their main means of gaming. Reciprocally, once the stores open up completely, pent-up demand should result in an increase of sales. As conditions improve into the year, I do believe that GameStop's prediction for positive EDITDA is entirely plausible. If it does turn out to be the case, the lack of any immediate bankruptcy could warrant covering by shorts and higher valuation multiple.
I will acknowledge that it has been a rough ride for the company the past few years. The share price decline over the years has not been pleasant and the lack of accountability on the part of management, though many are new, can also be distracting. However, one must focus on the future of the business and the likelihood of profitability, not on the past and on distractions like the proxy fight. GameStop is possibly in the best industry a retailer can be in right now with the pandemic, and the setbacks from the pandemic-related closures are temporary. Given the balance sheet health and strong demand for its products, I believe GameStop will continue to carve out its place as the Stop for the world's gaming needs. As always, please do your own due diligence before making investment decisions and thanks for reading!
This article was written by
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.
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