Secular Decline or Just a Bump?
People disagree on whether Game Stop's (GME) core business is in secular decline or if it is just a minor setback on the long road to a changing retail landscape. I fall in the former camp. While Game Stop is finding other avenues to make money (Collectibles and Technology Brands), pre-owned and new software games continue to be hit hard. I just don't see this changing anytime soon. Much in the way most videos are bought/streamed online and most computer games are downloaded these days, I see console games continuing to go this way too. Playstation, XBox, and Nintendo have been working to make it easier on the consumer to buy a digital copy directly from them and download them to your console in recent years.
Now that's not to say GME is doomed like Blockbuster. I believe it could take much longer for the decline of console games being sold in physical stores than it did for movies or computer games, but in the end I think it will be the same outcome. Also even if pre-owned games continue to take a hit for a long time, I don't see them going away all together and it seems that Game Stop is very well positioned to keep their market position in pre-owned. Furthermore GME management has done a reasonable job finding other sources of revenue and earnings as mentioned with Collectibles and Technology Brands above.
What really got me thinking about GME is a recent article by Michael Wiggins De Oliveira, Gamestop-yet-another-frustrating-quarter. He does a very good job lining out the problems facing Game Stop and the recent financial results. While I disagree with his valuation, I agree with his overall premise that GME is finally too cheap to ignore. His valuation called for 3% FCF growth over the next 5 years and 1% terminal growth. While GME could possibly grow free cash flow going forward, I see it as much more likely that FCF continues to decline for quite some time. Not only do I think revenue is likely to take a hit for many years to come (outside of big new console release quarters), I also think margins will continue to be hit as GME has to continue competing with direct online sales (from XBox/Playstation) as well as the other retailers Walmart, Target, and Amazon. It is very hard to see GME combating this with Collectibles and Technology Brands alone.
Forever a Value Trap?
GME has been a value trap for nearly 4 years now. I haven't gone back and checked, but I'm sure people were making the same arguments about why GME was undervalued when its price first fell off a cliff near the end of 2013 and into 2014.
I first started following GME sometime in 2016 when it was around $25/share and thought it could be a good value then, but knowing low valuations can many times go lower if a business doesn't turn around its fundamentals, I held off investing in it. Obviously I am happy with my decision as GME has continued to be a value trap and I would have lost much more in principal than I would have gained in dividends in that time frame.
So what's different now? Why do I think it's finally worth another look? Cash flow is extremely important in a business and while GME has been a FCF machine for many years, the stock price has finally gotten so cheap, management could buy back nearly 1/6th of the float every year if GME stays at these valuations.
I throw that out there for the shock factor, because they could only buyback that much of the stock if they cut the dividend all together (based on their FY2017 FCF projections) and use the entirety of their FCF on buybacks (no CapEx either). But the fact remains that even continuing with their dividend, if they use the rest of the FCF to buyback stock, they can still do so at a very rapid rate because the stock price has gotten so depressed.
The Power of Buybacks
Here is a scenario if GME were to use all excess FCF after dividends and if the stock price stayed around $19 over this time, how much of the company they could buyback. I also have the quarterly dividend raising by 1 cent each year as they've done the past few years and FCF declining at 5% per year, since I'm in the camp of their business being in secular decline.
So obviously there are a lot of factors playing in and I'm simplifying it, but under this scenario, they could cut the number of shares outstanding from 101 million down to under 54 million. Even with FCF dropping 5% every year, you'll also notice the amount spent on dividends dropping even faster percentage wise. Where dividends will take up ~51% of FCF this year, they would only take up ~48% of FCF in 2023, meaning that they would actually be able to make their dividend more sustainable (while still raising it) if they were able to buyback shares at such a cheap level.
Now one obvious simplification I'm making that will ensure it doesn't play out this way is that the share price certainly won't stay exactly at $19 over the next 7 years. and I highly doubt FCF will drop that steadily. It could drop faster, could drop more slowly, or it could even go up and obviously that will differ year to year. The point is to show how powerful buybacks can get when a business still generates significant FCF and share prices get very low. Now here's an example if the share price were to raise $2 a year.
I'm sure this scenario would make investors looking for capital appreciation happy, but the dividend would actually become a larger percentage of FCF and thus less sustainable over the long term. Under this scenario the dividend would grow from ~51% of FCF in 2017 to ~54% of FCF in 2023. So a little less sustainable dividend, but the buybacks could still do plenty of work.
Now lets check out a scenario where FCF drops 10% a year and the share price slowly dropping with it and a scenario where FCF grows 2% a year while the share price increases considerably (as I think would happen if GME could somehow manage slow growth):
FCF Dropping 10% per year
FCF Growing 2% per year
These scenarios really show how much is riding on the underlying business. If FCF drops at 10% a year, even with buybacks making it such that less is spent on the dividend each year, the dividend would become unsustainable. It would grow to 73% of FCF under that scenario. If GME could somehow find a way to keep the business from dying at all and grow about the pace of inflation at 2% a year, it shows that they could still rapidly decrease the share count even with the share price growing 10-15% a year.
If Shareholder Returns were more Flexible
Now for one last scenario that I know will never happen but I want to show the power of buybacks if management weren't constrained with keeping the dividend. In this scenario I cut the dividend completely and spend all FCF on buybacks. I even made this a pretty bad scenario fundamentals wise and had FCF drop at 10% a year, but I kept the stock price at $19/share to show how powerful buybacks are when a stock is trading at such low multiples for a long time.
So as you can see even with FCF dropping very consistently and at a pretty fast pace, GME would be able to buyback over 4/5th of the entire company. So at the beginning of 2024, the FCF would be down to ~$140 million, but the entire market cap would be ~$510 million (27 million shares x $19/share). FCF would then be over 1/3 of their entire market cap. Once again I'm ignoring the fact that their debt would then be higher than their market cap, but it still shows how much buybacks can do when there is plenty of FCF and a low share price.
I personally wish management of companies like Game Stop wouldn't lock themselves into a dividend and could have a little more flexibility in returning money to the shareholders. If management of Game Stop were allowed to buyback shares with the entirety of their FCF when shares get so low, they could buyback large chunks of the company and return to dividends after the share price recovers.
I realize this will never happen as many investors rely on the income of stocks like GME and management would be disrupting any sort or reliable income by doing this, but it's just a tangent I wanted to touch on.
There are a lot of variables in analyzing what the company could do with buybacks (how fast FCF grows/shrinks, how much is used on the dividend, and the share price). But this article is meant to show that the valuation of GME may have finally gotten so ridiculously low that management can create a floor in the share price by simply buying back shares. Even with FCF dropping at 5% in my first table, it shows that if prices stayed this depressed, GME could raise the dividend every year and still drop the payout ratio.
I made my model as simple as possible by ignoring mergers and acquisitions as another route to use FCF, but GME showed right in their Earnings Call Slides that they plan to use FCF for dividends, M&A, and buybacks. So once again, it's not that I think any of my scenarios will actually play out, I just wanted to show what a company with plenty of FCF and a low share price is capable of even as their business is slowly dying.
Some big risks still remain in GME despite the very low valuation. If the underlying business starts dying at 10-20% a year, buybacks won't do the trick. Also management is not likely to spend all the FCF on dividends and buybacks. If they invest in parts of the business or new areas of growth and those don't work out, the situation could fall apart much more quickly. I personally am going to do some short-term trading with GME but am still waiting to see how management follows through with capital allocation going forward before buying long-term. GME is finally so cheap though that if they buyback stock aggressively enough, they could likely outpace the decline in the overall business.
Disclosure: I am/we are long GME.
Additional disclosure: I am long GME by way of selling Oct 2017 Puts. I may close my position at any time.