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GameStop: A Take Private Candidate

|About: GameStop Corp. (GME)
Summary

GameStop is in decline given the industry transition to digital.

However, the Company trades at a discount to its year-end net cash balance, has a clean balance sheet and generates FCF.

Management has taken actions that would suggest a take private is a realistic alternative.

The stock is oversold with a large short concentration and the likelihood that the largest shareholders have sold a meaningful portion of their position.

Overview

GameStop Corp. is retailer of video games that operates over 5,700 stores worldwide. The Company sells new video hardware and software, pre-owned video games, accessories (such as gaming headsets and controllers), digital content and gaming merchandise (ThinkGeek). GameStop is not a sexy growth story as the business model is severely challenged due to the industry transition to digital sales. Research estimates that over 50% of sales are from downloads. Additionally, Electronic Arts, which publishes video game content, reported digital sales as a percentage of total revenues of 59%, 67% and 75%, respectively, over the last three years. As a brick-and-mortar retailer (all leased), GameStop's operating business is not compatible with such a trend.

Although management is committed to attracting people to their stores, for purposes of this analysis, I assume that their strategy will be unsuccessful. Any upside is welcome but is not the basis for this pitch. I believe that GameStop is a slowly dying business. Like other dying retailers, this death will take time. In the interim, there is considerable value not being recognized by the market. GameStop trades at a discount to its year-end net cash position, is well capitalized and continues to generate free cash flow ($231mm in 2018). The stock, which was trading at close to $50 in 2015, is trading at $4.14 today with a market capitalization of ~$375mm resulting in a historical free cash flow yield of over 60%. I believe that GameStop is likely to be taken private through either a management buyout or leveraged buyout. The recent actions taken by management indicate that a management buyout is a viable alternative. Whether it is done through an MBO or LBO, GameStop can be acquired with its year-end net cash balance with management or a sponsor collecting the free cash flow until the business runs its course.

Recent events

GameStop has undergone a tumultuous year. On June 19, 2018 GameStop's Board announced a strategic review of alternatives including discussions with third parties regarding a potential sale of the Company. On November 21, 2018 GameStop announced the sale of its non-core, Spring Mobile business for net proceeds of $700mm. The Spring Mobile transaction was completed in January 2019. On January 29, 2019 the Board terminated efforts to pursue a full-Company sale citing a "lack of available financing on terms that would be commercially acceptable to a prospective acquirer." In other words, an offer came in at a discount to the share price at the time of ~$16. On the news of the failed sale process, the stock declined to ~$11. By the Company's fiscal year-end, GameStop had $1.6 billion in cash with debt of $825mm ($350mm of senior notes maturing in 2019 and $475mm of senior notes maturing in 2021) resulting in a net cash position of $800mm. The Company's market capitalization at the time was $1.17 billion. Subsequent to the 10-K filing, the Company announced that it would retire the $350mm 2019 notes with proceeds from the sale.

Following the Company's terminated strategic process, an activist investor stepped in. On February 12, 2019, Hestia Capital Management sent a letter to GameStop's Board of Directors urging the Company to pursue a "public LBO" by funding a $500mm - $700mm Dutch auction tender followed by $100mm per year of additional repurchases along with operating changes. After not receiving a meaningful response, Hestia, joined by Permit Capital Enterprise, sent another letter to the Board on March 13, 2019, calling for a tender offer and 'Board refresh.' The activist investors concluded the letter by threatening to nominate a slate of board members by the March 28, 2019 nominating date if the Board refused to engage with them. Hestia and Permit followed through on March 28, 2019 by nominating four individuals. On April 1, 2019 the Company entered into a Cooperation Agreement with Permit and Hestia, in which the Company added two new independent directors to the Board in exchange for the investors withdrawing their nominees and voting in favor of GameStop's director nominees.

The stock price continued to decline following the Cooperation Agreement, falling to $7.82 ahead of the Company's Q1 2019 earnings release. On June 4, 2019, although expected given the stage of the current console cycle, the Company reported weak earnings. However, what was not expected was the Board's decision to eliminate the quarterly dividend of $0.38, which represented a 19.4% yield. Instead of paying the dividend, the Company repaid $39 million of debt, which was equal to the would-be dividend (~ 102.3mm shares x $0.38). The stock was decimated, falling 36% to $5.04. The overreaction was likely triggered by funds that sold, such as Fidelity, Blackrock and Vanguard which have a combined ~38% ownership, but we will not know until the 13Fs are filed.

At the time the Company did not announce any share buybacks but on the earnings call, the outgoing CEO Rob Lloyd had the following exchange:

Joseph Feldman (Analyst): "And then just a follow-up, regarding the debt level, because you guys did comment that with that incremental $160 or so million in cash that you have for the dividend, not paying the dividend that is. Is there a target debt level that you guys would like to be at, again recognizing that you have a little time before it's due, but is there a target in mind that you're trying to get to?"

Rob Lloyd (Outgoing CEO): "Yes, I wouldn't say there's a hard target in mind. I think recognizing that we have the 2021, they're at a favorable interest rate. We have the cash flow to be able to bring that down to perhaps not as a hard target but to get the debt to EBITDA level a little closer to one to one, and then give Jim and George and team an opportunity to evaluate that line of the entire capital structure and capital allocation policy.”

Why is the Company targeting a 1.0x leverage level? Per the bond indenture, the Company cannot do more than $20mm of share repurchases a year unless leverage is less than or equal to 1.0x. I estimate that Q1 2019 leverage was 1.13x ($436mm of 2021 notes / $385mm of LTM EBITDA).

On June 10, 2019, GameStop announced a tender offer of up to 12mm shares. The problem was the price was very underwhelming with a cash purchase price of no less than $5.20 and no greater than $6.00. The outcome was even worse with the tender being executed on July 10, 2019 at $5.20. It appears that tender served as a secondary offering for one of the big funds. Even with the reduction in shares, the stock continued its sell-off since the announcement falling to its current level of $4.20.

Conclusion

I believe that GameStop is undervalued. While the Company is suffering a slow death, it will not happen for some time. Sony and Microsoft each revealed that their next consoles will support physical media. The Company has a clean balance sheet with only $436mm of debt maturing in 2021 (this number may be less given the leverage covenant required to pursue buybacks). After repaying the $350mm 2019 notes, meeting Q1 2019 working capital needs and repurchasing 12mm of stock, GameStop has ~$481mm of cash on its balance sheet. The Company historically repays accounts payable and accrued liabilities in the first quarter with cash building throughout the year. GameStop’s cash balance should be closer to $1.0 billion by 2019 year-end resulting in the Company being currently priced at a discount to its net cash balance and less than 2x historical free cash flow. Assuming the current share price, by year-end the Company's TEV will be negative. Furthermore, the stock is oversold as 48% of the float is short and the three largest shareholders have likely exited a meaningful stake of their position.

Additionally, Management's recent actions signal that an MBO / LBO is in the cards. Management has taken credit enhancing moves such as using Spring Mobile sale proceeds to repay debt, eliminating the dividend to repay debt, repurchasing stock through a tender offer. I believe Management was fully aware of the consequences that eliminating the dividend would have on the share price particularly when JP Morgan is their financial advisor. In the event that an MBO was to occur later in the year, a fairness opinion would be required. With a lower weighted average share price, any premium will allow the board to argue that they met their fiduciary duty to shareholders. Separately, although the Company recently explored a sale process, the market capitalization was over 3x higher than the current market cap. I would expect that JP Morgan is reconnecting with potential buyers and seeking revised financing terms. At the current share price Management / Sponsor can acquire the Company with cash on the balance sheet and collect the cash flow until the Company no longer exists. Even with no upside, such a scenario would represent a very attractive IRR.

Catalysts

1) Management along with the activists have taken appropriate steps to enhance the Company's positioning for a take private.

2) Although the current activist investors entered into a Cooperation Agreement, another activist investor may step in.

3) The decline in the share price may make a transaction more attractive to a potential sponsor. JP Morgan may be reconnecting with previous bidders.

4) 48% of the float is short. Management can execute a short squeeze.

5) Oversold stock given a likely exit by the largest shareholders.

6) Potential for future buybacks.

7) As of Q1 2019, the Company remains on track to achieve annualized operating profit improvements of approximately $100 million.

8) The next console cycle is expected in 2020 with the release of PlayStation 5 and the Xbox Project Scarlett.

Risks

1) Business is in secular decline.

2) The Company can go dark if the shareholders of record falls below 300. As of March 21, 2019, there were approximately 1,383 record holders.

3) Short-term market pain as the Company reports weak earnings ahead of the new console cycle.

4) New CEO may want to implement his vision.

Disclosure: I am/we are long GME.