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2009 Year For GME? I Don't Think So

Summary

GME price is now lower than in dramatically undervalued 2009 market, but company results are much better since that time

It's physical gaming business is slowing down, but not dying. Diversification efforts look promising and paying off

Company has a big margin of safety

Comparing to 2009

Do you remember stock market crush in 2009 year? Even during deeply undervalued market GME price was never less than 17.5. Current price is 16. 

That time Gamestop earnings per share were 2 times lower* than today, it's book value was also 2 times lower and company paid no dividends (now it's yield is 9.5%). If we are looking just at the numbers and comparing 2017 and 2009, GME is much better now, but what about comparing it's business?

You might say that outlook for physical gaming business was much better at 2009 and it's hard to argue with that. You might also say that GME was a growing company in 2009, and now it is a dying one. I can't agree with this and will try to prove it.

I don't think that it is completely right to compare GME now and GME from 2009, but still I like this comparison and consider it demonstrative.

Earnings themselves doesn't change a lot, but number of shares was reduced by  62%.

About GME and outlook on gaming business

In 2012 year operating earnings from physical gaming business were 100%. In 2016 they were 63%. In 2019 they are expected to be 50% or less.

How video game industry is feeling itself in USA?

In 2016 total consumer spent 24.5 billions on video game content. This number is growing since 2011 for 1.4 billion $ a year on average. Data is taken from Entertainment Software Association (ESA). We are taking only USA data as 4k from 6k game stores are located there.

What is a market share of physical gaming industry? Is it dying?

Data from ESA includes mobile apps (that can be only digital), so we can't rely on it. I searched in gaming forums and found a lot of discussions on this hot topic. Surprisingly, most people prefer buying physical games. They are cheaper, easier to share and can be sold after usage. Some people also like collecting physical games. I do believe that there is still a big market for physical games. Saying that they would die is like saying that physical books would die.

What are GME revenue streams?

GME has 5 main revenue streams. We will talk about each as a percentage from total. But gross profit percentage varies a lot for this products, so we will consider gross profit numbers (that is closer to net income then sales number)

Pre-owned video games. It's gross profit percentage is an attractive 45%. This product has a significant, 33% share from total gross profit. In absolute numbers it's 1.04 billion $. This number is declining year over year (in 2014 it was 1.14 billion, in 2015 it was 1.11) and is expected to decline in mid-single digits this year too.

But GME doesn't sit idle watching this number going down. For example recently company started Power Pass - a new in-store game rental service that will allow people to take home pre-owned games as rentals. Paying $60 customer gets players unlimited rentals for six months (and takes one game with him). I like this new program as it allows GME to boost client trafic in their store. It is very important for GME to be able to sell products that they especially bet on (for example collectibles). I also like that GME needs no investment to start this program - it already has a lot of pre-owned games on their shelves. I read some customer expectations on this program in gamers forum and found out that majority of customers are waiting for it and going to participate.

According to GME financial statement average price of pre-owned game is 25$. As customer gets one game (after 6 month) for 60$, gross profit percentage would increase a lot. But I'm more interested in how would Power Pass influence gross profit numbers? Here are 2 formulas connected to revenue:

Revenue before PowerPass = Number Of Games Sold * 25 (avg. game price)

Revenue after PowerPass = Number Of People In PowerPass * 60 + Number Of Games Sold Without PowerPass * 25.

I expect that PowerPass would help to at least maintain gross profit on the same level.

New video games software. Gross profit percentage is 24%. It's 20% of gross profit. It also continues to decline and is expected to decline in mid-single digits. That is a bad sign because new video games sale numbers correlate with sale of pre-owned games number (because customers that are buying new games in GME are more likely to sell tham as pre-owned later).

New games hardware. Gross profit percentage is 11%. It's 5% of total gross profit. I can't say a lot about this category unfortunately. The only thing I know is that recently GameStop Almost Sells Through Its Xbox One X Supply In First 24 Hours. Sales of hardware for 2017 2Q increased 10% compared to 2016 2Q.

Collectibles. Gross profit percentage is 35%. It is a 6% of total gross profit. In 2014 GME had 32M gross profit from collectibles. In 2016 it was 171M and it is expected to increase 30-40% this year. So this market is growing very fast. There are standalone 86 collectible stores now (like ThinkGeek). I really like how management there. For example, not recently GME announced that 350 GameStop locations in the United States have turned into Pokemon Go gyms and/or PokeStops. Of course in this stores there would be a wide varity collectible toys related to pokemons (and not only them). I find this marketing creative and cheap (it actually costs nothing).

Tech brands. Gross profit percentage is increadible 72%. It is 18% of total gross profit. This is primarily 1400 AT&T branded stores. The AT&T branded stores sell both pre and post-paid AT&T services, DIRECTV service and wireless products, as well as related accessories and other consumer electronics products. Gross profit is also expected to grow this year. For now, in Q2 2017 it is even 21% of total gross profit. I personaly like this partnership. AT&T is one of the most respected and well known brends with a very big market share in USA. Back in 2012 there was no even 1 AT&T store. I really appreciate how quickly GME is able to transform. I'd also like to qute senior vice president of GME Jason Ellis:

"While people still think of the company as dependent on the gaming business, the roots of that business are that we’re one of the best specialty retailers in the country".

What about companies debt and balance sheet?

Long term debt is 816 millions. Total assets are 4.6 billion, total liabilities are 2.3 billion. Looks pretty solid, but one thing I don't like is a big ammount in goodwill - 1.7 billion. I don't really like big goodwill on balance sheet, because it's very hard to count it's true intrinsic value. Overall balance sheet looks fine and debt looks quite manageable. Company should pay 50 millions a year as an interest rate of it's debt.

What about compenies dividends? 

Current yield is an enormous 9.5% and GME is paying dividends for 5 years already. Of course when we see such rates we want to know if a company is able to maintain such numbers. To answer this question we need to look at companies free cash flow (actual money that company gets into it's pocket). GME has a really strong free cash flow. For last 10 years average FCF is 450 millions and there was no year when FCF was less than 320. GME forecasts 300 millions FCF for this year. From my point of view this is a very conservative forcast (and GME directors confirmed it on 2016 earnings call). In last year FCF was 400M. Comparing 2Q report 2017 and 2Q report 2016 we see that in 2Q 2017 GME has 124M more in cash flow and all CAPEx are spent already. One important thing to mension here: tax rate would be 5% higher compared to previous year. Anyway I'm expecting for something like 350-450M this year.  But let's be conservative and assume that GME would have 300M of FCF. It has to pay 50M to manage it's debt and 250M left. For paying dividends GME needs 155M and since GME is not planing any aquisions this summ looks completely managable.

So why I think GME has a big margin of safety?

Because I'm sure that in next 3 years GME would be able to generate enough free cash flow. And I think that most likely it would be able to generate enough FCF gor 5 years. Why is this FCF so important? Because GME pays dividends from it. Note: I'm not suggesting to buy GME because of it's high dividend yield. I'm suggesting GME because I think it will be able to generate enough FCF for maintaining dividends on this level. And if it so, stock price won't stay at this level for a long time.

Why insiders are not buying stocks if GME is so much undervalued?

It's the most frequent objection that I read in comments on GME. Well, we should dig into sec form 4 deeper to answer this question. Many officers own pretty large stacks there (like having 700k, 400k, 250k shares). It would be a nice signal if insiders would start buying shares. But since quite a lot of insiders have this huge stake and don't cut it, I'm feeling safe. May be insiders don't hurry in buying stocks because market feels very negative on GME and it is hard to predict how much can it fall (in terms of stock price).

Disclosure: I am/we are long GME.