GameStop Stock Can Quintuple Within Two Years: Portfolio Manager
By Scott Preston, Maven Group LLC
Feb. 12, 2020 2:31 pm ET
This article first appeared on SumZero, the world’s largest research community of buyside investment professionals. In some cases, Barron’s edits the research for brevity; professional investors can access the full version of this thesis and tens of thousands of others at SumZero.com.
Disclaimer: The author of this idea and the author’s fund had a position in this security at the time of posting and may trade in and out of this position without informing the SumZero community.
Target price: $21.75
Recent price: $4.19
Timeframe: 1-2 years
Thesis
GameStop – The Bears Are Right: The Physical Business Is a Cigarette Butt
I think bulls and bears have fallen asleep on GameStop (GME), focusing too much on the legacy argument while ignoring a silent transition taking shape. What I hope to do with this research is highlight the potential for a transformation to occur at GameStop, that if successful could reward investors handsomely.
The general view on GME is that it will be the primary loser as digital delivery takes market share in the video game world, especially as GameStop’s lucrative used-game business dries up. I will not argue this point at all; I am going to let the bears have their cake. I think the legacy business at GME is at major risk, and although it should rebound substantially from November 2020 through mid to late-2021, it will likely go into permanent decline after that. We can argue the scope of this decline until we are blue in the face, but I assume the first 60% will happen quickly and the rest will take a more gradual slope downward.
Another negative view is that this is likely the last console cycle (with physical games), and although GME will benefit and the stock is cheap, the company will be assigned zero multiple and the upside will be fast and short lived. I agree with this view 100%. However, what if the new laser-focused management team takes this upcoming console cycle and uses it to remake the store footprint to capture what might be the most exciting market opportunity over the next decade: interactive/social gaming.
I think in a nutshell the story boils down to:
1. How does management position GME to opportunistically leverage this upcoming console cycle to engage closely with both hard-core and casual gaming enthusiasts.
2. Leverage this above engagement to de-densify the remaining fleet of stores into gaming venues positioned to benefit from a rapidly evolving gaming landscape.
The Gaming Opportunity
GME has a momentous task in front of it, but it has two major luxuries that make a large upside surprise possible. First, the end market (gaming) is absolutely massive, approaching $150 billion. And second, this market is growing rapidly all over the world with billions of people playing games on their phones, PCs, and/or consoles. GME has already established relationships with 60 million engaged gamers through its PowerUp rewards program. This will become a key asset as the company transforms itself to tap some of the new and exciting trends in gaming.
Gamestop is uniquely positioned to become the new social/cultural hub for gamers. The company is currently testing its GME 2.0 concepts in the Tulsa, Okla. market. So far, the feedback has been positive and the company is learning valuable insights on how it can leverage these findings into remodeling its fleet of stores around the globe. The new stores are sleek and stylish, with significantly less inventory clutter. I would highly recommend that investors listen to the company’s latest presentation at ICR to get some more insights on the new store concepts and complimentary initiatives.
I have heard time and time again that millennials want experiences, and this is where GME has an opportunity to pivot the business to encompass something more than just a simple transaction. You will no longer go to GME to just buy games, but to get exclusive digital content, interact with friends in gaming arenas where you learn new skills, and battle other teams in rival cities. This brings traffic to the stores, where kids, teens and young adults are intensely engaged for hours on end. Find me any other activity that can lock people in as long as gaming. Can GME monetize this enormous engagement? I have no idea, but with the stock at 60% of year-ending cash, I would argue you are paying zero to see if any of the new concepts start to bear fruit.
New Management
GameStop has made some significant changes to senior management, bringing in George Sherman (CEO) and James Bell (CFO). Whereas the last management team tried to diversify out of gaming, the new management team has embraced the gaming market and understands that with the right moves it could carve out a very lucrative slice of a more than $150 billion market that should expand at more than double GDP for the foreseeable future. I believe management is doing a great job of balancing the company’s resources as it positions for the new console cycle while also keeping an equal focus on how the gaming ecosystem is changing and what they have to do to evolve and be successful. What is also underappreciated is Mr. Sherman’s realignment on the core, which will allow for better cash flow and greater business flexibility. Management understands GME 1.0 is sunsetting but recognizes the sun can rise again with GME 2.0. Let’s not forget Netflix used to deliver DVDs by mail.
Vendor Partnerships
This is another monstrous opportunity for GME. I believe if GME starts to show tangible evidence that it is driving a more engaged customer to its store for new experiences, game publishers and console manufactures will want to participate. Companies like Activision (ATVI) or Electronic Arts (EA) could partner with stores in order to showcase their games or try out new concepts. It is estimated the big publishers spend between $100 million to $300 million marketing new blockbuster games. Would there be a better opportunity to advertise and promote your product if you were Electronic Arts than a Gamestop 2.0 store that has kids to hard-core gamers engaged in their stores for hours with games, learning, or tournaments? Maybe ATVI pays $5 million to be the sole provider to 100 stores for a month and brings in professional gamers for tips, etc. There are so many ways to skin the cat here, but the opportunities to monetize these publisher and console manufacturer relationships could eclipse $100 million a year in high-margin revenue.
Another possibility that I assign zero value to is GME working with the publishers and console manufacturers to become the trading house for used digital games. GME could be in position to create a neutral platform (clearinghouse), and charge a nominal fee ($0.50) to facilitate transactions. The publishers would keep the profit and create residual value for their digital games. Everybody would win.
The Trade/Investment Setup
I think GME represents a compelling value at 50% of cash with very defined catalysts coming in the next year. We know that the period from the fiscal fourth quarter of 2020 through the fiscal third quarter of 2021 will be bad. The numbers will look terrible, but I believe the company will continue to generate substantial cash during this time through product rationalization and inventory management. The company will also use this opportunity to repurchase shares and could enter this fall’s console cycle with just 25 million to 30 million shares outstanding.
I am expecting this console cycle to be solid, but most likely it will not measure up to past cycles as far as benefiting GME. That being said, it will substantially improve the company’s earnings for at least two years. This is the whole point of my bull thesis. The company is not under the gun, it has the balance sheet and a console cycle that will provide it with two to three years during which it can make the absolute best and pragmatic choices in transforming to GME 2.0.
I have attempted to model the console cycle playing out, without any benefit from the new initiatives. I assume significant declines until the fiscal fourth quarter of 2021, when numbers rebound for four to six quarters followed by a likely permanent decline in the legacy aspects of the business (the slope is up for debate, but becomes meaningless if any one of the company’s new concepts gains traction). I also assume the company continues to slowly close stores, benefiting by a small degree on the cost side. Given the health of the balance sheet, benefits from working-capital unwind, and the cash-flow boost from the console cycle, I assume the company continues to buy back stock.
After 2022, revenue from legacy business lines will likely fall off significantly, so the extent to which management can carve out a long-term position in one of the greatest market opportunities out there will tell the next chapter in this saga. If your answer is that there are zero opportunities, maybe it still makes sense to be short. But if it’s 10%, or maybe 25%, GME could get interesting very quickly.
Other Considerations
The GME story requires that investors break away from something that is just assumed to be a given. I was hoping to transform the thought process. Below are some other items investors should consider during due diligence.
Try before you buy. This might sound trivial, but it could help drive significant customer engagement. Think about how many people hang out in Apple Stores, checking out products with little intention to buy. This is important for engagement, staying close to the customer and creating brand loyalty. This could also play into GME hands by helping to monetize the customer in numerous ways with their vendor partnerships.
Debt. GME currently has $419 million in bonds outstanding. The bonds mature next year (2021). It is my belief that the company will retire about $120 million of this and refinance the balance in the next two to four months. There is obviously some risk here, but I do think the company has a market for its paper and GME should be able to refinance a good portion of this balance.
Cost to de-densify and remodel. The overall cost to de-densify the fleet of stores should be minimal as the company’s average lease term is just 18 months. It can shrink its store count at a fast clip with minimal expense. Remodeling the remaining stores to GME 2.0 concepts will be more involved and the cost is unknown. Given the very small square footage of the stores, this expense should be manageable, but it will take capital away from other initiatives and capital allocation enhancements.
Game programing. The company recently held a programing class at one of its test stores. This proved wildly successful. This should not be viewed as a meaningful money maker but more as another way to keep people engaged with the new social/cultural hub concept. What I find most compelling about this initiative is that it could get GME in front of a younger audience that is the next generation of hard-core gaming enthusiasts. I could see this initiative being popular with a 12- to 16-year-old group versus the esports and D&D crowd, which likely falls in the 18-year-old-plus demographic.
Dungeons & Dragons. Most will laugh at this, but the game has a very intense and loyal group of players. They are highly engaged and will play for hours. The company has tested this in some stores, and again this has proven to generate traffic and solid engagement. There are great ways to monetize this through sales of collectibles and related D&D products. Also, with people intensely engaged in your surroundings for hours there are potential opportunities to market other products or maybe sell Monster beverages and chips.
Esports minor leagues. This is hard to quantify but with the company’s reach and its hard-core gamer engagement provide an interesting proposition.
Pro gamers. Apparently watching others game is as big an activity as gaming itself. GME is uniquely positioned with its new GME 2.0 stores to drive this engagement. They could bring in gaming professionals to give classes and provide tips. When ATVI or EA rolls out a new game, it could work with GME to host exclusive events where pro gamers come into GME and play the new games. I can think of few better ways to get in front of potentially thousands of hard-core as well as casual gamers.
Risk Factors
1. Any way you slice it, the first six months of calendar 2020 will look very bad from a financial headline prospective. Revenue will be down substantially year on year, as will earnings. These headlines are likely to feed the consensus that GME is doomed.
2. Something changes with respect to the console releases. Although both Sony and Microsoft have announced that their new respective consoles will be released in the fourth quarter of 2020, there is nothing that is written in stone. If there was a dramatic timeline change, this could put financial pressure on GME to transition its business much faster than expected and provide it with a much smaller cash buffer.
3. Management fails at finding success in transforming the business. All the new concepts fail, and the company is left with few options to counter the declines in the legacy business.
4. Company decides not to buy back any more shares. This would dramatically change my EPS outlook as the denominator would be much higher. Financially this would leave the company’s balance sheet with substantially more cash that would likely be invested in the new lines of business.
For the full report, including charts and a valuation discussion, please go to SumZero.com.
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