Revisiting GME

I looked at GME late last year, just as the share price moved away from me. I was not able to establish a position, but have been keeping an eye on it ever since.

Recently, the stock price fell back to the $20.xx range, and I started writing cash-secured puts, with the intent of establishing a 3-4% position.

Here is a slide-deck, which summarizes my current thoughts (Revisiting GME).

Basically, in the base case, I think the stock is worth somewhere between $25-30. In the worst case, it is worth somewhere around $15, while in the best case, it could be worth nearly twice its current worth. At current prices, it seems like an interesting risk-reward bet.

The stock has declined substantially, has high short interest, is extremely volatile, and pays a fat dividend. The sentiment against retailers is brutal. In short, if we have adequate faith in the valuation, it is an ideal candidate for selling options on.

GME: Tempting?

Note: This blog was written just before the latest quarterly results were declared on 11/22/2016.

Retail is brutal. My scars from Radioshack, Staples, and Tesco have not yet healed. Yet, for some strange reason, I feel inexorably drawn to GameStop (GME).

Background

GME is a brick-and-mortar video game retailer. It has 4000+ stores in the US, which constitute 2/3 of its 6000+ stores worldwide.

It sells video game hardware and software. It has a rewards program called PowerUp, which lets its 46M members “buy-sell-trade” their titles. The used games business is surprisingly lucrative – GME makes more from this part of their business than from selling new games. The return on equity is a robust 15%. They have some network effects. Like eBay or Craigslist, the sellers of used merchandise want to go where the buyers are, and vice versa.

Threats to GME’s business model include technological obsolescence and competition. There is no great reason that somebody like Walmart or Amazon cannot eat their lunch in the used game business, if they really wanted. And as the world moves from “physical” games to digital downloads, it is quite possible that GME – the middleman – will be cut out of the equation. These threats are real, and if either threat become serious, GME’s core business will go kaput!

GME has of course recognized this. They have begun spreading their bets by adding three different segments: (i) digital/mobile, (ii) TechBrands (simplyMac, SpringMobile etc.), and (iii) collectibles (ThinkGeek etc.) Currently, these represent about 25% of revenues (~2.5B), and 30% of operating income, but are expected to grow to 50% or more by 2019. However, there is always risk associated with moving away from one’s core competency.

Management seems quite able. They have judiciously spent free cash on (i) debt reduction, (ii) organic growth, (iii) acquisitions, (iv) buybacks, and (v) dividends. This “all-of-the-above” strategy has been applied  opportunistically, and someone considering buying GME should feel reassured that stewards of their capital are doing a better than average job.

The overall narrative is probably: “competent management trying to navigate a highly profitable legacy business  in secular decline into other new business lines.

Some Numbers

In 2007, GME has revenues of $5.3B. Since 2009, they have held remarkably steady at around $9B +/- 0.2B. ROE has also been steady around 15%. Operating and net incomes have oscillated around $650M, and $375M, respectively since the Great Recession. Over the past 10 years GME has gobbled a third of its shares outstanding; they have fallen from 158M in 2007 to 105M, currently. Therefore, EPS has increased from $2.40 to $3.75.

Debt/Equity oscillates depending on what the management thinks is the best course. Currently, debt/equity is at 0.4. The total debt of $900M is about a year and half’s worth of operating income. So levels of debt are very manageable. It is probably important to capitalize operating leases for retailers, since these are debt like commitments. Here, I am going to ignore that. In all my previous misadventures with retailers debt eventually has been the main problem.

GME pays a healthy dividend. It distributes about 40% of FCF. Currently, that means $1.48/share, which is a yield of nearly 6%.

Valuation

Again, there are plenty of ways to skin this cat. The BVPS is about $20/share, but it is mostly made up of intangibles and goodwill. The tangible-BVPS is about $2-$3/share. So, we probably have to value GME based on earnings.

Let’s consider a coarse valuation first. Operating income is currently about $700M. Management expects it to actually increase to $730-$800M by 2019. Let’s take a conservative number of $650M, which they have managed to hit regularly. The average interest expense has oscillate around an average of 35M. CapEx and depreciation essentially net out to zero every year. And the average cost of acquisition (since they are transitioning out of their legacy business) has been north of $100M. Suppose interest and net capex runs (using history as a guide) around $125M, and that income tax is around $215M. Thus, owners earnings are about $300M. This is likely a conservative number, that bakes in some decline in the overall business. If we are lazy and assume a cost of capital of 10%, we would value GME at $300M/10% = $3B. Dividing by the number of shares, we get a value of around $28.50.

I also played around with a DCF model in which revenues decline gradually starting from -4% in the next year to 0% in year 10. Assuming EBIT margin of 7%, and a tax rate of 36%. I assumed a sales to captial ratio of 3, and acquisition reinvestment scaling up from $100M in year 1 to $125M in year 10. After a few more assumptions, I came up with a value slightly higher than $30/share.

So it seems likely that shares are worth somewhere between $28-$30 a piece.

PostScript

I started looking at GME after I read a post on Barel Karsan. At the time the stock was trading around $20, and seemed intriguing. However, by the time I could find the time to do my due diligence, the stock had run up to $26, essentially eating up most of my margin of safety. A 10% discount is not appealing for a business with big long-term risks.

So right now, I don’t own any GME, but I will keep an eye out.