GameStop Stock Is Just Starting

GameStop Corp. (NYSE: GME) stock is up over 100% over the last eight weeks, impressive performance compared to both the broader market as well as the retail sector, and now with the markets taking a breather, investors are bound to question whether its time to book profits.

The market, fearful of the rise in online games, continues to see the business as a relic of the past when consumers were going to physical stores to buy, sell, and trade-in video game titles, ignoring the power of its strong franchise in the gaming community, which the company is finally starting to monetize.

After years of restructuring and with multiple growth catalysts, for both top and bottom line, on the horizon, the stock looks ready for a revaluation. The stock is trading at valuations cheaper than other restructuring plays in the retail space and cut off from the earnings potential of the business when things normalize.

The upcoming holiday season and the beginning of a new console cycle will throw light on this growing discrepancy between fundamentals and Street expectations, early signs of which are what these past few weeks stock performance is reflecting.

The stock is a core holding in our weekly list of top ideas for the week and yes; we hold the stock in our portfolio as well.

Doubts over the survival of physical stores discounted but this is not the end

The argument against the physical stores selling video games and related items are well documented, be it the rise in mobile gaming, growth in digitally downloaded games, or online games, and those concerns are discounted in the stock price as well.

What the market has yet to acknowledge is that all is still not lost.

The recent skirmishes, including a lawsuit, between Apple (NASDAQ: AAPL) and Epic Games, owner of Fortnite, will act as a wake-up call for publishers to avoid overreliance on an app ecosystem. Yes, the same won’t turn back the tide but may help slow down the deterioration in the business.

Besides, new consoles have a disk drive, almost guarantying that consoles will play both the physical and digital software, at least for the next seven years.

Retail stores play a strategically important role for console manufacturers, be it for brand building, maintaining the relationship with hardcore users and collectors, educating customers, and sale of accessories.

Deliveries are also getting faster, further supporting the omnichannel sales approach. The company has been able to fulfill 70% of the buy online pickup in-store orders on the same day, many within an hour or two.

Operations restructured

In the meantime, the company has been aggressively restructuring its business over the past few years, with big help from activist investor – Hestia Capital Partners, which also nominated two members to the Board in June of this year.

The company is aggressively cutting physical store locations, costs, inventory, and working capital. Indeed, the goal of $200 million in cost savings for this year has already been achieved during the first half of the year.

Yes, early signs of improvement are visible, even though sales declined by more than 26% and comparable store sales declined by 12.7% last quarter, ahead of earlier expectations.

These results were largely impacted by Covid-19, which led to 13% fewer store operating days, delays in the launch of new software titles, and constraints in the availability of new hardware. Besides Covid-19, the end of the seven-year generation 8 gaming console cycle also played a major role in declining sales.

In the meantime, omnichannel digital capabilities developed over the last year are fully functional and delivering now. Almost 40% of the sales from the closed stores have been recaptured by online and nearby physical stores.

Growth catalysts offer a window of opportunity

Yes, secular headwinds for sales growth are strong, but there do exist some favorable tailwinds as well, namely

–           New gaming console cycle that lasts years

–           Extremely fast-growing e-commerce business

–           New app, software launches, and other growth catalysts

Let the new console cycle begin

After seven years, the refresh of major consoles is about to begin. Both Sony and Microsoft are about to launch the next versions of the PlayStation and the Xbox, i.e. PlayStation 5 and Xbox Series X, for the 2020 holiday season. Last week, GameStop started taking pre-orders. Nintendo is also expected to launch the next-generation console – Switch 2 by early 2021, coinciding with the original console’s fourth anniversary.

GameStop, as a specialty video game retailer, stands to benefit immensely from this cycle, not just because of customer’s favorable response to new consoles, but also due to the resulting increase in sales of headsets and controllers as well as increase in software sales that follow the hardware upgrades. Call of Duty and Cyberpunk games are expected to launch by the fourth quarter and Microsoft’s Halo Infinite expected to launch in early 2021.

New consoles should also lead to more trade-ins opportunities that are beneficial for margins as well. To further monetize the upgrade cycle, the company plans to launch expanded finance & leasing options and delayed payment plans, complementing the increased customer interest.

E-commerce is growing fast without cannibalizing store sales

The rise of e-commerce business has been a major development for GameStop and an opportunity that the Street has failed to fully appreciate so far. Global e-commerce sales rose 800% during the last quarter, with e-commerce sales penetration rising to 20%, a significant increase from low single digits just a few quarters ago.

Standalone e-commerce is more than $1 billion business and growing at par or faster than some of the high-profile online retailers that are commanding sky-high valuations. More importantly, significant sales from closed stores also shifted online.

The new app, software launches, and other

The company is planning to launch a new re-designed mobile app, with an extensive set of features, including a digital wallet, customer rewards, gaming news, and other features that can help monetize and build upon its extensive customer base.

The company is also launching private-label merchandise and an expanded assortment of PC accessories during the current quarter, to participate meaningfully in the PC accessory market with higher margins products.

Timing of these growth catalysts couldn’t have been better

These growth catalysts are starting to take ground after years of operational restructuring, which should help margins improve as things stabilize. 

GameStop Corporation     
      
 2016201720182019Q2 2020
Gross Margins31%29%28%30%27%

Gross margins declined last quarter after years of improvement, mostly due to increased share of hardware revenue in the mix, but improving cost structure has been improving steadily. Last quarter, the company closed 206 stores worldwide, including wind-down of stores in the Nordic region.

Overall selling, general and administrative expenses reduced by $134 million for the quarter and $201 million during the first six months of fiscal 2020. Inventory reduced by 50% and accounts payable declined by 30%. Corporate jet was sold and sales-leaseback was completed on 3 of the 5 buildings owned by the company.

Capital expenditure for the year is expected to be around $55-60 million for the year, down from $80 million last year, but out of $55-60 million, $15 million is due to the holiday store merchandise refresh project, which will be reimbursed by the vendors.

All in all, a lean cost structure, reduced capital expense, and a strong balance sheet, things below the topline are all in great shape.

Valuation and why one should bother digging deeper

We believe the stock is underappreciated, whichever way one look at the name, be it

  • Relative to other restructuring stories in the retail space
  • Earnings power of the business with normalized margins
  • Standalone value of the fast-growing e-commerce business
 EV/ Sales
GameStop 0.2
The Container Store 1.1
Macy’s 0.5
Nordstrom 0.6
Kohl’s 0.5

Compared to other retailers that are under equally big problems and lack any near-term catalysts like new console cycle, the stock is trading at more than 60% discount.

GameStop Corporation  
Reverse engineering the expectations
Fiscal year20202021
Revenue growth expected-18.0%3.5%
Revenue $5,302 $5,488
Gross Margin27.5%29.0%
Gross Profit $1,458 $1,591
Operating expense $1,435 $1,475
Operating margin0.4%2.1%
Net Interest & Other $30 $30
Tax rate15%20%
Shares (M) diluted 66 66
EPS $(0.09) $1.05
Street-$2.11-$0.13
Academic exercise for Purnha’s internal use only. Not to be relied for investment decisions.

A quick back of an envelope calculation, using sharper than Street’s expected decline in revenue for the current year, margins moving back by next year, and operating expenses near last quarter’s level, will highlight the earnings power and leverage inherent in the business model.

Now that the company’s e-commerce business is drawing more $1 billion in sales and growing strongly, it won’t be long before investors start focusing on the value of the asset on a standalone basis.

DISCLOSURE: We are long the shares of GameStop Corp. Before writing a note, we usually ask (via Twitter and Stocktwits) for things readers would like us to cover in the note, please do share your views for our next note. This is purely an academic exercise for our internal use and we are NOT recommending buying or selling based on these projections.  

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