GameStop (GME) – “Swimming Against the Current”

A company we have been tracking and researching for better than two years now is GameStop (GME).  Our initial research on GME was predicated on the thesis that the company was highly overvalued with eroding earnings and reverse network effects.  For reasons described briefly here, we now believe there is value in the stock. However, investors will be unlikely to realize this value.

GameStop sells video games, gaming consoles, and gaming accessories such as controllers and peripherals.  The company also has a robust business selling used video games and allowing customers to trade in their old games for credit towards new or used games.  While worldwide gaming trends are highly favorable with gaming revenue reaching $152.1B this year[1], GameStop has faced strong headwinds from multiple fronts.

Most GameStop stores are located in malls, and the rise of Ecommerce has decimated foot traffic. Many shoppers, and most video game buyers, don’t see a strong need to go to the mall to make purchases as there are numerous alternative options available. High Speed internet has opened the world to cloud based gaming experiences and downloadable games have eliminated the need for physical disks. If no disk is required, there is no reason to go to the store.  Additionally, GameStop has high fixed costs in the form of rent, employee salaries, and inventory that quickly loses value.  For this reason, as the company declines, a decline of 1% in revenue can lead to a much larger, non-linear decline in profits. Finally, GME is heavily reliant on the launch of new gaming consoles and neither Microsoft or Sony have had a major refresh in many years.  The newest gaming platforms from both companies will not arrive until the end of 2020.

In my opinion, GameStop is a terminally ill business. But it can be managed for cash to the benefit of shareholders. A classic Buffett “cigar butt.” GameStop stock has dropped from a high of $55 at the beginning of 2014 to roughly $5 today. But the story isn’t all negative. Despite numerous challenges, the company remains highly profitable and has sufficient cash[2] and cashflow to pay down their debt and cover their ongoing lease obligations.  There is an opportunity to continue to run the business profitably while paying out a steady dividend to shareholders as the ice cube melts.  As the business gets smaller, management can reduce costs where possible towards an eventual end.  Not an outlandish thesis. Shareholders could be paid out in dividends significantly more than what they paid for their shares.

So why the pessimism around the stock? In short, GameStop has fallen victim to the “Institutional Imperative” defined as “a tendency to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so.” The company has gone through numerous leadership changes with more than 6 CEOs (interim and permanent) in the last 3 years. They are doing whatever they can to survive, but some of their choices for “reinvention” are questionable.

  • Acquired Kongregate, a social gaming destination and community for core gamers in the free-to-play gaming market in 2010. They sold this business in 2017 to Modern Times Group for $55M.
  • Acquired Spawn Labs, an early cloud gaming platform in 2011. They closed Spawn Labs in 2014.
  • They became a phone retailer in 2013 with the acquisition of Spring Mobile and additional add-on acquisitions. (RadioShack attempted a similar phone reseller diversification strategy during their decline.)  GameStop exited this business in 2018 through a sale to Prime Communications for $700M.
  • In November 2013, GME acquired Simply Mac to become an authorized retailer and repairer of Apple products. Another highly competitive, and unattractive, business.  After closing many of their retail locations in 2017, the company announced the sale of the remaining locations earlier this year.
  • Their latest growth initiatives are focused on e-sports (a highly competitive market already dominated by much larger competitors such as Activision and Electronic Arts among many others), and their ThinkGeek video game apparel, gadgets and collectibles. ThinkGeek is growing, but it’s not nearly as attractive and profitable as their legacy business.
Collectibles
Innovation?

Most of these ideas just haven’t worked to be transformative or provide a new lane for the company to differentiate.  Investors are discounting the stock to account for future bad deals. Management seems intent on fighting the current even if shareholders lose.

Show me how someone is compensated, and I will tell you how they will behave…

In June of this year, management announced that it was terminating its dividend to instead focus on buying back shares.  Finance theory teaches that investors should be indifferent to dividends or share buybacks as both increase the value of shares.  I believe this to be true when companies are operating under normal conditions.  For a company in distress, where the share price is falling precipitously, investors are better served (at least mentally, if not mathematically) if management pays out the cash in dividends or preserves the cash for a future use.  So why did management choose to end the dividend and buy back shares?  A review of SEC disclosures reveals that the new CEO, George Sherman, was granted 1.2M shares[3] of restricted stock when he was hired this year.  These restricted shares are unvested and do not receive dividends. So, although a dividend might be a clean reward to shareholders, management would not benefit and so they eliminated it.  Their compensation plan also reveals that management does not receive accelerated vesting of restricted stock upon a change in control. And while, the  Council of Institutional Investors deems this policy as good corporate governance, it makes an acquisition less desirable for management unless an acquirer is willing to make management whole on their unrestricted stock.  Most strategic acquirers won’t agree to such compensation because they likely plan to use their own team to manage the business post-acquisition.  However, this structure is perfect for a Private Equity buyer as they typically want to retain existing management, grant them equity, and reward them for growing the business or increasing profitability.  With the recent divestitures and end to the dividend, GME appears to be positioning itself for a sale to a PE buyer.  This is not the most desirable for outcome for existing investors as the elimination of strategic buyers means fewer bidders and a lower price. PE will buy the company as cheaply as possible and save all of the upside for post-acquisition.  Eventually, this cigar butt will disappear, but the PE buyers (and management) will keep that last puff for themselves.

[1] Market researcher Newzoo

[2] $424M (~$18/share) in cash, and negative net debt ($419M long term debt, not including lease obligations)

[3] Current value of this grant is ~$6.5M. Management having “skin in the game” is an attractive quality. However, in this case, the CEO was “granted” 1.2M restricted shares. This is not the same skin in the game as if he had purchased shares with money from his own pocket.

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