Between a Rock and a Hard Place

By Tom Gibbs - February 1, 2012 | Tickers: AMZN, EBAY, GME | 0 Comments

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On the surface, Gamestop (NYSE: GME) appears to be one of the most attractive billion-dollar-plus value plays on the market.  At a recent price of $23.50 per share, the corporation sells for slightly more than book value and only 3.45x and 8.45x last 12-month EBITDA and EPS, respectively. 

The company has historically performed very well, growing sales between 2003 and 2009 at a 36.6% CAGR, largely through organic means – average same store sales increases over the same period was 8.8%.  Most importantly, GME was able to maintain a return on core operating assets between 2003 and 2009 of nearly 21%, and grew its residual operating income at a 31.07% CAGR.*

In looking more closely at the company’s core operations, as well as the industry’s future potential shifts, an investment in GME may be a value trap, and its compelling market price lacks a meaningful catalyst to support a higher valuation.  There are several key reasons why the corporation may be prone to a continued weakened performance over the next several years.

Deceiving Barriers to Entry

Some of the historically strong bullish sentiments regarding GME are focused on the corporation’s apparent sustained competitive advantage in its core pre-owned video game segment.  The company is the largest pure-player in the space, and has grown sales over the past five years at a 17% CAGR while maintaining an average 48% gross margin. 

Assuming that GME’s trade-in-fueled business model continues into the future, the corporation’s current position would take a huge investment (both time and capital) to reproduce.  Primarily, a huge knowledge base of the pre-owned video game software/hardware segment must be obtained, largely through trial and error at first.  An entire catalogue of prior sales history must be kept and analyzed to maintain up-to-date information regarding relative trade-in values as well as demand profiles for consoles and individual games.

The entire trade-in information bank owned by GME is a very valuable asset, and not only does it require the corporation to keep and grow an extensive knowledge base, but it requires that the corporation has a very efficient inter-store communication system.  The distribution of pre-owned game trade-ins is hardly uniform – some stores and regions may have a higher stockpile of certain games and systems than other regions and stores.  In order to effectively manage the inventory and ensure an even, sellable inter-store mix, an inventory tracking system and efficient communications throughout the system of stores must be in place. 

GME’s successful Power-Up program, which grew its membership base by nearly 12.5 million in its first year of operation, fuels the concept’s growth.  Members trade in pre-owned games for in-store points, not cash, which can be used toward future purchases. 

The idea is simple, yet brilliant, and would be a huge barrier to entry assuming that this current business model prevails in the long run.  There are several examples of online, non-pure play companies that greatly improve upon this concept and show that it has little lasting value in the long run.

A quick look at Amazon’s (NASDAQ: AMZN) Marketplace or eBay (NASDAQ: EBAY) offer two examples that undermine GME’s concept.  First, both of these players make the entire competitive advantage around GME’s inventory pricing and distribution system more or less obsolete.  AMZN’s Marketplace and EBAY do not actually own the inventory and are not responsible for warehousing the goods, as their concepts focus on a portal that pairs buyers and sellers of personal merchandise.  A potentially meaningful risk involved with GME’s operations is its huge $1.77 billion inventory of games, consoles, and other pre-owned products including refurbished Apple tablets and phones. 

Unlike the AMZN and EBAY model that transfer the risk of product obsolescence to the merchandise owner, GME’s stock of pre-owned iPad 2 and iPhone 4 are prone to a huge depreciation in value upon the upcoming releases of the products’ next generation replacements.  The goods, when comparing GME and AAPL websites, are only priced an average of 20% less than brand new products, so it is not unreasonable to assume that AAPL’s mark-down of its remaining inventory upon the release of newer generations will have a substantial impact on the GME merchandise. 

The same holds true for its core pre-owned video game segment.  Nintendo has already announced that the new Wii U will not be GameCube game compatible, and it is rumored that Microsoft’s latest Xbox 720 console will not have used game playing capabilities.  Pre-owned GameCube games, like the AAPL products, constitute a small fraction of GME’s total revenue stream, and the Xbox 720 rumors are, well, rumors.  Although there is little risk of $1.77 billion worth of inventory obsolescence, the parallel does show that this is an inherently more efficient, and less risky, retail concept for the pre-owned video game niche. 

Next, GME’s Power-Up point system makes less sense when looking at an AMZN or EBAY-type setup.  With a negotiation/bidding process controlling the price of the merchandise, used game buyers can more effectively manage their purchase prices than if they were to purchase at a set-price GME retail outlet (or its website).  Both sites have a large “inventory” of goods, so the game rarity factor can be largely ignored.  Without the need for GME’s second mark-up on the goods, sellers can generally get more for their goods and buyers can generally get products slightly cheaper in a bartering system – essentially, the prices are made more efficient with the pairing of buyers/sellers and their willingness to pay/sell.  The point system that offers a discount on a future purchase to make up for the acceptance of a lower trade-in value no longer makes sense or adds value. 

The crux of GME’s entire business concept relies on the effectiveness of its pre-owned game trade-in system.  If any other entity was to enter the niche, which is highly possible due to the attractive margins, or even if a fraction of GME’s core customers migrate to a different buy/sell arrangement, the corporation’s entire house of cards is susceptible to an easy collapse – pre-owned trade-ins fuel the sale of pre-owned trade-ins as well as a meaningful portion of new console/game sales. 

A competitive advantage that is marked by large reproduction costs becomes less attractive when simply sidestepping and improving upon the concept is a viable option. 

Limited Ability to Control Destiny

GME is also highly dependent on hardware manufacturers and software developers to support their business.  First, these parties play a large role in the advertising and marketing of GME’s business concept.  As one of the highest-volume routes towards product distribution, GME’s business is infused with co-op marketing funds from these other parties in the supply chain. 

The company explicitly states in its annual filings that a significant portion of its ability to market to and attract customers is reliant on their continued and successful relationship with product vendors (the funds actually are used to reduce their COGS, so gross margins are slightly boosted as a result).  Likewise, these cooperative arrangements are cancellable by the much larger and more powerful vendors without recourse. 

Hardware and software manufacturers have already expressed their interests in cutting out players like GME to drastically improve their profitability – there is no sense in paying a reseller to market the goods when there is a growing demand by consumers to download software and upgrades remotely.  There have been many arguments made that the current systems – marked by slow download times and security issues – do not have a demand large enough to take away value from GME’s retail concept, and this is currently true.  However, as long as the end goal for software producers is digital distribution, GME’s model is viable until a suitably profitable distribution route can be established.

The release of the Playstation Vita shows that handheld gaming is already heading in this direction, and Nintendo’s Wii Virtual Console and Microsoft’s allegedly pre-owned game-free Xbox 720 show that even consoles are heading towards the controlling of a larger portion of the supply chain.  These examples go without mentioning the extremely fanatical popularity of online video game development and distribution companies like Valve.

A Value-Added Concept that Doesn’t Add Value

GME’s original value-added system is very reminiscent to that of Best Buy, although much more concentrated on a sole product segment.  When compared to original mom-and-pop stores, the Best Buy concept did create value – the corporation employed trained salespeople who could relay technical product information, and the big-box stores housed thousands of SKUs for easy and convenient product and model comparison. 

With all of the same information available online, and with an increased willingness of consumers to conduct research and bargain shop, the value-added system hardly adds value anymore.  GME’s core customer, and the one it spends money to target, is the “hardcore gamer” that engages in several transactions per month.  It is most likely that these individuals, who view gaming as a serious hobby, engage in research months before new products are released.  In essence, GME is simply a hub to complete the purchase transaction, and the trained sales personnel’s assistance is hardly needed. 

Despite its continually rising sales, the signs of GME’s diminished value-creation abilities are already present.  Residual return on core operating assets in the most recent 12-month period has decreased by 53% from their recent high in 2009, and gross margins on the business’ core pre-owned gaming segment have fallen several hundred basis points to 46% in the most recent quarter from their historical average of nearly 50%.  Likewise, the corporation’s top-line growth over the past several years has largely been fueled by new store growth, as comparable store sales have remained stagnant. 

Although this does not represent a huge performance impairment, the figures do show that even in an operating environment where digital distribution is in immature stages, and where video game popularity is at its height, the company is still susceptible to meaningful fluctuations to core profitability.  Every dollar that GME does not push down to its bottom line today is a dollar that will become increasingly difficult to report as net income as the industry continues to move away from the brick-and-mortar distribution network. 

*Note: Return on core operating assets = post tax operating income divided by net operating assets.  Net operating assets = (total assets – financial assets) – (total liabilities – financial liabilities).  Residual operating income = (return on core operating assets – cost of capital) * average net operating assets.  12% cost of capital requirements assumed in the above calculation.

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