GameStop's Got a New Game Plan

By j.a. graham - September 13, 2012 | Tickers: GME, MSFT, SNE | 0 Comments

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GameStop (NYSE: GME) appears to be entering its senescence but it may turn out to be a graceful, extended exit if investors are lucky. This is a no-growth story in spite of the ever-increasing billions of dollars spent by gamers. With technology evolving and the competition sharpening its knives, GameStop's business is disappearing.  Amazon (NASDAQ: AMZN) has been especially tough competition with promotional pricing and a wide selection of digital product. Digital games are the future for growth and Gamestop's strength has been in physical discs both new and used.  Games are information-dense and downloads consume huge quantities of hard drive space so physical software is still a good way to get games and keeps GME viable. 

GME is waiting for the game console  cycle to turn up and is counting on the release of new platforms to move the new game software. The start of the new cycle may prove to be less profitable this year with low expectations for the new Nintendo WiiU. Of more interest are Microsoft (NASDAQ: MSFT) and Sony (NYSE: SNE) who have not set  release dates for the new  Xbox and PlayStation 3. WiiU will have some positive impact on pre-owned games and  that has been included in Q4 guidance. With the more highly anticipated PS3 and Xbox a no-show in 2012,  GME has to make due with WiiU. That means continuing slow releases of new titles and disappointing hardware sales through the end of the year. 

Industry-wide slump

GameStop’s rapidly eroding business is not unique to them. Sales across the industry are down, but the cycle will turn as platforms and games are released and that provides a pending catalyst reversing accelerating losses for GameStop. In June alone, industry-wide total retail sales of systems, software and accessories were down 29% year-over-year. Hardware was hit the hardest at a 45% decline.

While hardware and software sales are slowing,  the transition to digital and accessory point card sales is booming. Future growth in gaming will be in digital downloads and GameStop is fast in adding digital sales to the mix. It is the only rapidly growing segment.

GameStop by the numbers

The company has four operating segments:

• New video game hardware
• New video game software
• Used video game products
• Other

" Other " includes digital and mobile devices and PC software and is the only GME business segment that is growing in the last quarter and were up 40.6%. Digital increased 27% to $134 million and is 8.6% of revenue. Mobile sales, made up of tablet and pre-owned iDevice products, were $29 million, on track to reach the company’s 2012 forecast of $150 to $200 million.

Results by segment Q2 2012

Hardware as a percentage of total revenue peaked in 2008 at 23.5% of sales (11.8% in Q2 2012) and hardware revenue peaked in 2009 at $1.8 billion—2011 hardware sales were only $1.6 billion. Hardware gross margins at around 7% are the worst across GME segments. The decrease as a total percentage of revenue will eventually improve margins.

 New video game software is the biggest percentage of business with gross margins around 21%. By the second quarter of 2012, sales were in accelerated decline. In 2007, new software grew at 62% and was more than 1/3 of the business. Sales growth was an unimpressive 2% in 2011 and a dismal (21%) in Q2 2012. New software sales are becoming a smaller part of total revenue as the faster growing, higher margin “other” products increased from 13% in 2011 to 21% of total revenue in Q2 2012. Other products had gross margins of 38% in Q2 2012. The transition to mobile and digital is a sound business decision.

While the CEO J. Paul Raines emphasized the importance of the expansion of gross margins for the last five quarters, it was overshadowed by operating and net margins contracting year-over-year. Margins are seasonal and while Q2 has the lowest margins by quarter, Q2 2012 was notable for the lowest margins seen in three years. 

The costs of running such a large number of stores are more efficiently distributed when revenue is high--retail 101. SG&A growth has been held in check over the past two quarters, but is now taking a larger bite out of gross and causing a contraction of operating and net margins.

In order to preserve net income and cash flow, if sales continue to slide and the new hardware cycle is delayed, GameStop will have to begin making decisions to cut the underperforming stores from the 6,628 store base. With falling revenue, the maintenance and expense of running stores with negative same store sales is eroding margins and draining cash that has now been promised to shareholders.  The projected net loss of 50 stores by the end of 2012 is a good start and while cash flow looks adequate to cover capital spending and dividends in 2012, GameStop will better serve investors by continuing to close underperforming stores and slowing expansion.

Even though expenses declined year-over-year, SG&A increased by 3% as percentage of revenue, causing margins to fall year-over-year. The high fixed costs of renting and running stores need better leverage and that requires higher revenue or a lower store count.

The Used Business Sinks

This segment is key to GME’s continued growth and a big portion of total revenue. The used game percentage of revenue is now 36% after sticking in the mid-to-high 20s for years. Gross margins are the highest of the segments at 48%, but revenue growth was a disappointing (11%) in Q2 after managing only a 6% gain in 2011. GME saw its lowest second quarter revenue in Q2 2012 since 2007 -— not an encouraging indicator for the remainder of 2012. While their business model is flexible and diverse, losing used game sales is especially painful. Without strong pre-owned sales, the business will struggle until digital and mobile mature sufficiently to drive busienss growth. 

The Rise of Digital

Paul Raines:

One of the things that we say a lot around here is, it's important to understand technology, it's also important to understand chronology -- as retailers, with millions of visits a week, we have to understand chronology. Consumers simply do not adopt all technologies at the same rate. So, yes, we think that the next consoles will have plenty of physical disk in them. We also think these consoles will launch with some DLC. We have built an ability to sell digital content in stores and online.

 The “other segment” is now 17% of the 26-week revenue -- up from 13% in 2011. They will need to continue  acceleration of sales in digital and mobile to offset the rapid declines in  hardware/software. With physical software sales dropping and a still limited selection of digital game titles, GME is looking at a few more negative comp quarters and a year or two of struggling to increase sales. Competition, fewer new releases and an extended new console cycle will continue to challenge them.

From the Q2 conference call, GME is counting on new releases for growth. Investors looking for yield would probably be satisfied with stabilization.

As in prior console cycles, the flexibility of the GameStop model drives greater pre-owned and now digital and mobile growth as new hardware and software decline. As the next generation of consoles enters the market in late 2012 and 2013 and '14, we will see top line growth accelerate and earnings growth.

Guidance

Q3 2012 same store sales are expected to be in the range (5%) to (10%). Guidance is cautious given the overall traffic declines  seen this year. Diluted EPS are expected to range from $0.28 to $0.36 on a share count 124.5 million shares (including buybacks through the second quarter). Full year comps are guided to (2%) to (10%) reflecting the uncertainty surrounding consumer demand at the end of this cycle in spite of the strong title line-up in the back half of the year. 

The holiday selling season is always important but even more so this year with new commitments to paying shareholders with dividends and share repurchase. Not only will revenue need gains sequentially and a strong recovery from the worst second quarter in years, margin expansion will be critical.

Our business, like that of many retailers, is seasonal, with the major portion of our sales and operating profit realized during the fourth fiscal quarter, which includes the holiday selling season. During fiscal 2011, we generated approximately 37% of our sales and approximately 53% of our operating earnings during the fourth quarter. During fiscal 2010, we generated approximately 39% of our sales and approximately 57% of our operating earnings during the fourth quarter.

They are reiterating EPS for 2012 at $3.10 to $3.30.  With EPS through Q2 at 70¢ and the guided high end for Q3 at 36¢, they need to do at least $2.04 in Q4 to come in at the low end.  That's net income of $385 million and at the current margin of 1.4%, $27.5  billion in 2012 revenue --ridiculous of course. To reach $3.10-$3.30, Gamestop needs higher net margins closer to the 4% seen in 2011. The revenue would be around $9.6 million.  Bottom line is that margin expansion is critical and GameStop needs to improve markedly over Q2. Comps at  (10%) and a net loss of 50 stores puts pressure on new locations to produce high revenue during the crucial holiday quarter to meet guidance.

Future cash flow guidance:

 Our current cash flow forecasts provides for over $2 billion to be returned in the next 4 years (intention is to return 100% to shareholders). We currently have $300 million remaining in a board authorization for buybacks. And our board approved a 67% increase in our dividend to an annualized dollar per share this week."

Management expects at least $500 million in free cash flow (after capex) for the next four years. What they expect and what free cash flow turns out to be may diverge.

Stores & capex spending

•  2011 -- $165.1 million to open 285 stores and other GME spent $30.1 million for acquisitions for digital expansion
•  2010 -- $197.6 million primarily to open 359 stores. There was $8.4 million for acquisitions
•  2009 -- $163.8 million primarily to open 388 new stores

They will open approximately 100 new stores in 2012 offset by the closure of 150 domestic locations. GameStop spends around $400K on a new 1400 square foot location. With stores turning in negative comps and the domestic base saturated, net closures is a sound business decision. Growth through increases in square footage when sales per square foot are down is a money-losing venture. A better use of cash would be returns to shareholders and that's where GME is going with a vengeance with both fast-increasing dividends and aggressive share repurchases. 

Share Repurchases

After paying down the debt, GameStop has redirected its spending into share repurchases for the last three fiscal years.

Offsetting the dilution from options has not been cheap; GME spent a net of $65 million in 2010 for an 8% decrease in shares—-the most expensive year. The deal was much better in 2011 where they managed an  8% decrease  for a net expense of $10 million (restricted shares not included). It looks like money well spent with decreasing share counts improving EPS.

Cash flow

For investors collecting dividends, the important story is cash flow. Growth is not a reason to invest. Even if GME continues to see revenue decline, if they can generate enough cash flow to pay dividends and buy a little stock, that makes a reasonable income-producing investment. If revenue resumes a precipitous drop without improving margins, low cash flow could necessitate cutting the dividend and result in loss of capital for investors as the floor falls out from under the share price. GME's cumulative CFFO is often negative until the fourth quarter underscoring management comments that 2/3 of business takes place in Q4 and the importance of high holiday sales. The pressure is higher this year to outperform with their new shareholder-friendly policies in place. A reversal of the dividend would have negative repercussions on the stock price.

From free cash flow (FCF), GME has paid off $550 million in notes in three years and has no debt today (other than lease obligations). Over $701 million has been spent purchasing treasury shares 2009-2011. Then in 2012, they began to pay a dividend. Free cash flow has not been adequate to cover all the expenditures and the cash balance has moved down over three years. Cash at the end of Q2 was $139 million and at the end of 2011 it was $655 million. It should rebound some in Q4. Without positive cash flow until Q4, GME will be running at a deficit consuming cash to meet dividends, share repurchases and capital spending.  With decreased capex spending and no debt, the dividend has a reasonable chance of coming through 2012 intact with strong holiday sales. 

Discounted cash flow—not exactly

Instead of trying to get a dollar amount for the price per share based on assumptions that may never came true, I looked at what expectations the market has built in to its valuation at the recent price per share. Using trailing 12-month figures and some trends and comments from management it was possible to model the growth rate the market expects under some specific conditions.

 The company has indicated that capex will be declining in 2012 as new store openings slow and do not outpace closures. For the model, capex was kept flat as EBIT decreased  by 6%  over ten years. The depreciation decreases 5% every year( per management comments) and the discount rate was 11%. With these inputs the share price is around $21 and may be justified following the ugly second quarter.

Looking at it from the perspective of free cash flow under the same  pessimistic assumptions, free cash flow to the firm comes in at levels high enough to pay the current dividend of $128 million per year for four years of declining revenue. By year five, GME would need to cut the dividend.

If the company is right about the cycle turning and revenues increasing by 2014, then the dividend seems safe until the projected release of new consoles and games in 2013 and 2014.

The aggressive raising of the dividend by 67% and share repurchases have helped the company recover from a 52-week low of $15.  The forward 5.4% yield puts a fragile floor under GME –a major miss in Q4 will remove it.

One Final Note of Caution

GME is facing a possible write off of a non-cash charge of goodwill.

Due to the recent decline in the stock price, the net book value of equity exceeds the market cap. They are required to test for impairment of goodwill and intangible assets.

Management believes that any potential impairment charge will be related to the goodwill and intangible assets in the international business and valued at $920 million. The value of the U.S. business has always been far in excess of the net book value of assets recorded in the U.S. reporting unit. The impairment is not related to the digital acquisitions.

The write off would be substantial and material but it is non-cash in nature and is not going to affect cash flow. The earnings headlines will sensationally report big losses if it happens and the stock price will be affected, but the cash flow and dividend will not.

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