Description

Assuming that GameStop comes anywhere close to meeting their 2012 FCF guidance of $500mm (they generated $450 last year), they will have a little over $1.1Bn of cash on the balance sheet with no debt; consensus EBITDA estimates for 2013 are $890mm.  Current market cap is about $3.15 Bn and they currently have $655mm of cash with no debt.  That means that in 10 months from now (the end of their current fiscal year), they would have the ability to take on 3 turns of leverage (~$2.7Bn of debt) and use the proceeds, along with $500mm of the cash they will have on the balance sheet, to pay a special dividend of $23.50 – over 100% of the current share price.  Alternatively, and a bit less aggressive, they could right now take on 1 turn of leverage (~$900mm) and use $50mm of their balance sheet cash and pay an immediate special dividend of $7/share – 30% of the current market cap.  In that scenario they would still only have a net debt / EBITDA ratio of less than 0.5x, with $500mm of FCF coming in the door over the next 10 months.  I am not suggesting that they should do either of options, but they could.  Even if the shorts are right about the long-term outlook for GameStop (I don’t think they are), this stock is just too cheap – and you don’t have to be able to look out 5 years.  With a company this cheap, with this strong of a balance sheet, with this much FCF, and that is currently growing, your downside is extremely well protected and there are a lot of ways you can make a lot of money. 

GameStop (GME) is currently trading at 2.8x consensus 2012 EBITDA, 7.3x EPS, 5.8x EPS (ex-cash).  They are projecting to generate $500mm of FCF this year and expect this to grow to $600-$650mm in 2014.  Assuming 2013 is somewhere in between those two numbers, that means they are forecasting to generate FCF equal to almost 70% of their Enterprise Value in the next 3 years.

I actually have a more fundamental thesis on this stock but, in the interests of trying to get this write-up done before the market opens, I will just present it in bullet-point form.  I am happy to go into more depth in the Q&A.

Investment Thesis

I am very well aware of the bearish arguments around GME, specifically as it relates to the potential for digital distribution to render its business model obsolete.  I actually think the threat of digital is greatly overestimated, certainly in the short- and medium-term, but even in the longer term (“short” meaning 1-2 years, “medium” meaning 2-5 years, “long” meaning 5-10 years).  In the meantime, while we wait to see how the digital threat plays out, there are a lot of good things that can happen for GameStop: (1) continued market share gains, rationalizing store base and cost structure, etc.; (2) new console cycle; (3) new initiatives pay off (iDevice buy/sell/trade program, digital initiatives, tablets, etc.).  In the event that I are completely wrong about the digital threat, we think that given the valuation, balance sheet, cash flow generation, short-term leases, and generally conservative management team, they should be able to take enough cash out of the business over the next few years to provide adequate downside protection.

 Key Investment Points:

 Digital Threat is Overstated

 Digital is not currently impacting GME’s business the way people think it is

?        This business is cyclical (around the console cycle).  Current industry trends are consistent with a console cycle that is long in the tooth, combined with the decline of some faddish products (Wii, Rockband/Guitar Hero), and general economic weakness

?        A lot of the “digital” that people talk about is either incremental (selling follow-on DLC with packaged software) or unrelated to packaged goods (Farmville, Angry Birds, etc. is a very different experience – different consumers, satisfying a different need)

?        Publishers/Developers talk a lot about digital; consumers don’t.  In the end it is the consumers who will decide how video games are distributed, not the publishers/developers.

There are many technological reasons why digital distribution will take a long time to gain widespread adoption

?        File sizes / bandwidth speeds (many hours to download games); games getting bigger

?        Streaming not feasible b/c of latency

?        Lack of hardware storage for downloaded content

?        Potential for usage-based broadband pricing would destroy economics for downloading/streaming

Biggest barrier is that there is no strong consumer value proposition for digital distribution

?        Current method of distribution is very efficient for consumers

?          15 minutes to go to the store (consumers like going to the store – not like movies/books)

?          Several months of entertainment value for that 15-minute trip (unlike movie rentals)

?          Ability to trade/re-sell games – makes gaming very affordable for a lot of people

?          Digital distribution is NOT a clearly superior method of distribution for consumers

?        This is unlike music, movie, books, photography, news, etc. where the value proposition was compelling for consumers

?        It is the publishers/developers who talk about digital; not the consumers

?          86% of consumers prefer physical (Sony research); has not changed in 2 years

?        Current industry weakness mostly due to a long console cycle and decline of fads

 ?        Hard to say the impact that digital is really having – not clear substitution (very different people playing Farmville, etc.)

 Even if digital distribution does overtake physical, it will take a very long time to occur

?        Need to overcome the technological hurdles

?        Even if there is no friction, consumers take time to change habits (music, movies, etc. are taking many years to get to mass adoption of digital)

?        Challenges for publishers/console manufactures with making the transition – they need retail; you can’t launch a big software title or console platform without retailer support – that makes the transition to digital extremely difficult.

Option Value: New Console Cycle

New consoles will spur industry sales, as they always have (maybe not to the same extent given the competition from new forms of gaming, but new consoles will get the hardcore gamers spending again)

Wii U to be launched in 2012 – not necessarily next gen as it is catching up to Xbox 360 / PS3, but will get the Nintento lovers spending again

?        High probability that both MSFT and SNE have a new console in 2013-2014

?        No logic to rumors that next Xbox will not have a disc or will not play used games

?        Consumers not ready for all digital; cutting out used games would make gaming unaffordable for a big segment of gamers

?        Would lose market share to Sony – MSFT goal is to own the living room, why would they come out with a console that many gamers (e.g., ones who like used games, don’t have broadband, demand backward compatibility, etc.) would never buy.

?        Would lose retailer support (a la PSP Go – Sony’s attempt to launch hardware without a software component – it was a big failure)

 Option Value: iDevice Initiative

 GME is extending their buy/sell/trade program to used iDevices (and eventually Android devices)

 Have all the ingredients that they need

?        Customer trained to trade in used product for currency to buy games

?        Refurbishment capabilities, distribution infrastructure, operational expertise, etc.

?        Customer that is comfortable buying used products from GameStop

 Very attractive business model

?        No incremental capital investment needed

?        Minimal inventory investment (pay for inventory mostly with trade credits)

?        Minimal inventory risk as there are plenty of 3^rd party aggregators who buy in bulk and sell internationally

?        Rapid inventory turns, high ASPs and above company-average GMs; minimal incremental SG&A

?        Very few, very high volume SKUs  - operationally less complex than video games

?        Immediately profitable (30% incremental margins)

?        Early signs are the customers are very receptive to the initiative – both on the buy and sell side; business was just launched a few months ago – guidance is for revenue of $150-$200mm this year and $550-$600mm by 2014

?        Small stores mean this initiative could really move the needle (ala Radio Shack with digital converter boxes)

 Potential market is huge – everyone has a couple iDevices and Apple refreshes the products every year

 Option Value: Digital initiatives

Trying to get into digital via numerous channels – selling DLC in-store, social gaming platform (Kongregate), PC Downloads (Impulse), Streaming (Spawn Labs)

?        Unclear if any of these initiatives will really pay off, but there are reasons why GME could be successful

?        They own the customer – have the relationships, have the data, have the marketing expertise

?        Many gamers (low-income and younger ones) don’t have credit cards

?        Can use GameStop trade-in credits to purchase digital

?        Minimal investment/risk for GME (not paying high prices for acquisitions – just buying technology)

?        Arguably a lower probability of material success in digital, but payoff (growth + multiple expansion) would be massive – think NFLX

Option Value: Private Equity Buyout (the simple math makes this an obvious possibility)

Downside Protection

?        Flexible lease portfolio (very short-term leases; average lease term is ~2 years) means they can downsize quickly; already beginning to experiment with store closures and sales transfers

?        A lot of FCF - $450mm in 2011; guidance of $500 for 2012 and $600-$650 by 2014

?        A lot of capex/opex could be (and we think will be) cut

?        Great balance sheet (no debt and $655mm of cash)

?        Disciplined management team – running biz so they can downsize if necessary; not overpaying for desperate acquisitions; returning cash (over $1Bn of cash used for debt paydown/buybacks in last 2 years; initiated a dividend; another $500mm buyback authorization just announced)

?        Great valuation – ~2.8x EBITDA now and business not currently in decline (forecasting to grow EBIT ~10% in 2012 and ~30% 2014 over 2011.

 Summary

Base case: industry muddles along for the next year or so until the new consoles are introduced; new consoles will drive industry sales and make people realize challenges are cyclical and not secular.  In the meantime, GME continues to take market share, improves operations (store closures, cost cutting, etc.), and generates incremental cash flow from initiatives like iDevices.  Stock worth $35-$40, assuming no meaningful multiple expansion.

Upside: Cyclical recovery with new console cycle, plus GME is successful in some digital initiatives / very successful in iDevices; investors get comfortable that there is terminal value; Stock worth $50-$100, assuming meaningful growth and multiple expansion.

Downside: GameStop business model is disintermediated by digital distribution and none of its growth initiatives materialize.  Stores are closed, investment/capex is cut materially, business is run for cash.  Stock worth $20-$25, based on winddown DCF analysis.  As mentioned earlier, in 10 months they could take on debt and pay a special dividend equal to over 100% of current market cap.

Catalyst