Feb 24 2020 - Approaching The EndGame(Stop)

Common comparisons to defunct retailers lack important context.

Current catalysts for shares are numerous and significant.

Any upward movement could trigger a vicious short squeeze.

The year-long battle between GameStop (GME) bears and bulls is approaching its conclusion. Between management changes, battles over the eventual dividend cut, and buyback decisions, it has been a wild time to be a shareholder. It has also been almost exclusively painful as the share price has once again dipped below , after briefly rallying over 100% from .15 lows in Aug-19. For those who got in at the lows, some nice gains have been had, but the general experience has been continued agony for long-term holders:

The recent back and forth regarding the conclusion has been centered around what the new console cycle will do for the stock. You can read the bear case here and the bull case here. Even someone over at SumZero got in on the action. I want to look at a different angle, the incessant comparisons to Blockbuster and RadioShack.

Bears: It’s The Next Blockbuster/RadioShack

GameStop, like these legacy retailers, has been getting crushed by falling margins and revenues. Many investors are quick to point out we’ve seen this before, and that the business model is outdated and will not recover. Despite improvements in FY18, SSS in FY19 fell off a cliff, with Q3 showing a 23% YoY drop. Horrifying stuff when you’re long. Check out the EBITDA and EBITDA margin and over the last 5 years:

Another overhang for the business has been the outstanding debt due in 2021, 9m on Nov-19. Moody’s just downgraded the bonds, citing concerns with the sharply falling revenues. While their price did trade down somewhat, the current yield remains around 8%.

The crux of this thesis: the business model is dying, and management will continue to invest in a broken model until they become bankrupt and the stock becomes a 0. Maybe they’ll launch some new shiny new eSports initiatives that will sound good, but only expedite the collapse.

Reviewing the scary charts above, it can be easy to miss that GameStop is essentially priced at 1x EBITDA. Outstanding short interest is essentially 100%. Any unexpected catalyst for the stock could send shares ripping higher. While I won’t disagree that the business is experiencing some secular decline, I believe there are a few other points that bears miss when making this comparison to these bankrupt retailers:

RadioShack

Read about the debt deal that Salus Capital offered the now-defunct retailer in 2013. Comparing the requirements put on the business to GameStop’s debt covenants makes it clear these two situations are not identical [i.e. RadioShack wanted to close over 1,000 stores because they had too many (like GameStop) but Salus limited them to 200 per year (unlike GameStop)]. GameStop Management understands this and is working to cut back density:

• “As we continue our evaluation of underperforming aspects of our business, we are on track to have between 230 and 250 less stores on a global basis, net of new openings by the end of fiscal 2019. The closure rate of underperforming stores is very consistent with the last several years and supports our continued efforts to dedensify our fleet to optimize profit production in select markets and trade areas.”

GameStop management has also acknowledged they are looking at closing marginally profitable stores which operate near other stores in their area, as the costs decrease significantly, while the revenues generally move to the other store. It's worth noting that 95% of stores are four-wall profitable and most leases expire in the next few years, so GameStop has a lot of flexibility here.

As can be seen from the article above, RadioShack, 3 months before bankruptcy, had m in cash and 1m in long term debt, and over 0m of net debt the year prior. Comparing that to the hundreds of millions in net cash GameStop currently possesses, upcoming revenue catalysts, and the lack of handicapping covenants their debt imposes upon them, and it becomes clear these situations are not identical. RadioShack gross margins also fell off from over 45% in 2010 to under 35% in 2013. GameStop gross margins meanwhile are actually higher in the TTM period than they were in 2010 and 2011, and from their peak of 31.4% in FY17, remain above 28%.

Blockbuster

When discussion an outdated business model, few examples come to mind faster than Blockbuster, which is summarized here. This is not a new comparison. As you can see from this link, some of the facts regarding Blockbuster may surprise you:

• Blockbuster was only profitable for two years between 1996 and 2010.
• Blockbuster had one key business model, renting DVDs, that grew stale as the cost to buy DVDs plummeted, and the medium became more effective to deliver digitally.
• Blockbuster had to take out almost a B loan to pay a dividend to Viacom when they were spun off, burdening them with debt throughout their run as a standalone business.
• Blockbuster revenues fell almost 50% from 2006-2010.
• Same article: “But in 2009, the year before Blockbuster filed for bankruptcy, by-mail rental (still Netflix’s main business then) accounted for a little over billion of the .1 billion industry Blockbuster operated in. Vending — i.e. Redbox and its cousins — was worth 7 million. Netflix may have landed a death blow in Blockbuster’s final year or two, but the retailer had long been kicked around by a fragmenting market and financial woes.”

Many bears would argue the second bullet directly captures the risk for GameStop, that the medium has moved to digital. This assertion lacks perspective on the following facts, however:

• GameStop has outlived Blockbuster for 10 years and been profitable for almost all those years (most recent dip caused by writeoffs, not unprofitability of core business).
• Adjusting for Spring Mobile sale, GameStop revenue has not seen anything like a 50% decrease.
• Even with the Netflix (NASDAQ:NFLX) headwinds, the movie rental business didn’t die, it just changed. Apollo bought Redbox for .6B in 2016, years after Blockbuster ceased operations.
• The Power-Up Rewards program at GameStop gives gamers an incentive not to shop at Amazon (NASDAQ:AMZN) or Walmart (NYSE:WMT), and not to download their games.
• There are other items for sale at GameStop than just new and used games (Dismiss Funko Pops' (FNKO) obsession at your own risk, the love is real).
• Gen Z prefers in-store shopping more than millennials.
• Only 34% of gamers prefer digital console downloads.
• GameStop is seeking to capitalize on the explosive growth of E-Sports.

Catalysts

For anyone who has been following this story closely, this won’t be new information, as the arguments have been made on SA before, but can be summarized simply:

• Trading at 1x trailing EBITDA.
• 0m of liquidity at the end of FY19, potentially including reduction of shares/debt outstanding (awaiting update at earnings date).
• Console refresh cycle hits in 2020, first major refresh since 2013. All new consoles will have disk drives. The PS5 is rumored, but not confirmed, to be backward compatible to the original PlayStation and could be a boon for pre-owned sales.
• New management team is pragmatic, sees the opportunity, and has been repurchasing shares as hoped, reducing outstanding share count by at least 40%.
• Overdue SG&A cuts have been made, and Nordic exit should save them around m annually.
• First insider buying since Sep-16.
• Additional assets include around m in real estate, a magazine with 7.5m subscribers, and a corporate jet currently for sale for m. Given that Time Magazine sold for 0m with less than half the subscribers, Fortune for 0m, and even Money (was rumored to) sell for around m. I don't know what value it would command on the open market, but m doesn't seem unreasonable given those sales. So around half the current market cap could potentially be liquidated just from sales, and leasebacks in the case of the owned real estate.

Risks

• Management fails to complete remaining repurchase authorization.
• Refresh cycle is delayed past 2020.
• GameStop does not refinance debt in 2020.
• Management fails to pull any additional levers to monetize assets.
• Management fails to right size store base over the next couple of years.
• Significant institutional holders sell all their shares, allowing shorts to unwind positions, leading us to:

A Final Word On Short Interest

I hate trading for a short squeeze, but in this case, it’s an additional potential catalyst I am very much excited about. 63.4m shares of GameStop are currently sold short. 65.9m shares were outstanding as of 12/4/19, the most recent information available. The possibility exists that GameStop exhausted their ~0m repurchase authorization since, and the number resides closer to 40m shares. But we will assume no further purchases to be conservative. Share amounts taken from most recent 13D filings, proxy, form 4s, etc.

Note – I have assumed activists Scion, Permit, and Hestia hold their shares such that they cannot be shorted, and that Management shares cannot be borrowed and shorted. These amounts are based on 13F/13D filings as of the dates provided, significant selling or buying may have taken place since those times. Management shares were based on the form 4s filed since the last proxy and could be slightly off.

I point this out to indicate that the number of shares readily available to be repurchased may be much lower than investors realize, before any recent GameStop repurchases. With 0m in liquidity at the end of the year, it’s not hard to envision Management authorizing the additional repurchases needed to break the back of the shorts. For 63.4m shares sold short and potentially less than a couple of million readily available for investors to cover, this is a tinder box waiting to explode. Completing the remaining authorization should essentially remove the remaining shares available to short from the market and trigger a massive squeeze.

Conclusion

The lack of predatory lenders, ballooning debt situations, and evaporating gross margin highlights the challenges faced by GameStop are not the same as those faced by RadioShack. Fundamental differences between movie rental and physical game and hardware purchases separate Blockbuster and GameStop from the outset, and a deeper dive into Blockbuster reveals a business model that was broken long before Netflix took flight. Going forward, I expect a vicious correction as the market digests that GameStop is being run by a sharp management team, bent on creating shareholder value and fully aware of the challenges they face, executing in time for the 2020 console catalyst. I would not want to be short this stock over the next 12 months.

Disclosure: I am/we are long GME. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.