GameStop Set to Disappoint the Market in 2011?

GameStop $GME is a business that has been aggressively shorted over the last few years, but is it now becoming a contrarian play? Investors have been quick to sound the death knell for GameStop due to the ‘oncoming’ onslaught of online gaming sales, and according to Yahoo Finance the short percentage of the float was around 24% However, the recent results were superficially quite good and the stock rallied. Is it time to buy?

GameStop Earnings and Margins

A quick look at revenues over the years (year end to Feb)...

Sales ($m)	2007	2008	2009	2010	2011
New Video Game Hardware	1,073.7	1,668.9	1860.2	1,756.5	1,720.0
New Video Game Software	2,012.5	2,800.7	3685	3,730.9	3,968.7
Used Video Game Software	1,316.0	1,586.7	2026.6	2,394.1	2,469.8
Other	916.7	1,037.7	1234.1	1,196.5	1,315.2
Total	5,318.9	7,094.0	8,805.9	9,078.0	9,473.7

...reveals that growth in the Used Video Game Software segment appears to be slowing. The importance of this can be demonstrated by a look at gross margins.

Gross Profit ($m)	2007	2008	2009	2010	2011
New Video Game Hardware	77	108.2	112.6	113.5	124.9
gross margin	7.2%	6.5%	6.1%	6.5%	7.3%
New Video Game Software	427.3	581.7	768.4	795	819.6
gross margin	21.2%	20.8%	20.9%	21.3%	20.7%
Used Video Game Software	651.9	772.6	974.5	1121.2	1140.6
gross margin	49.5%	48.7%	48.1%	46.8%	46.2%
Other	315.2	351.6	414.6	405	452.6
gross margin	34.4%	33.9%	33.6%	33.8%	34.4%
Total	1471.4	1814.1	2270.1	2434.7	2537.7

Over the years, the used game segment has made up the bulk of profits but growth appears to be slowing.  I think this is an understandable issue and I would like to explore the reasons why.

GameStop Structurally Challenged?

There are four main challenges to GameStop and I think all of them are significant.

1. Best Buy and Walmart are encroaching on their market share
2. Online merchants are grabbing market share from in-store sales
3. Software manufacturers are shifting to delivering the games online (avoiding piracy and protecting IP is a key driver here)
4. They are being forced into the 'long tail' of retail (superstores are selling the blockbuster titles) which is an area that is not their forte

The likes of Best Buy $BBY and Wal-mart $WMT, as indicated in an earlier article, are seeing some of their traditional markets erode to online competition. Therefore, they are seeking new ways to sell to their captive audience of shoppers. Naturally, selling new and used gaming software fits perfectly into the sales demographic of kids making trips to their outlets. This competition is significant for GameStop.

Similarly, online competitors like Amazon are continuing to grab competition from GameStop. The advent of smart phones that can read bar codes and immediately compare prices will pressure margins for ‘bricks and mortar’ retailers. GameStop will still be able to offer the ‘retail experience’ of kids checking out new releases but as the tables indicate hardware sales are low margin, and new software sales do not make up the bulk of GameStop’s profits.

However, the key challenge for GameStop will come from how the gaming companies deliver files. With the advent of 4G and other ‘fat bandwidth’ provision, it will become feasible for games to be sold online. This has great advantages to the gaming industry because they will be able to insure against piracy by selling gaming upgrades and licences to the original purchaser. This helps avoid the kind of piracy that is rife in this form of Intellectual Property. This will be a significant problem for GameStop and I think will hurt them sooner rather than later.

A Value Trap?

I think there is a value trap here. GameStop are talking about closing 200 stores and opening 200 others in an attempt to restructure the business, but I think the decline and structural challenges are already showing in the numbers. Let’s look at sequential numbers...

Gross Profit ($m)	Jan-10	May-10	Jul-10	Oct-10	Jan-11
New Video Game Hardware	40.9	21.2	25.9	21.7	56.2
gross margin	5.5%	6.1%	8.2%	7.9%	7.2%
New Video Game Software	322.2	174.5	141.7	182.4	321
gross margin	20.6%	20.0%	21.4%	21.7%	20.1%
Used Video Game Software	360.7	274.4	260	250.2	355.8
gross margin	46.4%	48.1%	46.0%	47.4%	44.2%
Other	150.3	100.7	89.2	92	170.7
gross margin	33.6%	34.7%	34.8%	35.9%	33.3%
Total	874.1	570.8	516.8	546.3	903.7

..and margins are clearly falling in the used games category. However sales are doing ok (on a like for like comparison)

The reason for this is that I suspect Sales for the used game segment will do well for a while due to the hardware upgrading cycle causing lots of new inventory to become available. Unfortunately, for GameStop this will be sold off a lower margin and is likely to get lower still, as games shift to being delivered online. All of which creates a value trap for GameStop, they could be reporting good sales growth but I would keep an eye on used game software margins. I think they are set to fall aggressively.

Is Traditional Retail Structurally Challenged?

One of the key secular growth trends set to dominate retail over the next few years is the transition from bricks and mortar sales to online sales.  Another, more cyclical, theme relates to the unequal nature of the economic recovery.  Put simply, emerging market demand is pushing up the price of those goods that the lower income groups spend a larger part of their discretionary income on.  So with higher food and energy prices there will be less spend on consumer discretionary for lower income groups.

Putting these two themes together, it is not hard to see that businesses like Best Buy $BBY, Family Dollar $FDO and Dollar General $DG should be structurally challenged. Indeed, Best Buy gave Q4 results recently and it disappointed the market with its outlook and guidance. However, the likes of Nordstrom $JWN and Coach $COH (Japan aside) have been demonstrating good growth.  Moreover, companies like Amazon $AMZN and Walmart $WMT are key beneficiaries because they both can grab market share from the likes of Best Buy.

What Best Buy Earnings are Telling the Market

Best Buy gave numbers and guidance

• Full Year Guidance of $3.30-$3.55 vs. $3.56 estimates
• Q4 revenue decline by 2%
• Same stores sales decline of 4.6% partially offset by new store growth!
• Gross Margin expansion

Clearly, Best Buy has some issues to deal with and the company was quick to cite disappointing sales of higher margin TV sets and net book sales. Moreover, declining sales has had an effect on inventory and analysts were quick to focus on the rising inventory plus working capital requirements. High inventory is a problem because it implies a reduction in future margins (to shift slow moving stock) and it also raises question about the structure of the business.

 

($m)	2008	2009	2010	2011
Revenue	40,023	45,015	49,694	50,272
Inventory	4,708	4,753	5,486	5,897
Revenue/Inventory	8.50	9.47	9.06	8.53

So we see that the revenue/inventory ratio is rising. This is not usually a good sign.

The Case for Making Best Buy a Best Buy?

The positive case for Best Buy is best made with reference to its evaluation and restructuring program. The decline in sales could be seen as a result of an unfavourable product sales mix (TVs, net books, lack of new upgrade cycles for windows) and the difficulty of beating tough comparable sales. There is no doubt that Best Buy is generating huge amounts of free cash flow and it is capable of using this cash to generate EPS growth via share buy backs. Indeed, current analyst (and company) estimates do not account for buy backs. More importantly, Best Buy is generating the cash in order to restructure the business.

The restructuring program centres on shifting sales towards things like Best Buy Mobile, tablets and gaming. In addition, Best Buy is reducing the size of stores in the US so the possibility exists for an increase in sales per square foot as well as learning how to maximise sales in new stores.  Gross Margins rose in these results and the company has been aggressively controlling SG & A costs. Initiatives like ‘buy online pick-up in store’ are intended to differentiate Best Buy from online only competition and are reflective of how Best Buy is competing.

We can see these issues reflected in gross margin growth which has been in sequential decline.

($m)	2008	2009	2010	May-10	Aug-10	Nov-10	Feb-10	2011
Revenue	40,023	45,015	49,694	10,787	11,339	11,890	16,256	50,272
Gross Profit	9,546	10,998	12,160	2,793	2,918	2,983	3,943	12,367
Gross Margin	23.9%	24.4%	24.5%	25.9%	25.7%	25.1%	24.3%	24.6%

However, on a yearly comparison Q4 gross margins were actually up.  

Best Buy a Structurally Challenged Stock?

The negative case centres on the argument that-despite the cheap evaluation-Best Buy is structurally challenged and these issues will see a future decline in earnings and cash flow generation. For example, a comparable retailer in the UK is HMV (cds, dvds, games etc) and this company looked very cheap for a long time on traditional evaluation metrics. However, the share price continued to decline with ongoing structurally challenges. This is a significant point because Best reported that European sales growth and gross margins were negative.  As HMV went, so could Best Buy.   Indeed, many of Best Buy’s initiatives are focused on restructuring to face the online threat, but is the company capable of meeting these challenges?

For example, reducing store size is wonderful, but it implies reduced sales of ‘bulky’ products and these products tend to be those sold in store.  Retailers tend to buy IP based purchases online and it is this type of purchases  (mobile, tablet, gaming etc) that Best Buy think it can expand into. Furthermore, opening new stores when existing sales are in decline is usually a bad move in retail. It suggests that the company will be implementing more of a failing business model or sales mix.

Similarly, new technological developments like customers being able to scan barcodes and search online for cheaper alternatives will challenge Best Buy margins and sales growth. Moreover, online retailers specialise in ‘long tail’ provision, so if Best Buy wants to compete with them they will have to hold larger inventory and that will eat into cash flow generation.

Essentially, new technologies and ‘convergence cannibalisation’ (ex cameras, computers, phones, ipods merging into a single device) from companies like Research in Motion $RIM and Apple $AAPL are challenging retailers like Best Buy. Unfortunately, this comes at a time when discretionary spending in middle income America is being pressured by high food and energy costs.

Whilst Best Buy Mobile sales growth is good, this could be seen as being driven by a cyclical uptake of things like smart phones of which Best Buy is not particularly well positioned to take advantage of for follow up sales.

Is Best Buy a Stock to Buy?

On balance, I think not. The stock trades at $29.22 and has an EV of $13.45bn.  I think that history shows us that despite the superficial attractions of a high free cash flow yield (above 10%) and low P/E ratio of 8.8x  the structural trends against this business are significant. I would look for a fall in comparable sales to revenues ratios before considering a long term purchase of this stock. For short term investors, I suspect that given improved macro-economic fundamentals there is some upside here because investors will like the evaluation-after all every stock has a price- but I think the challenges for Best Buy will accelerate and, I place little confidence in the forecast estimates.