Keith Lance
In April, I started coverage of GameStop (NYSE:GME) with a “Sell” rating, saying there was a secular shift away from physical video games and the stock looked overvalued. More recently, in October, I said the company wouldn’t be able to cut its way to success. Let’s catch up on the name.
Company Profile
As a reminder, GME is a video game retailer that sells new and pre-owned video games, gaming console hardware and related accessories, as well as pop culture collectibles and merchandise. The company sells its goods through stores and online. Under the GameStop, EB Games, and Micromania banners. It also owns the Zing Pop Culture brand in Australia and Europe, which sells collectibles, apparel, gadgets, electronics, and toys.
Through the first nine months of the year, nearly 55% of GME’s sales were hardware and accessories, 30% was software, and 15% collectibles. The U.S. accounted for about 66% of revenue, while Europe was 19%, Australia 10%, and Canada 5.5%.
Almost Breakeven Earnings and Creating An Investment Vehicle
There was some pretty interesting developments when GME reported its Q3 results last month. First, the company had nearly breakeven earnings for the quarter, losing just -$3.1 million, or -1 cent a share. That was a huge improvement from a loss of -$94.7 million, or -31 cents a share, a year ago. Adjusted EBITDA, meanwhile, came in at $5.1 million compared to -$66.6 million. That is certainly a feather in the cap of new CEO Ryan Cohen.
Just as importantly, GME generated $19.1 million in operating cash flow in the quarter, and free cash flow of $11.1 million. It ended the quarter with $1.21 billion in cash and marketable securities and $30.5 million in debt. It has $968.5 million in operating lease liabilities.
The results were helped by expense control, as revenue fell -9% to $1.08 billion. However, it reduced SG&A costs by nearly -24% to $296.5 million. In my last write-up I said GME could not cut itself to prosperity, but it did show it can cut expenses enough to get to breakeven during a non-holiday quarter, at least for the time being.
Perhaps the biggest revelation in the quarter, though, was that in December, the board gave Cohen the ability to invest the company’s cash in public and private market securities. He individually and the company will also be allowed to invest in the same companies at the same time, according to the company’s third quarter 10-Q. That’s a bit of a conflict of interest in my view, as we technically don’t know whether his personal investments or GME’s investments get buying and selling preference.
Now with this disclosure, GME also added three new risk factors in its filings. The first is the simple one that the value of its securities may decline, whether they be stocks, debt, or non-marketable securities. Second, the company noted that its portfolio could be concentrated in only one or a few holdings. And third, the company will have to mark unrealized gains and losses on its balance sheet.
In my last article, I said I thought Cohen may try to use the cash to make an acquisition and get into another businesses. Using the company’s cash pile to invest in other businesses is another option in a similar vein.
This strategy could be a bridge into buying another business. Businesses get bought in stages quite frequently, and investing with an option to invest more and take a company over completely is a common strategy. With GME not holding earnings conference calls, it is not certain what exactly Cohen’s plan is.
He also could start running a pseudo investment fund using GME’s cash, where he trades in and out of public equities. Cohen made a name for himself trading meme stocks and netting $60 million in profits on a $120 million trade of now bankrupt Bed Bath & Beyond. He is also under SEC investigation for these trades, having been accused of alleged securities fraud and insider trading.
Or perhaps Cohen fancies himself as the next Warren Buffett, and plans to use GME as his investment vehicle to buy long-term core holdings and entire businesses, creating a holding company. This was supposedly the plan of Eddie Lampert when he took over a declining retailer in Sears, but that’s not what he ended up doing, and it ended poorly for Sears shareholders, who may have thought they were getting the next Berkshire Hathaway (BRK.B).
At the end of the day, GME as it is constructed today as a psychical video game seller does not have a long-term future as a business in my opinion. The industry is shifting to digital downloads, subscriptions, and live services. While GME had carved a niche from offering pre-owned games and allowing players to trade in games, that market is dwindling. And while over half its sales are now hardware, there really isn’t much reason to have physical stores dedicated to consoles, accessories, and games.
Thus, while Cohen has cut expenses leading the company into being a breakeven business for now, he won’t able to turn it into a thriving business given the continued secular headwinds it faces. I believe he must use the company’s cash to turn it into something else.
Valuation and Conclusion
GME currently carries a market cap of around $5 billion and an Enterprise Value of about $4.3 billion. The company is projected to have adjusted EBITDA of $148 million in FY25 (ending January). Almost all of the company’s EBITDA tends to come in Q4, and the quarter tends to be a good one for cash flow as well.
Given the secular declining nature of the business, I’d want a least 15% FCF yield in valuing the stock. It could possibly do $150-200 million in FCF. That would value the core business at about $1.2 billion, or around $4 per share. Its after-tax cash, using a 25% tax rate, is worth about $3 per share. At this point, though, I’m not taking into account its lease liabilities, which if paid off would drop its after tax value of its cash to about 60 cents. However, I do think the company can run them off over the next few years. Overall, I’m looking at a fair value of around $5.00-7.00.
The latest bull hope is that Cohen will turn GME into a great investment vehicle, but this is easier said than done. I think the best move would be to buy a new business and start moving in another direction. About 39% of GME’s operating leases were set to expire in FY23 and only 16% are set to expire in 2027 or beyond, so there is an opportunity to make this shift over the next few years.
However, whichever route it takes, buying a new business or investing in securities, it won’t be easy. Given its current overvaluation, I rate GME a “Sell.”
