Blog@Motiwala Capital

We have owned GameStop (GME) since the inception of Motiwala Capital in early 2011. The stock has been quite volatile going from $19-$20 when we bought to a high of $28 after Q4 2011 results on what seemed like a short squeeze, and then back and forth between $20 and $26. The stock has been very weak so far this year down 25% YTD despite a 5% rise yesterday after Q2 2012 earnings.

I have been meaning to write about GameStop for a while now and it seemed like a perfect time to share my thoughts on GameStop. Todd Sullivan who runs (Value Plays) posted an article on GME titled “GameStop Same Store Sales Crater And Admits Writedowns Are Coming” after it announced Q2 2012 earnings yesterday. I responded with my comments. My comments are below but It would make sense to read his article first.

Hello Todd,

Let me begin by saying I appreciate you taking the time to analyze GameStop and posting this article. I have a slightly differing take on a few of the points you make. This reply is intended to have a discussion. I respect the other point of view and it helps me test my thesis.

Let me try to address a few points you make.

1) Good will write down is a non-cash event. It will not affect the cash flows or impair their balance sheet. Yes, the income statement will take a hit ( as it did in Q4 last year by $81m). As per what I heard on the call, this is an accounting rule where they need to test for and impair goodwill when the market cap is lower than book value (which is the case today). This is the least of my worries from your points above.

2) I agree that without the buybacks their guidance given in the Q4 2011 call would have been missed. Goes to show how difficult it is to forecast even one year sales and profits for anyone. However, I am more interested in FCF. More on this later.

3) Lets talk about SSS and the dropping top line which is what most people focus on. Most followers of the gaming industry would know that the current console cycle is 7-8 years old. That means almost everyone who wanted to buy a gaming console has bought one. What does that mean? Sales of hardware consoles declining. I am not sure if the game lineup is also soft causing this to drop or whether this means a permanent shift to alternative gaming/entertainment. Gaming consoles cost what $100-$300 a pop and software is $60 a game. So, that goes a long way in dropping top line and reducing SSS. Yes, an increasing top line is what every investor looks for. But, if the company can pull other levers to keep profitability during the low point in the cycle, it must be applauded. Gaming is a cyclical business. And Yes i noticed that used game revenue also dropped this quarter and I will have to keep an eye on that as well.

4) What no one talks about is the improvement in Gross Margins over the last 3-4 quarters due to the new businesses (DLC, Mobile, IOS device refurshment program). Just this quarter GM was 33.5% over 31.2% last year. That meant Gross Profits dropped only 4.5% v/s a 11% decline in Sales.

The company is now debt free so saves interest expenses. It has kept SGA flat in a tough sales environment. Unfortunately with falling sales, SGA as a % of Sales is higher and hence operating margins suffer. But, any investor will know that margins is part of the story. There is asset / inventory turns that are equally important. So, I focus on cash flows over the income statement.

5) As per GME press release from Q4, “Adjusted diluted earnings per share, excluding restructuring, impairment and debt retirement expenses, were in-line with guidance at$1.73, a 10% increase compared to adjusted diluted earnings per share of$1.57 in the prior year quarter. “. ( so it was not $1.61 but $1.73 but you are in the ball park). So, to meet the 2012 guidance GME has to do $2.17 as you rightly said in Q4. I am also not sure they will hit that but i am not so worried. The share count is lower by atleast 10% from last year so that gets you close to $1.9. If you notice Depreciation/Amortization is running lower by $2.5m/quarter due to lower capex. GME is now debt free and so has saved about $3-$4million a quarter over last year. About $6.5m savings a quarter over 2011. Thats 5cents a quarter. So that gets Q4 to $1.95 or so.

I think the difference is coming from WiiU release in Q4. That is my best guess. Management did say on the call that WiiU is baked in their full year results. They said its not aggressive but reasonable. I have no way to verify if they will get that or not. But, even if they hit $2.0 in Q4 and $2.9 for 2012, it would be pretty good in this tough environment.

6) The discussion no one has is about Cash Flows and FCF. It is more important v/s the EPS number. I am interested to find out if GME can achieve FCF of $400-$450 million they have averaged over the last 2 years. Remember, FCF is running ahead of Net Income. To present numbers,

In the last 3 years, GAAP Net Income was $340m, $408m and $377m
Cash Flow From Ops was $625m, $591m, $644m
FCF was $459m, $390m, $480m.

Clearly, the $80m write down in Q4 2011 had no material effect. What it did was to widen the gap between NI and FCF. I cannot remember a single analyst saying FCF/Share last year was $3.32 a share.

6) Valuation, Capital allocation and management: You hit the nail in the head that investing cannot be done purely by buying cheap looking stocks based on screening or valuation metrics. I focus on many aspects when considering a stock for an investment

(i) Valuation:

Share Price : $18
Shares : $130m
Market Cap: ~$2400.
Cash $130m
EV ~$2300m

At the average $400m in FCF that GME has done last two years, GME is valued at 6x P/FCF! On a P/E basis, at $3 in EPS, GME is also at 6x P/E.

(ii) Capital allocation. I give a lot of importance to this when evaluating any stock as the cash produced is no good if it does not go to shareholders return. So, lets take a look at what GME management has done with the Cash it has produced in 2010, 2011 and so far in 2012.

2010: Repurchased shares worth $381million, Paid back $200m in LT Debt. Dividends = 0. Total $581 million. FCF that year was $480 million.

2011: Repurchased shares worth $262million, Paid off all debt of $250m (debt free). Dividends = 0. Total $532 million. FCF was $390 million.

2012: Repurchased shares $260million In 2 Quarters, no debt, $40m in Dividends = $300million.
(Has used cash from balance sheet to do so)

(iii) Current dividend yield is $1/ Share annually. That is 5.5% yield at @$18. ! The dividend was raised from 15cents quarter to 25 cents a quarter. I guess no seems to care for that.

This company has returned 100% of its FCF to share holders for the last 2 1/2 years. in the Q2 call, management again said we will return 100% of FCF to shareholders. But, I guess no one cares for that. People only look at SSS, declining top line.

(iv) Management stake: Chairman and CEO are required to own 5x of their base salary in common stock, other execs 3x. Chairman owned 700k shares and CEO owned 540k shares as per recent proxy. That is worth $12.6m and $9.7m respectively. Their salaries were $900k and $1million respectively.

So to conclude you have
(1) A market leading company operating profitably (Net Income and FCF) in a tough environment at the bottom of the gaming cycle
(2) The stock provides a 15% FCF yield and a 5.5% dividend yield on a 30% payout ratio.
(3) The company has no debt and pays out 100% of FCF to share holders.
(4) Reasonable level of skin in the game.

Yes, there are headwinds being at the low point of the cycle, lower consumer spending, weak macro, alternative gaming distribution. But, GameStop has done everything a shareholder can ask for.

thanks
Adib

Disclosure: Long GameStop.