Just under a year ago my friend Saj Karsan suggested I take a look at GameStop Corp (NYSE: GME). Living in Toronto, I was not familiar with the GameStop brand, but I was familiar with its EB Games locations I had seen around town. Here’s the first thing I read about the company, from Google Finance:
GameStop Corp. (GameStop) is a retailer of video game products and personal computer (PC) entertainment software. The Company sells new and used video game hardware, video game software and accessories, as well as PC entertainment software, and related accessories and other merchandise.
Yuck. A used video game retailer. “Do people still play video games?” I asked myself. Who buys used video games? Didn’t all these places go extinct like Blockbuster?
You are probably thinking the same things right now. If you are, you, like me of twelves months ago, would be wrong. Dead wrong.
GameStop is, like many value investments, suffering from a severe case of popular misimagination. But I assure you, if you can set aside your preconceived notions and look at the company’s fundamentals directly and without bias, you will experience the same cognitive dissonance that I did. Except, unlike normal cognitive dissonance, this may lead you (after your own in-depth research and due diligence, as always) to the same conclusions I have reached: GameStop is severely undervalued.
Readers of my website will know the general process I go through in looking at a company. First, I recreate all of the company’s annual financial statements in my valuation model. I do this usually for the last decade, but sometimes I’ll go back further if I think it will help reveal greater insight. Then, I reproduce the last three two or three years worth of quarterly statements too (again, depends on whether something about the annual figures causes me to think something extra will be gained from another year of quarterly statements).
The model that I’ve built automatically generates the ratios and graphs I look at for assessing trends and hunting for financial shenanigans.
Here are some of the things I found. First, the company’s returns have been stellar, and rather than declining over time (as I would have expected, given my initial comparisons with Blockbuster), they have trended up over the last half decade. The recession, as you can see below, took a toll on the company, but by far less than I would expect given the discretionary nature of the company’s products. And returns stayed in the double digits throughout the recession. On a quarterly basis, you can see the importance of the Christmas season, as expected. You can click the following graph for the full size.
One of the next things I looked at is the company’s margins over time. I like to check for whether the company has been experiencing any margin contraction that would warrant further investigation. As you can see from the chart below, the company’s margins have been incredibly stable throughout the recession. In fact, they have been incredibly stable for most of the decade. Again, you can see the effect of the Christmas selling season. Given the decline in Gross Margin and the jump in Operating and Net Margins, you can see that the company’s strategy at that time of year is to offer discounted merchandise, recognizing that they will sell significantly more product, with the result being a higher bottom line. Also, from the graph below, you can see the company’s impressive revenue growth historically. You can click the following graph for the full size.
So far so good, but from my reading of Financial Shenanigans, I am well aware of the ways companies can manipulate their financial statements in order to make their performance appear better than it is (though, it would be difficult to keep it up for a decade). So, I look for concerning trends in the elements of the company’s Cash Conversion Cycle (namely, Days Sales Outstanding, Days of Inventory and Days Payables). What you’ll see in the next graph is that the company has an extremely short Cash Conversion Cycle, which I’ve noted in the past can be a competitive advantage.
The company has experienced a slight increase through the recession. This is the dual effect of Days’ Payables declining to a decade low point, and Days’ Inventory creeping up. The net figure is so low that I don’t think there is anywhere near a cause for concern here. In fact, another company that I am a big fan of, Best Buy (NYSE: BBY), has a much higher Cash Conversion Cycle.
Another thing I look at, both for my ultimate valuation and for my efforts to ferret out any financial shenanigans, is the company’s free cash flows. Additionally, since GME is somewhat acquisitive, I also looked at its Free Cash Flows after Acquisitions. Here’s what I found:
From this, you can see that the company has done a good job growing free cash flows along with revenues, and that FCFs and Net Income have tracked pretty close to each other for most of the last decade (the red line). Though, on a quarterly basis there is considerable variance (as expected, given the seasonal nature of its business).
After all this, I think back to my initial thoughts about GME. Is GameStop the next Blockbuster? Well, there is always the possibility that the good times are over. But as you can see from the graphs, any unbiased observer can see that there is nothing to suggest that GME is going bankrupt anytime soon. But wait! I can see what’s on your mind. You are thinking that, just because I’ve shown a company with strong returns, prodigious free cash flows, impressive growth and stable margins, I have missed one key point: the company’s debt level. Certainly a massive debt load would grind this company into dust if any of the elements above reverse, right? Not quite.
This chart shows that the company’s debt level has been falling precipitously over the last six years (dispelling any concern that the company’s impressive returns in the graph up top are the result of management irresponsibly bingeing on debt). While the country may not emerge from the recession debt free, GME most certainly will.
Clearly GameStop management isn’t a one-trick pony focusing only on revenue growth at all costs. They’ve proven their ability to growth revenues, and to do so in a profitable manner (growing earnings and free cash flows in line with revenues). This is what I look for in an investment and I don’t think one could say this was the case with Blockbuster.
All of this is wonderful you say, but there is the pesky matter of valuation. A company with impressive performance metrics like those shown above should have equally impressive multiples, eliminating any investment opportunity, right? Shouldn’t efficient markets price this such that risk adjusted returns are equal across all assets? Well, like any value investor (or really, anyone with their head on straight who has looked at the markets for more than a few minutes) knows that the markets often create strong investment opportunities through temporary mispricing. Such appears to be the case here.
GME is trading well below its 2007 highs, when debt levels were significantly higher, and revenues and free cash flows were significantly lower. To justify the current (as of 6/22) price of GME, which is $26.54, I had to make excessively pessimistic assumptions about a very quick fall in revenues combined with severe margin contraction. Is this likely? If you believe the company is comparable to Blockbuster, you probably believe it is not only likely, but it is certain. I, on the other hand, look at the company’s recent history (during the recession) and believe that a fate similar to blockbuster’s certainly isn’t likely in the near term. In the near term, I think it is more reasonable for the pessimistic scenario to show slower growth (or even no growth) and stable margins (after all, they’ve been able to maintain stable margins for a decade). In this version of the pessimistic scenario, I see upside. This is not to mention my optimistic and neutral scenarios, which take into account a strengthening economy (it’ll happen some day!) which show a fairly clear mispricing.
There’s one more thing I thought I would touch on: shareholder returns. Though the company does not pay dividends, it does repurchase shares. And boy does it! In January of this year, the company repurchased $112.2M worth of its shares. Then in February it announced a new $500M repurchase program, which between February 4th and April 1, it used to the tune of another $117.7M. These figures may not seem like a lot, but keep in mind that this amounted to ~8% of the shares outstanding, in just four months. I eagerly await their next quarterly report to see how much more of the $500M repurchase program they’ve used.
So, as is my favourite thing about companies that repurchase shares at such a drastic clip, there are two things that will happen. Either the market will disagree with me and GME will stay at bargain basement levels, or the market will agree with me and the price will improve. If the former proves to be the case, I have little to lose. Over time, I expect the company will continue to repurchase shares and I will ultimately hold a more concentrated position in a company that has the strong fundamental characteristics that I look for. Additionally, while GME no longer has the short interest it once had, the company still has ~36M shares sold short, out of a total of 141M, which is quite high and indicates further opportunity for a short squeeze (especially as the repurchases decrease the size of the float). If the latter alternative proves to be the case, I have nothing to lose – my position becomes worth more as the price rises to GME’s intrinsic value. I am quite comfortable with these alternatives. Are you?
Author Disclosure: Long GME