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Turnaround Letter
Out-of-Favor Stocks with Real Value

September 11, 2020

GameStop reported earnings on Thursday. We are keeping GME shares a Buy with a $16 price target.
GameStop (GME) - GameStop is a highly unusual situation. The secular shift to downloading video games is gradually rendering the company’s console and cartridge/disk focus obsolete. Combined with the aging console cycle, pandemic-related store closures and the company’s planned store base reductions, sales are falling rapidly (down 27% this past quarter). The company is cutting costs aggressively but the current trajectory could eventually lead to GameStop’s financial demise.

However, the company has $735 million in cash, only partly offset by $437 million in debt. For reference, the $298 million in net cash is $4.58/share, or about 72% of the current share price. Half of its total debt matures in about six months, while the rest matures in 2023. Many of its store leases expire within two years, helping to alleviate the lease obligation liability.

Also, two major console makers, Microsoft and Sony, are soon releasing their first new boxes in nearly seven years. Similarly, new software titles are anticipated in the next two quarters. These releases could lead to a surge in traffic at GameStop, helping to further replenish its cash coffers.

GameStop has a relatively new CEO with a mandate to turn the company around. The board has been refreshed, and includes the former president of Nintendo and activist investors.

This is quite a backdrop for the 2nd quarter earnings report.

Revenues fell 26.7% from a year ago. About half of this was caused by the reduction in store operating days due to the pandemic, with another sizeable driver being the permanent closure of stores to reduce their store base. Online sales grew 8x (or, 800%).

While the narrative says the company’s relevance is evaporating, we actually find it fairly impressive that gamers keep coming to GameStop’s stores despite its supposedly aging/irrelevant inventory. Similarly, its stunning growth in online sales further suggests that it sells merchandise that gamers want to buy. This sounds like a good business model to us. GameStop seems to have a lot more going for it than the narrative suggests.

The operating loss of $85 million, with impairments and a gain on sale removed, was only $39 million lower than a year ago, thanks to an impressive cost-cutting effort. A loss is a loss, for sure, but a very respectable preservation of economic viability in our view. Most of GameStop’s profits are produced in the holiday season, so the loss, per se, wasn’t a huge issue except that it puts much higher pressure on the upcoming November-December period.

Perhaps most surprising is that, despite the operating loss, the company generated $193 million in cash from operations. Driving this gusher: the company cut its inventory level in half compared to a year ago - as it sold down its inventory without having to replace it.

Also, the company generated about $52 million in cash by selling some of its office buildings and its corporate jet. Another $44 million in cash from building sales was added after quarter-end.

In the next quarter or two, GameStop will consume cash as it needs to buy new consoles and other inventory, as well as spend more aggressively on marketing, to prepare for the holiday/console cycle. These initiatives might consume $400 million or more in cash.

Despite the stock’s sharp decline yesterday, we think the real game is just ahead. If the company can capture new traffic this holiday season, helped by console and software buying, and then convert that inventory into yet more cash, the stock will do exceptionally well. If not, the stock will languish or worse.

We think the story will get better as the holiday and gaming cycle approach, while recognizing the sizeable risks involved. GameStop shares are only appropriate for risk-tolerant investors.

We retain our Buy rating with a $16 price target on GameStop (GME).

Disclosure Note: One or more employees of the Publisher own shares of all Turnaround Letter recommended stocks, including the stocks mentioned in this note.