Turnaround Letter Buy-rated GameStop (GME) reported very weak fiscal third quarter results that reflect a combination of near-term cycle lows and long-term secular battle for relevance. Revenues fell sharply as customers appear to be waiting for next November’s new XBox and PlayStation consoles. The revenue decline drove an operating loss for the quarter instead of an expected profit.
GameStop shares fell about 17% in mid-day trading to about $5.40/share. While the drop is large, the shares remain well-above their August lows of $3.25/share.
The loss of ($0.49)/share was well-below expectations for a $0.17/share profit. Adjusted EBITDA of $5 million compared poorly to consensus estimates for a $51 million profit. Revenues of $1.4 billion fell declined by 26%, much worse than estimates for a 15% decline.
GameStop’s decline in revenues was driven by a 23.2% decline in same store sales with another 2.5% decline due to closed stores and foreign currency. Much of the weakness was due to GameStop being captive to the game console cycle. The current console cycle is in its end-stage, when gamers have little interest in visiting the stores to buy/trade game gear. Avid gamers await the next console cycle which should start in November 2020 with the release of the new Xbox and PlayStations. The company provided some evidence that the new console cycle will bring back customers: in the quarter, sales of the new Nintendo Switch products were very strong at GameStop stores.
In the quarter, sales of accessories and pre-owned equipment showed less weakness, while Collectibles sales grew 4.3%.
The daunting revenue decline masked some improvements in GameStop’s business. Gross margins actually expanded, by 1.90 percentage points, to 30.7%. A combination of higher margins in several product categories and a favorable mix of products sold supported the expansion. Overhead costs also declined, by about 6%, as the company is about half way through their $100 million in targeted cost savings.
Inventories appear to be in much better shape, down more than 30% from a year ago as the new management pares down overstocked products. Store closings, including a wind-down of their Nordic region stores in Europe, should help boost profits in future quarters.
GameStop repurchased 22.6 million shares for $116 million. In the past year, the company’s share count has fallen to 67.8 million shares, a third lower than a year ago.
The company will likely produce sizeable free cash flow this year, adding to its current $290 million in cash balances. Debt of $419 million is not due until March 2022.
Investors need to be patient while waiting for the upcycle
GameStop expects that weak results will continue until the next game console ramps up in November 2020. Along the way, the company expects to improve its overall positioning to be ready to capture larger profits that this upcycle could generate. The management is highly confident that the upcycle will generate much stronger results. We find this reasonably credible although by no means a certainty, as the downcycle can’t entirely be separated from the secular shift to digital downloading and away from console games.
The company’s strong cash flow generation, very reasonable debt balance and high and improving cash balance provide valuable downside protection to shareholders during the wait.
We think the fundamentals along with the potential upside in a year are well-worth the wait.
We continue to rate shares of GameStop a Buy with a price target of 16.
Disclosure Note: One or more employees of the Publisher own shares of all Turnaround Letter recommended stocks including GME shares.