Turnaround Letter Buy-rated GameStop (GME) reported a sharp 13.3% decline in first quarter 2020 revenues and the elimination of its dividend. Even though the earnings were ahead of consensus expectations, the revenue decline and dividend cut were enough: investors sold the shares aggressively to close at $5.04, down 36% on the day. It was an ugly start to the company’s comprehensive turnaround program.
More than half of the year over year revenue decline came from the 36% decline in new hardware sales. The Sony PS4 and Xbox One console cycles are winding down, with no new consoles in the immediate pipeline. GameStop described how they experienced a similar downcycle in 2013, although we are skeptical that the next upcycle will show a similar uptrend as consoles are less-relevant now than in 2013. However, they are not irrelevant, and we anticipate some renewed user enthusiasm in the next upcycle.
Gross margins actually increased to 30.4%, as the weaker sales of low-margin (only 9.6%) game hardware helped highlight other higher-margin products. Collectibles, a surprising and strong new category, grew 11%, with its 32.7% gross margin increasing from a year ago.
Selling, general and administrative costs declined by about 6%, due to better expense management and what appear to be higher-than-normal costs a year ago. The company’s first priority is to further reign in these costs.
New leadership team
In addition to the new CEO (George Sherman, former head of Verizon Wireless’ largest authorized retailer), the company has a new CFO (Jim Bell, former CFO and interim CEO of the parent company of restaurant P.F. Chang), and a new Chief Merchandising Officer (Chris Homeister, former CEO of The Tile Company and a veteran of BestBuy). Also, GameStop highlighted internal promotions of two executives to head strategy and transformation initiatives. It will likely take time for this new group to formulate and implement their strategy, but we like the fresh views that outsiders can provide.
Turnaround Plan – Sounds Good But Execution is Key
On the conference call after the report, GameStop’s new leadership team outlined their turnaround plan. The first focus is on boosting GameStop’s operating efficiency, then on improving its pricing strategy, and ultimately on developing new revenues streams. In essence, fixing what it can control, then fixing problems over which it has less control.
The team seems well-aware of the urgency involved in finding new revenue sources as well as improving the gross margins of their existing products and reining in GameStop’s cost structure. The new CEO’s comments that it needs to “remain a viable player” reflects this healthy perspective.
On cost-cutting, the company has a $100 million target which will fully take effect next year. Part of the plan also includes improving the in-store experience, along with better store merchandising of high-volume products and better pricing on their trade-in products.
A promising revenue path is their move into the e-sports industry. GameStop has developed partnerships with leading e-sports operators. Combined with their GameInformer magazine franchise, the company may have a real opportunity here, but it is too early to effectively gauge. The management didn’t discuss other revenue opportunities other than to describe how Collectibles will be an important part of their future.
Follow the cash
Given the company’s $543 million in cash, along with its likely $100-$200 million in surplus cash flow this year, it was encouraging that they have no plans to make any acquisitions or to diversify outside their core business. They have plenty to occupy their attention without the distraction and financial drain of a deal. Paying down their debt will greatly ease the financial pressure. The $157 million/year in funds freed up from dividend payments would reduce the $469 million in debt to about $155 million in two years if not partly re-directed toward other uses.
For investors wondering where $1.1 billion of the $1.6 billion in cash on the year-end balance sheet went: about $750 million went to reduce accounts payable and other current liabilities (similar to prior years) and about $350 million was used to reduce debt. We would expect the FY2020 year-end balance sheet to show a healthy build-up in cash.
GameStop will also be divesting their SimplyMac franchise. This will likely generate incremental cash inflows in the third quarter.
Not GameOver
Despite the weak results, GameStop did not change their 2019 guidance for revenues to decline 5-10%. However, even assuming the full 10% revenue decline, the company looks likely to continue to generate surplus cash flow this year excluding funds freed up from the lack of dividends.
GameStop’s turnaround has hardly begun. The sharply disappointing 1Q20 results reflect their challenges but largely occurred before any of their nascent turnaround efforts had started.
The turnaround plan sound plausible, but (justifiably) the market will assume the worst until it can see several quarters of tangible evidence that the revenue trends can be turned upwards.
Despite the disappointing start, we continue to find value in GameStop shares.
We continue to rate GME shares a BUY with a price target of $16.
Disclosure Note: An employee of the Publisher owns GME shares.