Turnaround Letter Buy-rated GameStop (GME) reported earnings and guidance that disappointed the market’s expectations.
However, it outlined a general plan, with an early emphasis on e-sports, to focus on building its core gaming franchise and improving its operational efficiency. It is supported by a strong balance sheet, with an estimated $325 million in cash in excess of its debt (or, $3.20/share) after it pays down debt, repurchases shares and pays a full year of dividends. The new CEO starts on April 15th. Two activists working together were granted a board seat plus consultation with the GameStop board on selecting another independent director.
GME shares fell 4.7% yesterday and rose 4.2% today, to $10.03.
The 7.6% decline in revenues for the quarter appears worse than it is. Excluding the effect of changes in foreign currencies, revenues declined 6.2%. When excluding the effect of the 53rdweek in 2017 (compared to 52 weeks in 2018), revenues declined only 3.8%. Same-store sales, which removes the effect from newly-opened or closed stores, increased 1.4%.
Gross profits matter a lot to GameStop
Gross profits matter a lot to GameStop due to the changing sales mix and large differences in profitability of its product groups. Pre-owned game products, for example, comprised 17% of 4thquarter revenues yet produced nearly 30% of its gross profits. Its gross margins are a wide 42%. This product group is much more relevant to GameStop’s profits than new hardware, for example, which generated a sizeable 25% of revenues but produced only about 6% of the company’s gross profits.
In the 4th quarter, gross profits fell 13%, or $116 million, to $749 million. The company did not separate out the 53rd week, currency changes, or same-store effect, although we believe these had a roughly similar effect on gross profits as they did on revenues.
The largest contributor to the $116 million decline in gross profits was Pre-owned game products, which had a $77 million decline in gross profits. This represented nearly two-thirds of GameStop’s total decline in gross profits. The segment’s 26% drop in profits was roughly in-line with the 21% decline in its revenues. This segment is currently the heart of the company, so GameStop needs to meaningfully improve or offset this weakness.
Adjusted EBITDA of $221 million fell 25% from a year ago, driven largely by the decline in gross profits. The Adjusted EBITDA margin of 7.2% compared to the year-ago Adjusted EBITDA margin of 8.9%.
Guidance was weak, may include some expectations-setting
GameStop provided limited guidance as it awaits the April 15th start date of its new CEO George Sherman. For fiscal year 2019, the company anticipates total sales and same-store sales to fall 5-10%. These are large numbers and may be realistic but in our view, they are somewhat pessimistic and perhaps reflect a lowering of expectations to ease the transition for the incoming CEO.
Strategic update: debt paydown, share repurchases, dividends, focus on core business
On the post-earnings conference call, the company highlighted the $1.6 billion in cash on their balance sheet (which includes $700 million from the recent sale of the Spring Mobile business), with $350 million to be allocated toward repaying an upcoming debt maturity and $300 million to be allocated to a share repurchase. As they recently declared their $0.38/share quarterly dividend (about $155 million/year total), they implied that this will remain an important part of their cash outlay priorities.
After the debt paydown, share repurchases and paying a year’s dividends, the company would have about $800 million in cash, partly offset by $470 million in debt. This is almost $3.20/share in net cash. They described how this would provide them with the financial flexibility to fund new initiatives – focusing on expanding and strengthening their core gamer franchise. They have initially identified e-sports as a segment to pursue. This rapidly growing field offers considerable promise for GameStop, a leader in the gaming industry. We support these growth initiatives as long as the company stays focused on its core gaming franchise.
Operational improvements
Along with the focus on core growth initiatives, the company outlined how it will improve its operations. Management set a $100 million target in lower costs, beyond any reinvestment back into the company. We think this is actually a modest goal, as it is only 5% of the company’s $1.9 billion in annual Selling, General & Administrative costs. We expect some improvements in the company’s technology and data analytics capabilities will help their overall business.
Activists get at least one board seat
Two activist funds working together will be granted a board seat for one of their candidates. The company also said it will appoint an additional independent board member in consultation with the two activists. This is a partial victory, as the activists sought “several” directors of their choosing, as well as an aggressive tender offer by the company rather than a more vague repurchase plan. These board changes are positives.
The GameStop turnaround is in the very early innings and moving in the right direction.
- Earnings before interest, taxes, depreciation and amortization, which is a measure of cash operating profits.
We continue to rate GameStop (GME) shares a BUY with a $16 price target.
Disclosure Note: An employee of the Publisher owns GME shares.