Assessing GameStop as an interesting investment opportunity (Part 1 of 5)
Thesis overview
GameStop (GME) is a global specialty retailer of video game hardware/software/accessories and mobile phone re-commerce (unlocking etc.). The company derives a substantial portion of its gross margin (41%) from the purchase and resale of used games, typically from customers, but increasingly from liquidation closeouts and other retailers clearing inventory. The value proposition of GME starts (and ends) with the premise that gamers seek salvage value from their games, particularly those shiny new $60 ones. Salvage value serves as credit toward future hardware/software/accessory purchases without the headache/fees and two-step process of selling for cash into Amazon/eBay/Craigslist before outlaying the next purchase. The GameStop trade-in model is relatively seamless and allows the company to maintain a negative working capital balance that outpaces any big-box specialty retailer.
Management has amply demonstrated to be a group of smart capital allocators within the business and the shareholder base. We estimate average sales per square foot of $900–$950 to outpace Best Buy’s $750–$800 despite GME possessing more than triple the store units (albeit at one-twentieth the square footage). GameStop’s latest store expansion plan focuses on the relatively young Tech Brands segment (where gross margins are not far off the used game segment) following last year’s tactical acquisitions of Apple (AAPL) and AT&T (T) mobile phone resellers. Free cash flow after acquisitions has not gone below $380 million annually in over six years and management has returned all $1.7 billion (37% of market cap) of it to shareholders through dividends and buybacks.
The bearish thesis against GME has long been that either:
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Some hyper-efficient retailer like WalMart will enter the used game market and take away significant share
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Digital game copies (which have no salvage value) will replace physical discs and render the gamer value proposition obsolete
WalMart (WMT) in the past tried a version of the used game model using a third-party kiosk approach, not unlike what it does today with Jackson Hewitt for tax preparation. The effort failed miserably after the partner went out of business, but now they seem back for more, this time without a third party. While this approach won’t likely have the same poor result, we believe that GME has a defensible market share based on:
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Store network distribution (small units in strip mall locations, accessible to both urban/rural consumers)
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Supply chain efficiency
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General brand ecosystem (staff members are typically avid gamers who are genuinely interested in chatting up and advising consumers)