GameStop (NYSE: GME) | What is it Actually Worth?
Updated: May 30
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Prior to the recent saga, GameStop has been relatively unattractive.
Its strong focus on brick-and-mortar retail led to declining revenues as the gaming industry digitalizes and disintermediates.
In FY2019, GameStop embarked on a restructuring programme with the goal to become the leading global omnichannel retailer for all things gaming.
By establishing itself as a one-stop-shop for all things gaming and aiming to offer customers same-day delivery and superior customer service, we believe that GameStop is heading in the right direction.
Efforts thus far include trimming down its store footprint, establishing e-commerce capabilities and strengthening its balance sheet amongst others.
However, the outcome of its restructuring is still highly uncertain and significant execution risks persist.
GameStop's very thin margins put it at high risk of not being able to breakeven.
DCF-based fair value estimate of US$36.18 (WACC of 9.47%, exit EV/EBITDA multiple of 9.9x, terminal growth rate of 2%).
GameStop is an omnichannel video game retailer selling new and pre-owned gaming hardware, software and collectibles. Hardware and accessories account for the largest proportion of GameStop’s revenue (50%), followed by software (39%) and collectibles (11%).
As of 30 January 2021, the company operates 4,816 stores across the United States, Canada and Australia and Europe. It is currently the leading gaming specialty store chain in the US where it derives the majority of its revenue (67.1%). The company also sells its products digitally through GameStop.com and its mobile application. However, its e-commerce platforms are currently only available to US consumers.
GameStop operates as a pure distributor and does not manufacture any of its own products. It purchases products from hardware manufacturers, software publishers and distributors. Its top suppliers, Nintendo, Sony, Microsoft, Electronic Arts and Take-Two accounted for approximately 68% of inventory purchase in FY2020.
What caused the GameStop Mania?
GameStop has garnered a lot of media and retail attention lately following its short squeeze. It began with many hedge funds betting that GameStop will ultimately go bankrupt. This is done by short selling the stock, whereby the hedge funds borrow shares and sell them in the market at a high price hoping to buy them back after the price falls and return them to the lender. At one point, short interest was nearly 140%. While such a phenomenon is rare, it is possible. Investor A may have borrowed GameStop shares from a broker and sold them to Investor B who has an agreement with his brokers to lend out the shares to Investor C to sell short. Hence, the same shares can get borrowed and sold multiple times.
The extremely high short interest in GameStop makes it prime for a short squeeze. If the price of GameStop rises enough, some short sellers may be forced to cover their shorts and in doing so, buy back GameStop shares on the market, adding buying pressure and sending GameStop’s price higher. This in turn forces more short sellers to be squeezed out of their positions as GameStop’s price continues to trend upwards.
Some day traders on r/wallstreetbets saw the opportunity and announced their position in GameStop call options on the forum, encouraging other members in the community to do the same. Notably, Keith Gill (aka u/DeepF***ingValue), a long-time GameStop advocate who has been posting screenshots of his GameStop portfolio since 2019, announced that he doubled his holdings. As more community members began uploading screenshots of their positions in GameStop and the gains they have made, even more people piled into the trade, building the momentum. Some members participated in the trade to “punish” hedge funds that sought to profit from GameStop’s troubles.
On top of the short squeeze, the gamma squeeze caused by the use of call options by bullish traders also spurred the rally. When a broker sells call options, they typically hedge the risk by buying shares in the underlying stock. This is known as establishing a covered call. By doing so, the call option seller will not suffer massive losses if the stock price were to rise far above the strike price. Buying to hedge put further upward pressure on GameStop’s share price, forcing even more options sellers to buy to hedge. Furthermore, the fact that options are leveraged instruments mean that each dollar spent on options can drive between 5 to 50 dollars of share purchase as option sellers hedge their exposures.
GameStop’s share price reached a record high of US$483.00 in less than a month before crashing to the US$40s in early February. It has since rebounded strongly once again.
The timeline of events is as follows:
(1) 11 January 2021: GameStop announced the appointment of 3 new directors to its board, one of them being Ryan Cohen, co-founder and former CEO of e-commerce company, Chewy.
(2) 14 January 2021: The announcement sparked retail interest on r/wallstreetbets , causing GameStop’s share price to increase two-fold from US$19.94 on 11 January to US$39.91 on 14 January.
(3) 19 January 2021: Citron Research took aim at GameStop buyers, saying that the stock will fall back to US$20 fast. GameStop closed at $39.36.
(4) 22 January 2021: Retail support grew for r/wallstreetbets and GameStop surged, closing at US$65.01, up 51% in a day.
(5) 27 January 2021: Elon Musk tweeted “Gamestonk!!” with a link to the r/wallstreetbets forum after markets closed on 26 January. GameStop shares soared about 140% after-hours, opening at $354.83 on 27 January.
On this day, Melvin Capital and Citron Capital closed the majority of their short positions after suffering heavy losses. Citron Capital covered most of its positions at a 100% loss while Melvin Capital reported a 53% loss in January. Citadel and Point72 infused US$2.75bn into Melvin Capital to shore up the fund.
(6) 28 January 2021: Retail brokerages like Robinhood placed trading restrictions on GameStop along with other “Meme stocks”. These restrictions included higher margin requirements, limiting buying and short selling and more. Robinhood cited the reason being a ten-fold increase in its clearinghouse deposit requirement.
Whenever investors trade securities on Robinhood, Robinhood works with a clearinghouse to clear and settle the trade. As a clearinghouse member, Robinhood has to comply with membership rules such as deposit requirements to reduce risk to the clearinghouse. Clearinghouses act as an intermediary between buyers and sellers in financial markets, acting as both the buyer and seller in a trade and hence subjecting themselves to default risk from both parties. To mitigate this, clearinghouses impose deposit requirements to ensure both parties have enough money to cover losses if prices move against them. The deposit requirement depends on the volatility of a certain security. As the volatility of these “Meme stocks” spiked, deposit requirements increased as well. Hence, Robinhood had to limit the buying of these securities in order to meet deposit requirements.
With buying restricted but selling allowed, GameStop sold off, closing at US$193.60 on 28 January, down 56% from its 27 January closing price of US$347.51.
(7) 29 January 2021: SEC concluded that the actions of these Reddit traders are not market manipulation. Robinhood also eased trading restrictions on GameStop and other “Meme stocks”. GameStop closed 68% up at US$365.00.
(8) 2 February 2021: GameStop fell 60%, closing at US$90 on 2 February before falling a further 41% and closing at US$53.50 on 4 February. Throughout most of February, it traded between US$40.69-US$63.77
(9) 24 February 2021: GameStop rallied once again after the company announced that Ryan Cohen will be leading the company’s e-commerce shift. Share price surged over 100% to close at US$91.71. The new surge looks to be a gamma event driven by massive call option buying. The volume of call options reached 41.1m, 118.9m and 82.9m on 24, 25 and 26 February respectively, up significantly from just 13.1m on 23 February.
Share trading volume followed shortly after.
George Calhoun, Founder & Director of the Quantitative Finance Program and Hanlon Financial Systems Center at the Stevens Institute of Technology, had superimposed the option and share volume charts and we can see that option trades are driving the share volumes with pulses in option volumes preceding the pulses in share volume.
There is no one factor driving the sharp move this time. Rather, the surge can be attributed to a variety of factors including retail trading momentum as those who missed out on the previous rally and those hoping to profit more piled in. Other reasons include the resignation of GameStop’s Chief Financial Officer and Ryan Cohen’s ice cream cone tweet which some interpreted to be a positive signal.
(10) 24 March 2021: Following GameStop’s disappointing 4Q2020 results, its share price plunged 34% to close at US$120.34 on 24 March 2021. However, it did not stay at that price range for long as the company’s shares surged 53% the following day fueled by bulls on r/wallstreetbets encouraging each other to “buy the dip”.
What is GameStop Actually Worth?
There is currently a disconnect between GameStop’s share price and its performance. Prior to this whole saga, GameStop has been relatively unattractive. Due to its strong focus on brick-and-mortar retail, GameStop’s revenue has been declining as the gaming industry digitalizes. This is largely due to declining store count as the company shutters underperforming stores and consumers shift to purchasing gaming hardware and software online. Revenue in FY2020 was also hard hit due to COVID-19 as GameStop was forced to shutter stores, leading to a 21.3% decline yoy.
Over the same period, other players in the video gaming industry have experienced high growth, indicating that GameStop’s decline is caused by idiosyncratic factors rather than industry-wide reasons.
In terms of margins, although the company has engaged in various cost reduction efforts, the decline in selling, general and administrative (SG&A) expenses lagged the revenue decline. Disregarding FY2020 due to the impact of COVID-19, SG&A expenses decreased at an average rate of 5.1% between 2016 to 2019 but revenue fell at an average rate of 9.1% per annum over the same period.
The global video gaming industry can be split into 3 segments: mobile, console and PC.
While mobile games account for a large share of the pie and is expected to be the fastest-growing segment due to its accessibility to casual gamers, we see little opportunity for GameStop to tap on the growth. Mobile games are largely sold through app stores on mobile phones with in-game credits usually purchased directly through the game itself, making it difficult for GameStop to insert itself into the value chain.
We also foresee GameStop’s relevance in the console segment to decline due to digital disintermediation. With console makers now selling their consoles directly online and allowing for digital game downloads through their console systems, GameStop’s role as a middleman has diminished.
As for the PC segment, it is a highly contested space with digital game distributors like Steam already occupying the lion share of the market and with loyal networks of customers, making it difficult for GameStop to seize a significant share.
Console Games: Digital Disintermediation to Put Pressure on GameStop
GameStop has traditionally focused largely on the console game segment, selling new and pre-owned consoles along with their games. Currently, new and pre-owned console games still make up almost 70% of games sold on GameStop.com. The trend of digital disintermediation has taken a toll on its revenue. Between 2015 and 2018, when GameStop still reported sales from its new hardware and new software segment, sales declined at an annual rate of 3.1% and 5.5% respectively.
In the past, GameStop served as a middleman between console makers and consumers. However, now that companies like Sony, Microsoft and Nintendo are selling their consoles directly to consumers via their websites, GameStop’s relevance as a middleman has dwindled. These console makers are also increasingly focusing on game sales directly through their console’s online store (i.e., PlayStation Network, Xbox Live, Nintendo Switch Online). Not only is buying directly from the console’s online store more convenient for customers as the games will be ready to play almost immediately, but publishers also have an incentive to distribute their games digitally due to higher margins. According to Daniel Ahmad, a video games analyst at Niko Partners, publishers would traditionally make about $35 on a $60 game sold in-store, but online downloads allow them to make as much as $45 per game; this can increase to $57 for platform holders like Sony selling their first-party games digitally. To encourage digital downloads, many console makers are already removing disc drives from their latest consoles. Both Microsoft’s PlayStation 5 and Nintendo’s Switch do not have disc drives.
What is happening to the console games industry now can be likened to what has happened in the music industry. In the past, people were listening to music on vinyls before switching to cassettes, then CDs, then MP3s. But now, almost all music is downloaded digitally or streamed. As more and more console and PC makers start to phase out the disc slot in their products, physical games copies may become antiques like how vinyls, cassettes and CDs are antiques in music.
This trend is also expected to negatively impact GameStop’s trade-in business since the ownership of digital game software cannot be transferred. This can be observed from how pre-owned sales declined at an annual rate of 7.7% between 2015 to 2018.
PC Games: Slow Growth and Highly Contested
Of all 3 segments in the video games industry, PC games is expected to experience the slowest growth. Global Newswire valued the PC games industry (software only) at US$28.7bn in 2019 and forecasted that it will grow at a CAGR of just 0.28% to reach US$29.2bn by 2025.
Digital disintermediation has a lower impact on PC games due to the lack of a centralized online game store for each PC model, offering retailers the opportunity to value-add by offering consumers a one-stop-shop for a broad selection of games across publishers. However, the space is currently highly contested. GameStop competes with mass-market retailers, digital game distributors and other gaming specialty stores.
Gaming specialty stores like GameStop are positioned between mass-market retailers and digital game distributors. Unlike mass-market retailers, GameStop sells games products exclusively. Unlike digital game distributors, GameStop sells a much broader range of gaming products including consoles, accessories and even electronics which most digital game distributors do not carry. However, GameStop does not have a game client. A game client connects individual gamers to a main server, allowing them to play multiplayer games, provides game updates and allows gamers to access all their games through one centralized library. Without a game client, when one buys a PC game from GameStop, GameStop will provide a code that is then entered into Steam or other game clients to redeem the game. The game will then show up in the user’s game library for them to play. Unless GameStop sells games that are not available on other gaming specialty stores, there is little incentive for customers to buy their games on GameStop as doing so adds an additional step in their purchasing process.
The table below provides a comparison of GameStop with top PC game distributors.
While GameStop is currently undergoing restructuring to establish digital distribution capabilities, we opine that it would be challenging for GameStop to seize a significant share of the PC games market given that other players in the industry have already established game distribution rights with publishers and loyal networks of customers.
Where Does GameStop Stand?
Despite all the headwinds, we think that GameStop’s vision to establish itself as the leading global omnichannel retailer for all things gaming and entertainment is the right position to adopt. Even though GameStop cannot compete with console makers or digital game distributors directly in their respective industry segments, it can still carve out a position for itself in the industry by being the “Amazon” of video gaming.
An analogy is as such: some customers may still choose to purchase Samsung televisions on Amazon even though they can purchase directly from Samsung. Hence, even though Amazon may sell fewer units of Samsung television compared to Samsung itself, as Amazon casts its net wide across many different brands and products, it is still able to generate substantial revenues by offering customers the convenience of being able to order a variety of products from one platform and have them shipped on the same day.
The overall video gaming industry stretches far beyond consoles and game software, even though much of the growth occurs in the mobile segment which is difficult to reach for GameStop, growth in that segment, or any segment, in fact, is expected to flow through to related industries such as gaming accessories, collectibles and more. For instance, the global gaming accessories market is expected to grow at a CAGR of 9.5% between 2020 to 2025 according to Mordor Intelligence. While the collectibles market for TV, movie, gaming and animation characters is expected to grow at a CAGR of 4% between 2021 to 2024 according to PR Newswire. In short, there are a plethora of opportunities for GameStop if it can only seize it.
Therefore, we welcome the entry of activist investors to accelerate GameStop’s digital transformation, with Ryan Cohen, founder and former CEO of Chewy, at the helm. We resonate strongly with his vision for GameStop. In his letter to GameStop’s board dated 16 November 2020, Cohen said that he sees GameStop as a company with “valuable assets, including a strong brand with a large customer base”. He believes the company can be the “ultimate destination for gamers” if it “takes practical steps to cut its excessive real estate costs and hire the right talent, it will have the resources to begin building a powerful e-commerce platform that provides competitive pricing, broad gaming selection, fast shipping and a truly high-touch experience that excites and delights customers”. He also mentioned that this “type of world-class infrastructure that was constructed at Chewy”, contributed to Chewy’s success.
Aside from Ryan Cohen, the new Strategic Planning and Capital Allocation Committee tasked to accelerate GameStop’s transformation also consists of Alan Attal, former CMO of Chewy and Kurt Wolf, CIO of Hestia Capital. Matt Francis, former engineering leader at Amazon Web Services was also recently appointed to be the CTO. We believe that the new team has the required strategic and operational qualifications to be leading the transformation.
What has been done thus far?
The restructuring efforts thus far can be summarised as follows:
Establish Digital Distribution Capabilities: The company relaunched GameStop.com in August 2019 and launched a mobile application in October 2020 to allow customers to shop digitally. E-commerce sales grew 191% yoy in FY2020, accounting for 30% of total sales, up from a low single-digit percentage prior to FY2019.
Store-Fleet Optimization: The company has closed more than 1,000 stores since the restructuring began in FY2019, representing underperforming localities and de-densification in certain states. The company also completely wound down operations in Denmark, Finland, Norway and Sweden. The goal is to have a more profitable footprint that can support same-day delivery.
Divest Non-Strategic Assets: The company divested Simply Mac, the largest certified reseller of Apple products, and Spring Mobile, an AT&T authorized retailer of wireless services in FY2019 and FY2018 respectively to generate cash proceeds to be reinvested into its core video games business.
Strengthen Balance Sheet: In FY2019, GameStop used cash on hand to redeem US$350m unsecured senior notes and executed a series of open market purchases of 2021 Senior Notes totalling US$53.6m. On June 3 2019, the Board also eliminated the Company’s quarterly dividend which saves approximately US$155m annually. The company also paid down its outstanding borrowings under its revolving credit facility and redeemed the rest of its 2021 Senior Notes on 15 March 2021. GameStop managed to reduce overall debt by US$401m in FY2019 and a further US$57m in FY2020.
Improve Working Capital: Merchandise inventory declined 31% yoy in FY2019 and a further 30% yoy in FY2020. This led to an improvement in inventory turn from 4.4x at the end of FY2019 to 5.9x, driving improvements in working capital. Accounts payable also decreased 64% yoy in FY2019 and a further 10% yoy in FY2020, reducing the likelihood of GameStop running into short-term liquidity problems.
Cost Reduction: The company delivered a US$408.5m decline in SG&A expenses in FY2020, representing a 21% decline yoy. These cost reductions are expected to be permanent due to the permanent closure of stores and related labour costs.
Increase Liquidity: In FY2020, the company completed 5 sale-leaseback transactions related to office buildings and the sale of a corporate travel asset, raising US$95.5m.
However, we believe that there is still a lot of work to be done. Even though GameStop had dramatically trimmed its debt, the company’s retained earnings had declined even quicker due to negative net income, dividends and share repurchases. This led to the company’s D/E ratio doubling from just 2.03x in FY2018 to 4.66x in FY2020.
Furthermore, even though the company is working to reduce costs, EBITDA margins continued to decline as cost reduction efforts fail to keep up with revenue decline.
Now that GameStop has stabilized its core business, the next step is to focus on building an efficient distribution network to support its e-commerce business.
In 3Q2020, GameStop rolled out same-day delivery for online transactions. GameStop partnered with last-mile delivery services to deliver directly from local GameStop stores. This gives them an edge over console makers like Sony, Nintendo and Microsoft that take a minimum of 3 days to deliver. Customers may also choose to pick up their order at GameStop stores. What many do not realise is that e-commerce is a very infrastructure intensive business. In order to establish efficient distribution networks, e-commerce players require an extensive network of physical distribution centres or warehouses. With a presence in 51 out of 52 states in the US and over 3,000 stores across the country, GameStop has the physical assets to enable customers to receive their shipments quickly.
On top of fast shipping, the company also stated in its FY2020 annual report that it will be taking the following steps in FY2021:
Investing in technology capabilities, including by in-sourcing talent and revamping systems, and evaluating next-generation assets.;
Building a superior customer experience;
Expanding product offerings to include PC gaming, computers, monitors, game tables, mobile gaming, and gaming TVs;
Modernizing US fulfilment operations to improve the speed of delivery and service;
Establishing a US-based customer care operation, and;
Leveraging the Company’s digital assets, including Game Informer and PowerUp Rewards, to increase market share within the growing online gaming community.
It seems to us that Cohen is working to establish a similar business model at GameStop as he did for Chewy. By matching Amazon’s shipping speed, pricing and discounts, and surpassing Amazon’s customer service and return policies, Chewy was able to establish dominance in the pet food industry.
Everything sounds good on paper thus far but we would like to highlight that there are significant execution risks involved as GameStop is still in the early stages of its transformation.
As such, in building our valuation model for GameStop, we decided to build in 3 scenarios:
As the company’s restructuring efforts are solely focused on the US with no concrete plans for its international operations, we will only be explicitly forecasting its revenue from the US while assuming international revenues will continue to decline.
Even though GameStop has since changed its revenue segments to include only hardware and accessories, software, and collectibles, we decided to make use of its old breakdown as the various sub-industries have drastically different growth prospects.
New Hardware: According to Grand View Research, the US gaming console (hardware) market was valued at approximately US$11bn in 2020 and is projected to grow at a CAGR of 3.3% between 2020 and 2025. In the base case, we projected that revenue from new hardware sales will grow above the industry rate as GameStop slowly regains the market share that it lost. In this scenario, we expect the company to seize a 9.0% share of the US console market by FY2025, up from an estimated 7.2% in FY2020. In the bull case, GameStop will win over customers with superior customer service, same-day delivery and competitive prices to occupy 11.3% of the US game console industry. In the bear case, fulfilment capabilities are not well established and GameStop fails to deliver its promise of same-day delivery to customers, causing its market share to remain stagnant and the company to not be able to win over customers from competitors.
New Software: We projected that the sale of physical game software will continue to decline albeit at a slowing rate as the gaming industry continues to digitalize and console makers phase out disc slots.
Pre-owned Products: Likewise, we anticipate the decline in pre-owned revenue to continue decreasing as the number of physical game copies in circulation declines.
Accessories: With the exception of mass retailers like Amazon and Best Buy, GameStop carries the largest selection of gaming accessories, offering customers the convenience of having a one-stop-shop where they can purchase their full gaming setup. Coupled with customer support staff who are well versed with game products and delivery speeds that are on par with Amazon, we expect GameStop to grow at rates above the industry growth rate and seize a larger share of the US gaming accessories industry in the base case. In the bull case, we project that GameStop will exhibit much higher growth as they establish partnerships with more vendors to provide customers with an even wider accessories range. In the bear case, growth rates lag industry growth rates as GameStop fails to deliver the products on time or if prices are not competitive.
Digital: According to Statista, the worldwide digital games industry (including console and PC games) is forecasted to grow at a CAGR of 8.5% between 2020 to 2025. We do not expect GameStop to be able to steal share from other market players like console makers and digital game distributions in the segment. For console games, there is little incentive for customers to buy from GameStop when they can download directly from their consoles’ network. For PC games, it is also more convenient for customers to buy from digital distributors like Steam which have a game client. Therefore, the only way GameStop can grow its market share in this segment is by offering customers lower prices than competitors (bull case). Otherwise, in the base case, we project that GameStop will just maintain its current share and grow at industry growth rates. In the bear case, should GameStop fail to actively strike deals with game publishers for the latest and most popular games, it could see its market share being eroded.
Collectibles: With the exception of FY2020, collectibles is the only revenue segment that has been experiencing positive revenue growth over the years. GameStop offers one of the largest selection of video game, movies, television and pop culture collectibles. It also sells exclusives that are only available at GameStop. As of FY2020, GameStop already has an estimated 26% market share in the US animation collectibles industry. With its shift online, we expect it to be able to sustain the growth momentum by offering customers the convenience of online browsing and delivery. Hence, in the base case, we forecast that GameStop will continue growing above industry growth rates to attain 31% market share by FY2025. In the bull case, GameStop will establish even more exclusive partnerships with vendors, winning 39% market share by FY2025. In the bear case, should GameStop fail to actively strike deals with vendors to offer customers the latest and most exclusive merchandise, its market share could remain stagnant.
In our base case, we project that revenue from the US will continue to decline albeit at a slower pace between 2020 to 2022 as the growth in newer categories like new hardware, accessories and collectibles are insufficient to offset the decline in new (physical) software and pre-owned products.
Moving down the income statement to margins, we forecast that gross margins will dip further in 2021 due to promotions to establish GameStop.com’s customer base on top of increased freight and credit card fees associated with e-commerce. Afterwards, recovery is expected as the company achieves scale economies. EBITDA margins are also expected to remain depressed in the near term as the company continues to incur costs associated with transformation initiatives. Such costs amounted to US$76m in FY2020 and we expect similar amounts to be incurred for the next 2 years.
With the above key revenue and cost assumptions, based on our excel financial model, which is accessible to our Snowball Community members for download [sign up here], we derived a weighted average fair value/share of US$36.18 for GameStop using a blend of both the Discounted Cash Flow Model (DCF) with the Gordon Growth Method and the Exit Multiple Method. This represents a downside of 80% from the last closing price of US$181.
WACC of 9.47% derived using CAPM cost of equity of 6.42% and cost of debt of 6.75% plus a risk premium of 5% as GameStop is currently in a critical transition stage.
Exit EV/EBITDA multiple of 9.9x, which is the 25th percentile peer EV/EBITDA multiple.
Terminal growth rate of 2%.