Why GameStop's Private Equity Dreams Won't Come True
Updated: Jan 31, 2019
GameStop ($GME) stock has been beaten down continuously over the last 5 years, from a November 2013 high of nearly $58 per share to just $15.80 as of today's close (01/24/19). However, the stock is up nearly 40% in the past month since hitting a 52-week low of $11.56 in late December of last year. This move has been driven by rumors of a potential private equity buyout - a deal that simply does not make sense to me, especially not at today's valuation of $1.6 billion.
If you are familiar with the Video Game Industry, you are likely not surprised by the decline in GameStop's business. Secular growth in digital game downloads and in-game micro-transactions for downloadable content (DLC) have been devastating to the brick-and-mortar retail business. Digital downloads accounted for 60% of the $34.6 billion in console revenue in 2018 and is expected to continue to grow rapidly. This trend is displayed clearly in the financial results of publicly traded video game companies such as Take-Two Interactive ($TTWO) and Activision Blizzard ($ATVI). The following charts plot the two companies' physical retail sales against their digital online sales:
The implications of this trend are twofold: In addition to the obvious point that these digital downloads cut into GameStop's new game sales, they also reduce the number of physical copies of games that could generate used game sales for GameStop in the future. Used games are a growing segment of the business as new game sales continue to decline and also generate a significant amount of gross margin:
Pre-owned games generate nearly twice the gross margin of new games for GameStop. If physical copies of games continue to become less popular, pre-owned games will simply be harder for GameStop to find.
Additionally, their attempt to grab a piece of the digital download market by selling digital download codes has not gained traction. Why would a consumer drive to the store and buy the code from GameStop when they could just buy the game online from their console and download it without ever leaving?
Another key segment of GameStop's business is console sales, which contributed greatly to the business's improvement in 2018. However, many of those sales were the result of the release of Nintendo's Switch, in addition to Sony and Microsoft's refresh of the PS4 and Xbox One consoles, respectively. While these consoles will continue to generate revenue for GameStop, it is likely that console sales will slow in the coming years. 2019 will be the 6th year in the current console cycle, which typically last 8 to 10 years. We may not see another significant console launch until 2021 or later - not a good sign for a retailer who is becoming more reliant on console sales every year.
All of this leads me to my main point: Where's the upside for a potential PE buyer?
Well, the recent sale of GameStop's technology brands business provided a cash infusion of $700 million. Half of this will most likely be used to pay off the $350 million in 5.5% bonds that mature in October of this year. The other half of this cash would contribute to paying off their 2021 bonds in the case of a PE buyout. Additionally, 87% of their 7,276 store leases expire within the next 4 years, providing some flexibility for a PE buyer to close under-performing stores.
The company is cash flow positive with strong liquidity. However, their free cash flow has been shrinking year over year since FY 2016 (CY 2015), a trend which speaks for itself:
When considering private equity deals, I am looking for a growing company, in a growing industry. Essentially, I am looking for the most cost-efficient way to buy into an industry with tailwinds. If the company has a good product, in a growing industry, but has been mismanaged: even better. I can get in cheap (due to poor management) and come in, fix the identifiable problems in the business and ride the tailwinds of the industry to a 25%+ IRR. GameStop, however, has been relatively well managed in my opinion. The problem is that they have been well managed in an industry with extreme headwinds to growth and profitability. And, having just sold off their technology brands business, they are as concentrated as ever in the retail video game industry. I simply do not see the upside in this deal for a PE buyout. I can't imagine trying to pitch this deal at a $1.6 billion valuation to a group of LPs.
In summary, GameStop is a company that is struggling to survive in a dying industry. Good management has kept their liquidity strong and their cash flow positive, but I would not want to be put in charge of this business today and tasked with turning it around. Especially not at a $1.6B valuation. There are simply too many headwinds in this industry to justify a buyout at 4x forward EBITDA.
For what it's worth, I have no position in the stock. I just do not see the upside for a PE fund in this case, for the reasons listed above. If you truly believe this buyout is going to happen, feel free to reach out to me on twitter @Pivotal_Capital and change my mind.
UPDATE: On Tuesday, January 29, 2019, GameStop ($GME) announced the termination of their attempt to sell the company due to their inability to secure funding at terms acceptable to the acquirer. This announcement sent the stock into free fall, and closed the day at a 52-week low of $11.28 (-27.23% from Monday's closing price of $15.50).