I’m weary of the bull/bear argument over GameStop Corp. (NYSE:GME) stock. Both sides usually are far too simplistic: Bears argue that physical video game sales are declining — which is true … but that’s been the same argument made for some six years now, to varying degrees of success for GME shorts.
Of course, GameStop management is aware of that trend, one reason the company is diversifying into accessories and reselling wireless phones.
Bulls on GameStop stock point to the company’s earnings multiples and valuation, which is equally simplistic. If those earnings are declining, GameStop stock is going to decline. And the company’s cash-rich balance sheet won’t help if the company has to pay to exit unprofitable leases.
The more true argument relative to GME stock comes down to two questions:
- How much value can GameStop wring out of the declining legacy business, whether through physical video game sales or the shift to accessories and other items?
- What is the new “technology brands” business worth?
And between GameStop earnings for the fourth quarter and external headwinds, I simply don’t see enough value in GME stock.
GameStop Earnings Are Declining
The legacy GameStop business clearly is declining. For full-year fiscal 2017 (ending Jan. 28), same-store sales declined 11%, including a 13.5% drop in U.S. locations. Consolidated non-GAAP EPS fell as well — albeit just 3.4%
But the fall in GameStop earnings belies the problems in the business. Adjusted net income actually declined 6%, as share repurchases lowered the diluted share count. And adjusted operating profit in the legacy GameStop business fell 17%.
That’s a major problem for GameStop shares. Within the video game business, sales are declining — and GameStop earnings are declining at a faster pace. That’s a classic case of the same deleveraging that has hammered retail stocks over the past few quarters. While GameStop management continues to talk up a shift to collectibles – including converting over 150 locations to “hybrid” video game/collectible locations – that seems unlikely to be enough.
After all, those locations still are in malls, where traffic continues to decline. Gap Inc (NYSE:GPS) has said average locations are seeing 6% to 8% fewer customers each year. And there’s another retailer trying a similar strategy: Trans World Entertainment Corporation (NASDAQ:TWMC), whose F.Y.E. brand is trying to diversify away from dying music and movie sales. TWMC stock has performed even worse than GME stock, and trades at its lowest point in five years.
The question is whether the recent weakness is coming from “disintermediation” by direct online sales — or whether there’s just a lull in the console cycle. No doubt, there’s a bit of both. But it’s worth noting that GameStop’s pre-owned business declined rather sharply in FY16 as well, falling 5.1% and seeing gross margin fall year-over-year. That pre-owned business was the bulwark against direct online sales: buying physical discs from GameStop created a built-in rebate once the game was completed. Lower pre-owned demand looks like a harbinger of things to come.
The major problem with the argument that lower physical video game sales are just cyclical is GameStop’s own reaction. If physical sales are coming back, why is GME moving so hard, and so fast into collectibles?
Technology Brands Won’t Save GME Stock
The effort to diversify away from physical video gaming has led to the buildout of a technology brands segment. And GME is making a big bet there. A formerly cash-heavy balance sheet now carries net debt, and interest expense is guided to take up over 10% of FY17 operating income.
At this point, I’m getting skeptical of GameStop’s prospects with the new initiatives.
Revenue from GameStop’s technology brands rose 44% in Q4, but “primarily” from store growth. Same-store sales do not appear to be growing at a very high rate. GameStop already is taking charges for certain acquired stores, including former RadioShack locations. Adding insult to injury, the Simply Mac concept is getting weaker product allocation from Apple Inc. (NASDAQ:AAPL).
From a broader standpoint, the new initiatives simply aren’t good businesses — and that, too, is a big problem for GME stock. Simply Mac is supposed to operate in markets too small for Apple Stores, but if Apple doesn’t want those markets, what exactly can GameStop do with them?
As for the wireless businesses, including Cricket, investors should consider the current valuations of Verizon Communications Inc. (NYSE:VZ) and AT&T Inc. (NYSE:T). Investors clearly are worried about pricing in the space, particularly after Verizon matched the price on an unlimited data plan from Sprint Corp (NYSE:S). It’s optimistic, to say the least, to expect that pricing pressure not to make its way to resellers — and GameStop now is the largest reseller in the country.
Should You Short GME?
All told, there’s simply too much risk in GME stock — and it’s too optimistic to argue that GME is “cheap enough”. A forward price-to-free cash flow multiple of 7.1 looks attractive, as does a 7%-plus dividend yield. But GameStop earnings are declining, and the company may add to its debt to further build out the tech brands segment.
At the end of the day, this looks like a declining business, and it’s simply difficult to make money on a declining business. There’s a reason why GME still has a short interest over 24% despite those “cheap” multiples.
At this point, I’m not sure how much near-term downside is left in GME stock to support a short. That seems true even if GameStop earnings disappoint in FY17. But there’s more than enough risk to negate the bull case here. It’s possible GameStop could execute its strategy, but it’s unlikely and the road will be difficult. There are easier ways to make money in the market.
As of this writing, Vince Martin did not hold a position in any of the aforementioned securities.
