GameStop and a Lesson in Patience

This article was first published on 7/30/2013. To get articles like these sooner subscribe to our newsletter here.

GameStop (NYSE:GME) has been one of our holdings for a long time (coming up on four years), and until recently one of our worst performing stocks. I decided to write about GameStop because not only is it an interesting story, but also it’s a great example of the anatomy of a good investment idea. We can follow the story from my research in 2009 and purchase in 2010 to the stock’s constant underperformance to our being criticized for holding it to our triumph today. Finally, we (and our clients) are being rewarded after waiting more than three years.

GameStop is a videogame retailer with over 6,600 stores worldwide. The company sells new videogames, new videogame hardware, used videogames and hardware, and various digital offerings as well as its own video game magazine. Here is a breakdown of sales for GameStop’s fiscal 2009, which is what we were looking at when we first bought the stock.

As you can see, the biggest moneymaker for GameStop is the sale of used video games followed by new video games, 43% and 34% of gross profit, respectively. Digital (part of “Other”) only accounted for 18% of gross profit; however, gross margins in digital are quite high and for the “Other” segment, were the second highest at 33.6%.

So, GameStop’s health seems dependent on used games and new video games continuing to do well or if GameStop could substantially increase its digital presence.

Most people thought the company was headed down the same road as Blockbuster. Jim Chanos, a famous hedgefund manager that runs a short only hedgefund (meaning they only bet against stocks they think will fall), was betting against GameStop. He gave an interview to Forbes, which I think sums up the bear thesis for GameStop. Here’s the quote from the Forbes article:

Analog media across the board has continued to march toward the digital age, and Chanos still see value traps on the horizon. Music companies have taken huge hits, and video rental companies like Blockbuster have followed suit. Next up? Chanos think Gamestop is at risk.
“It is cheap,” he said. “Boy is it cheap. But boy is it in a bad business.” As more games move to digital, prices fall, margins shrink, competition increases and Gamestop’s trade-in used game marketplace flounders.

“This is one you’re going to think is cheap all the way down,” said Chanos.

He also gave a presentation at the Value Investors Congress in October 17, 2011, where his presentation included a few slides about GameStop. Below is the main slide about GameStop.

First off, it’s important not to get too worried because someone famous doesn’t like a stock you bought. If we randomly choose any stock, then I can almost guarantee that you’ll find a bunch of successful, famous investors that love it and own it and you will find about an equal number that don’t like it and don’t think it’s worth owning. Remember John Paulson, who rose to fame by making billions off the housing bubble? If you followed him blindly, then you would have lost a ton of money buying gold and Sino Forest, a fraudulent Chinese forestry company.

The important thing isn’t who owns or doesn’t own a stock, it’s why. And it’s up to you (or if you are a client, me) to do the research to see if you agree or disagree with them.

Let’s go through the issues that Chanos and others raised one by one. Here is the first and biggest one: Is GameStop similar to Blockbuster and all the record stores?

Is GameStop Similar to Blockbuster?

“Your world has sheltered one of my citizens. He will look like you, but he is NOT one of you.”
-General Zod, from Man of Steel

Quite simply, for all the world, GameStop looks like Clark Kent. It looks like another brick and mortar media retailer, such as Blockbuster, Sam Goody, or RadioShack, destined for the ash heap of history. The companies seem so alike on the surface. They sell similar items and face similar threats, but GameStop is much more Kal-El than Clark Kent.
Here are two photos of Blockbuster stores.

Notice how the stores are packed with expensive furniture and fixtures. There are kiosks, TVs, a weird pavilion thingy with a bench (or something?), special lighting to make the shelves of movies look attractive, and all kinds of large shiny signage. Also notice something else: There is a ton of empty floor space. Square footage costs money—increased lease payments, utilities, and so forth.

Here’s a picture of a Sam Goody store circa the 1994–1998. The store looks smaller than Blockbuster, but still has some empty space and lots of signage and displays.

Now take a look at a few pictures of GameStop stores (ignore the mass of people in them for a moment and just concentrate on the stores themselves).

They are small, packed to the brim with merchandise, and have hardly any empty floor space. Note the merchandise stacked up against the window to the right of the door in the first picture. They have some signs and some TVs but not nearly as much glitz and glamour as Blockbuster. GameStop’s stores are the retail equivalent of a fat man stuffed into an old, two-sizes-too-small t-shirt. It may not look pretty, but you can’t deny it’s effective.

GameStop stores in 2009 averaged about 1,500 square feet (they are even smaller now), compared to 5,700 square feet for Blockbuster in 2002. GameStop used 4,331 stores to cover the United States in 2009. Blockbuster used more than 5,556 in 2002. In 1995, before the mp3 and digital distribution was popularized, Trans World Entertainment (parent company of an extensive list of music chain stores) had stores that ranged in size from 1,300 to 27,000 square feet, with most stores being in the range of 3,000 square feet.

Also, Blockbuster planned on staying for the long haul. Leases (essentially a form of debt) were generally five to fifteen years. GameStop uses shorter leases of three to ten years.
In 2009, GameStop generated $813.25 in sales per square foot of retail space. (Note: This number excludes all sales labeled as “Other,” which is the segment in which GameStop accounts for digital sales). In contrast, Blockbuster generated barely over $100 ($114.88) of sales per square foot in 2002. In 1995, Trans World Entertainment was able to generate sales per square feet that ranged from $165 to $385. Blockbuster plastered the United States (and other parts of the world) with giant expensive stores sparsely stocked with cheap merchandise ($3 rentals) and dug in like ticks. GameStop covered the same area with about one-fifth fewer, cheaper, closet-sized stores stocked to the brim with expensive merchandise ($60 video games).

We can see clearly that the businesses have vastly different models and vastly different finances. So, we’ve dealt with Chanos’ (and others’) first argument that GameStop is just like BlockBuster and all the record stores. But just because they’re different doesn’t mean GameStop is or was a good investment. They can be different and GameStop still can be a horrid investment. Let’s look at the next few arguments that Chanos and others raised.

Will There Be Too Much Used Game Competition?

When we first started investing in GameStop, the threat of other retailers trying to muscle in on GameStop’s lucrative used game’s business was seen as one of the biggest threats to the company. This idea is one of the most logically inconsistent theories I have seen put forth for the demise of GameStop. The investment thesis goes something like this: Best Buy, Wal-Mart, and possibly Target are going to enter the used game business and have great success despite their having tried and failed numerous times. This success will drive down used game prices and compress margins and will hurt GameStop. At the same time, the used game business will also start to be a terrible business and eventually cease to exist as most game distribution moves to digital.

How is it that executives at Wal-Mart, Target, and Best Buy can be smart enough to finally get in on the used game business despite their predecessors failing yet also be dumb enough to enter what the short sellers claim is a dying business? In this theory, the executives at the other retailers are simultaneously both brilliant for being able to enter this market but colossally stupid for doing so.

In any case, both Best Buy and Wal-Mart ceased a majority of their used game business when the third party company that managed it, E-Play, shut down. Managing a used game trade-in business is a tricky and complicated business. You have to refurbish and test every game and console that is traded in, manage pricing for an enormous catalog of games, and maintain appropriate inventory in thousands of location. And that’s just the tip of the iceberg. People have been trying, and failing, to enter the used game business for years.

Will the Used Game Model Disappear?

Wal-Mart and Best Buy might not be a threat to used games, but there is a very big and very real threat to this business model. This narrative plays out as another big business versus the consumer battle. But first, here’s a story to illustrate the model.

I recently purchased a home. Considering it sits on almost a half acre, I thought owning a lawn tractor would be a good idea. The seller of the home, Don, was moving into an apartment at a retirement community so I bought his old John Deere riding mower. You see, once Don bought the mower from John Deere it was Don’s. He could do whatever he wanted with it, including sell it to someone else. John Deere had no say in the matter.

Imagine a world where Don couldn’t resell his mower. Imagine instead, he had essentially to rent the mower, paying a yearly “user fee” to John Deere for the privilege of using the mower. He and only he could use it. Once he stopped paying the yearly fee, Don either had to destroy the mower or return it to John Deere. What if he wanted to help his neighbor and mow his lawn? Well, he would have to pay an extra fee to John Deere. What if Don could buy the mower like usual but was barred from reselling it? If he didn’t want it anymore, then he couldn’t put an ad for it up on Craigslist or sell it at a yard sale. He was stuck with it or he had to throw it away.

As a consumer, which method of “ownership” would you prefer? For almost any item, consumers would prefer to buy something outright. That ownership model also ensures there is a vibrant secondhand market for products for cheapskates like me. I buy used vehicles, used lawn mowers, and even used filing cabinets for my office.

As a business, which method would you prefer? The rental method, of course. No one can have your product unless they pay you! It’s better to keep ownership of the asset and rent it out than sell the asset. Welcome to the world software companies are trying to create. Rather than selling a copy of their software to a user the same way John Deere sells a lawn tractor, they want to rent everything to you.

It’s an extremely lucrative business model. You, the business, own all the assets. The poor peasant consumers are forced simply to hand over money for the right to use them without ever actually taking ownership of any assets.

It’s this “rentier” model of software that I see as the greatest threat to used video games.

Video game consumers would have been subjugated long ago to this rentier business model if not for the fact that there are competing game consoles (Nintendo, Sony, and Microsoft). Even more than wanting to please game publishers, console makers want their console to be the dominant one in the marketplace. We thought consumers would win this battle. We thought console makers would be forced to allow used games lest a competing console business allow used games and gain market share.

This threat of what the others were doing played out as Sony kept coy about whether the new PlayStation 4 would allow used games. Meanwhile, Microsoft, as usual, barged ahead with their consumer alienating behavior and announced no used games for the next Xbox. Sony then told everyone their PS4 would allow used games. So, a few days later, Microsoft reversed course and caved in with this blog post by Don Mattrick, president of the Microsoft Interactive Entertainment Business division [emphasis mine]:

Today I am announcing the following changes to Xbox One and how you can play, share, lend, and resell your games exactly as you do today on Xbox 360. Here is what that means:
An Internet connection will not be required to play offline Xbox One games – After a one-time system set-up with a new Xbox One, you can play any disc based game without ever connecting online again. There is no 24 hour connection requirement and you can take your Xbox One anywhere you want and play your games, just like on Xbox 360. Trade-in, lend, resell, gift, and rent disc based games just like you do today – There will be no limitations to using and sharing games, it will work just as it does today on Xbox 360. In addition to buying a disc from a retailer, you can also download games from Xbox Live on day of release. If you choose to download your games, you will be able to play them offline just like you do today.

Ah, good old Microsoft … one of these days Steve Ballmer will get fired. Thank goodness Steve Ballmer got “fired”.

Is There a Digital Threat?

The other big threat to GameStop was supposed to be the digital distribution of games. If people start buying digital copies of most games, then not only do they not need to go through GameStop but there will also be no physical copies of the games to trade in later as used games. GameStop would face a double whammy of falling new video game sales and falling used game sales.

I wrote an earlier article back in November 2010 about how I viewed GameStop. That article focused on the threat of digital sales and is available here.
I also posted the comment below on the article to further expound on why I didn’t think digital distribution would take over in the near term:

Let’s look at the different options for consumers, first looking at the video rental and music biz and then games.

For video rental consumers had two options:
Option 1) Blockbuster, et. al. Drive 15min to the store, rent video (10min) drive 15min home. Watch video. Then find time a week later to spend another 20min returning it.

Option 2) Streaming services/On demand, et. al. Log on to whatever media device you are using, find the video you want and start watching instantly or after a few minutes of buffering.

Clearly Option 2 is the best and easiest and it’s no surprise digital won out.

Music
Option 1) Record Stores: Drive 15min to store, spend 10min finding and buying CD which by the way you can’t really use because you don’t have a CD player, everything is mp3s now. Drive 15min home. Oh and you also might have to buy the whole CD when you just wanted one or two tracks.

Option 2) iTunes, et. al. Log on, Download/listen instantly. Only have to buy the song(s) you want.

Clearly option 2 is best and it’s no surprise TransWorld Media died.

Now, gaming:
Option 1) Drive 15min to store. Buy game (10min). Drive 15min home. Start playing. Also able to trade in physical disc later for cash.

Optional: Trade in older games for cash or credit towards new game.

Option 2) Steam, et. al. Log on, wait 3-4 hours to download (computed using average file sizes of popular games and connection speeds from Akamai’s state of the internet report) in optimal conditions. Unable to trade in disc later because now you don’t have one (although I suspect this might be changed in the future with more robust DRM and you may be able to digitally trade in an old game)

Optional: Make separate trip to trade in used games or sell on eBay, etc. Don’t get money instantly but you may get a better price selling them yourself.

Why is Option 2 the superior way to go? While internet connection speeds will certainly rise so will file sizes. Why would consumers favor waiting longer to get an item they want and then being stuck with that item forever even though they now have no use for it?

With videos and music digital is clearly superior, you get your purchased item instantaneously and often times cheaper and in a more convenient format. Also most people seem to favor owning a library of movies and music. Not so with gaming. Yet what catalyst is going to change that? File size and connection speeds will both grow. Storage isn’t an issue with the PC gaming market. And most people don’t keep libraries of older games and console systems. To me as a consumer where is the upside to digital? For add-ons and other extra content sure, but the initial releases?
Remember that the price of GameStop when we bought it was implying that digital would start taking an enormous bite out of profits immediately. We do agree that eventually a lot of content will move to digital distribution.

How Things Played Out

First, here are the financials for the latest fiscal year, 2013.

The next table shows how 2013 stacked up against 2009, which was roughly the last fiscal year completed before we made our initial investment.

Both Sony and Microsoft are releasing new versions of their video game console hardware this year, so sales of new systems have fallen in anticipation of the new products. New video game profits have been about flat. Used game sales grew 20%. But, the most important figure is digital game sales grew 25% and gross profit grew almost 43% (some of this growth has been organic while some is via acquisitions). The demise of GameStop has not happened yet. Used game sales and digital sales have been strong.
This is what the anatomy of a good, market beating investment idea looks like. Below is a chart of the share price of GameStop and the S&P 500 since our initial investment in GameStop in 2010.

Almost immediately after making the investment, we start to lose money. Although the market as a whole goes down, we lose more money than the S&P 500. We lose money for little over a year before matching the performance of the S&P 500 for several months. Then, we go right back to losing money for another 12 months. This time we are losing money as the market is going up. Wow! We must be really stupid and have made a huge mistake.

Finally, starting just a few months ago, the good news that we thought we’d get starts to come out. GameStop sales and profits have held up and both new consoles from Sony and Microsoft will fully support used games.

When you are investing, patience is the key. Throwing in the towel early would have cost my clients and me a lot of money.

Disclosure: Long GME, MSFT