GameStop: The Next Blockbuster?
GameStop is the world’s largest retailer of video games and hardware. They operate 6,549 stores in United States, Austria, Australia, Canada, Denmark, Finland, France, Germany, Italy, Ireland, New Zealand, Norway, Portugal, Puerto Rico, Spain, Sweden, Switzerland, and the United Kingdom. GameStop’s profit comes from four product categories. Its new video game hardware category accounts for 6.5% of its gross profit; new video game software, 21.3%; used video game products, 46.8%; and other, 33.8%. Other includes video game magazines and various online video gaming properties.
GameStop’s core used game business seems to be under threat from a recent Federal Circuit Court decision and the announcement by BestBuy that they will enter the used game business. Meanwhile digital distribution is a looming threat for GameStop’s new games business. Morningstar recently summed up GameStop’s prospects this way: “We believe the long term prospects for this no-moat retailer are bleak.” It’s no wonder GameStop currently trades at a P/E of 8.79 and a forward P/E of 7.3.
So is GameStop a value investment or a value trap? Let’s look at the three main issues weighing on GameStop’s stock price: the Vernor vs. Autodesk court decision, used game competition, and digital distribution.
Vernor vs. Autodesk Court Decision
The Vernor vs. Autodesk court decision deals with the concept of “first sale,” which is described this way on the EFF’s website: “The ‘first sale’ doctrine expresses one of the most important limitations on the reach of copyright law. The idea, set out in Section 109 of the Copyright Act, is simple: once you’ve acquired a lawfully-made CD or book or DVD, you can lend, sell, or give it away without having to get permission from the copyright owner. In simpler terms, ‘you bought it, you own it’ (and because first sale also applies to gifts, ‘they gave it to you, you own it’ is also true).”
Recently, the Ninth Circuit court ruled in Vernor vs. Autodesk that an individual could not resell a piece of software produced by Autodesk on eBay because the court claimed the individual did not own it; they were just licensed to use it. The ramifications of this could be big: no more reselling of DVDs, CDs, or used video games. But before we panic, let’s look at the Ninth Circuit court and the decision itself.
First, the court’s decision was not “en banc.” That means it was not decided by the whole court, just a three-judge panel. While this is normal in most cases, for a case of this magnitude that overturns a previous ruling, it is odd that the decision wasn’t made en banc. Vernor has now filed a brief requesting a hearing en banc. This may lead to a modification of the original ruling.
Second, consider some background about the Ninth Circuit court. It is the most overturned circuit court in the country. Because of its zany decisions, it is sometimes referred to as the “Ninth Circus.” As of October 2010, of the 47 current federal cases the U.S. Supreme Court has agreed to review, 18 or 19 (if you count a special three-judge district court case) are cases from the Ninth Circuit. To put this in perspective, only 20% of the population lives in the Ninth Circuit district yet Ninth Circuit cases make up 40% of the nation’s reviewed cases. Cases from other federal circuit courts encompassing 80% of the population account for only 60% of the cases the U.S. Supreme Court will be hearing. The Ninth Circuit court clearly issues controversial rulings.
Furthermore, the Ninth Circuit court is the most overturned circuit court in the country. (There are thirteen circuit courts for those keeping track at home.) From October 2000 to October 2009, the Supreme Court vacated or reversed 148 of 182 of the Ninth Circuits cases. That is a reversal rate of slightly more than 81%. The other twelve circuit courts had reversal rates of only 70%. But, wait, it gets worse for the Ninth Circuit. Of the 148 cases the Ninth Court had reversed, 72 of those were unanimous reversals. That means not a single U.S. Supreme Court justice agreed with the original verdict. But, wait, it gets even worse. Of the 72 unanimous reversals, 15 were summary dispositions. (A summary disposition means the Supreme Court thought the original verdict was so erroneous that no briefs or arguments were needed for clarification or explanation.)
It’s easy to see how the Ninth Circuit court earned its circus nickname. Considering that the current Ninth Circuit ruling overturned a previous judgment in favor of Vernor, the fact that the current ruling goes against the long established “first sale” doctrine, and that the Ninth Circuit has an abysmal record on appeals; it is likely the decision will be modified or reversed. While legal experts might debate the validity of the ruling and debate the first sale doctrine’s application to software, the statistical evidence based on the previous record of the Ninth Circuit is in favor of a reversal or modification.
Used Game Competition
The used game business is the biggest source of GameStops’ profits and is a high margin business. It’s no surprise then that other companies have tried and are trying to muscle in on that business.
BestBuy and Wal-mart first entered the used game market in 2009 when they allowed a third party company, E-Play, to place used game kiosks in their stores. After just eight months of operations, in early 2010, E-Play shut down. But recently BestBuy announced it was reentering the used games business.
In the latest conference call, Paul Raines, the CEO of GameStop, said, “We have seen no competitive impact from emerging competitors in the used business and also have not seen any impact from the first user codes in recent titles. We are watching carefully the latest round of competitor entries in the used business, but would remind investors of the extensive competitive barriers GameStop has built around the used business.”
So what is GameStop’s competitive barrier? The network effect. Simply put, the network effect means a product or service becomes more valuable the more people use it. In GameStop’s case with its used business, the more people that trade used games in the more used game inventory GameStop has and the more used games GameStop has the more people want to go to GameStop to trade their games in and buy other used games. And so the cycle goes.
A competitive advantage such as the network effect is most durable when paired with some other advantage. Unfortunately, GameStop does not seem to have any other durable long-term advantages besides the network effect when it comes to its used game business. It is possible for competitors to overcome GameStop’s advantage by offering significantly better pricing on used games to entice more people to trade their games in, but the competitor will have to endure a period of low to no profitability while they attempt to steal market share from GameStop. As we saw with E-Play, the big box stores’ previous attempt only lasted eight months until they gave up. How long will a GameStop competitor be able to live with losses while building up the business this time around?
While the long-term effect of competition on GameStop will likely be muted, the company will continue to see margin pressure in the near term in its used game business. GameStop has a habit of pricing used games as aggressively as possible. With a competitor around, GameStop may have to price its offerings a bit more attractively. GameStop’s used game margins have also been declining since 2008 as the chart below shows.
It makes sense to include continued margin pressure in any valuation models, but a significant loss of revenue is farfetched at this point.
Digital Distribution
Digital distribution of video games has been a looming threat against GameStop for the past few years. The Bears claim that brick and mortar retailing of video games will go the way of the in store music retail and video rental industry. To them GameStop is the next Blockbuster or Tower Records.
To see if that claim is true let’s first examine a dying business with a terminal condition. How does it look? Take, for example, Trans World Entertainment, which at one time owned just about every major record store chain in existence (f.y.e., Camelot, Coconuts, MediaPlay, Sam Goody, Suncoast, Strawberries, etc). While niche record stores still may have a place, the mass consumption of music has definitively moved online.
The chart below shows Trans World’s Revenue, Gross Profit, and EBITDAR (that is, earnings before interest, taxes, depreciation and amortization, and restructuring charges). I chose this measure because I wanted to look at how digital distribution was affecting Trans World’s business. I was not interested in accounting decisions, corporate decisions such as restructuring, financing decisions, or tax decisions with Trans World; I just wanted to see what was happening in their core business and how those stores were being affected by the transition to digital distribution.
As you can see, the company’s acquisition binge kept top line revenue relatively steady for awhile, but the bottom line measures of profitability steadily declined.
The following chart shows the year-over-year change in comparable store sales with important events in digital distribution marked in callouts.
Again, you can see the effect that digital content is having. Starting with the introduction of Napster and the popularity of mp3s, same store sales begin to decline. By the time iTunes Store is introduced in 2003, same store sales are in a free fall.
Now that we know what a dying retail business looks like, let’s take a look at GameStop. The chart below shows revenue, gross profit, and EBITDAR from 2002 to 2010.
By all measures the business continues to generate healthy top and bottom line growth.
The following chart shows the year-over-year change in comparable store sales with important events in digital distribution marked in callouts.
Again, the chart shows nothing to be concerned about. As GameStop is a global retailer we should expect to see some cyclicality in y-o-y same store sales. But the introduction of Steam in 2003, Xbox Live and Steam offering of third party software in 2005, and Playstation Store in 2006 has not translated in to any significant problems. In fact right after their release we see GameStop post three successive years of double digit same store sales increases.
We saw the introduction of disruptive technology in the form of digital distribution impact Trans World right from the start of its introduction. Steam, with an estimated 70% market share in digital distribution, was released in late 2003. In 2005, the first publisher partnerships began. In the interim years, it has yet to have a significant effect on the top or bottom line of GameStop. It’s been five years and we are still waiting on the death spiral in GameStop’s business to appear. To be sure, digital distribution will have some impact, but GameStop is still growing.
Valuation
With all the unknowns facing GameStop, and the uncertainty every company faces, one of my favorite ways to approach valuations is to use James Montier’s suggestion of a reverse engineered Discounted Cash Flow (DCF) model. Instead of making guesses at every variable (garbage in) and getting garbage out, just see what the current market price is implying by working backwards. Of course, we still have to make some assumptions around the discount rate to use.
We will use a simple two-stage DCF model, with the trailing twelve months cash flow of $447M as the starting amount. We will use a discount rate of 11%. GameStop’s cash balance of $289M is added back to the ending valuation and the long-term debt of $448M is subtracted.
In order to justify a price of approximately $20, GameStop would need to see free cash flow drop by 7.5% each year for five years before finally leveling off at a 1% long-term growth rate. Clearly, the stock is trading at depressed levels based on the market’s fear of declining revenue and margin compression.
Summary
GameStop faces some very real risks over the coming years, but most of those risks are already incorporated into the stock price as we have shown. For investors willing to take a risk, GameStop offers the chance of a substantial reward. Conservative investors, however, might want to look elsewhere as GameStop has no asset based downside protection.
Disclosure: Long GME