Is Gamestop Overvalued? – Supporting Arguments

Consumer Confidence Will Hurt Future Sales and Projections:

The beginning of a new videogame console hardware cycle impacts Gamestop not just in the sale of new hardware (where Gamestop’s gross profit margin is 7.6%), but starting another generation of game software that will fulfill future demand. The last console cycle started in 2005 with the Xbox 360 launch and in 2006 with the Nintendo Wii and Sony Playstation 3 launches.

The “next generation” of videogame consoles began November 18, 2012 with the Nintendo Wii U and will continue in Fall 2013 with the releases of the Xbox One and Sony Playstation 4.

I argue that much of the financial success of the previous videogame consoles and Gamestop can be attributed to a broader economic conditions from 2005-­2008.

Using the Consumer Confidence Index, the last console cycle which launched in 2005­-2006 began near the height of consumer confidence and spending in recent history. It’s very possible that the new Playstation 4 and Xbox One will not sell as well as the Playstation 3 and Xbox 360 due to the change in economic climate. The poor performance of the new Wii U discussed later supports this theory.

Consumer Confidence Index

The Conference Board Consumer Confidence Index®

Is it possible that consumer confidence will either increase in the future in the middle of the console cycle or that spending on games won’t be correlated to consumer confidence? It is possible, but I suspect unlikely. Academic research has found a moderate connection between the consumer confidence numbers and consumer spending in the following quarter. [Ludvigson, Sydney, 2004, Journal of Economic Perspectives].

Gamestop’s same­ store sales the past five years are in line with a decrease in consumer spending. From page 29 of the 10K, same ­store sales growth has been:

2012: ­-8%
2011: -­2.1%
2010: 1.1%
2009: ­-7.9%
2008: 12.3%

A historical look at the Nintendo Wii’s sales through 2008 would show huge sales growth despite the broader economic conditions, but Wii sales began to slide in 2009 and continued until the present day. All three systems saw sales rise during the typical cyclical holiday seasons in 2007 and 2008, but the systems with the largest sales increases were the cheapest, with the PS3 lagging due to its higher price at the time. These were systems which had already been on the market for two to three years with a library of games for sale.

Poor Wii U Sales:

The Wii U has been a disappointment since it launched on November 18, 2012. As of March 31, 2013, only 3.45 million units had been sold, well short of its originally estimated 5.5 million. At the E3 industry conference last week, only three new Wii U exclusive titles were announced.

A comparison between the second months of the Wii and Wii U shows the stark contrast in the current and likely future performance of the Wii U. In January 2007, the Wii’s second month, the Wii sold 425,000 units. In January 2013, the Wii U’s second month, the system sold 57,000 units, 13% of the number of Wii units sold at the same early point in the system’s launch near the end of a holiday season.

Fewer consoles sold likely means less software sold. Less new software sold means fewer used games down the line. Nintendo announced in May 2013 that it had missed its profit goals by nearly 50%.

Whether the lackluster Wii U sales are due to lower consumer spending in general or mismanagement by Nintendo, lower hardware sales will translate into lower software sales for Gamestop. This should give pause to investors expecting that the other console launches later this year will be guaranteed successes.

Game Streaming Plans In Motion:

Sony and Microsoft have both made investments into technology for streaming games over the internet. Once game streaming becomes mainstream and gamers can access games over the internet on demand, this will have a negative impact on disc­-based game sales.

In late 2012, Microsoft hired a number of employees from the bankrupt OnLive game streaming technology company.

At the E3 convention, Sony confirmed that it will launch a game streaming service in 2014, starting with older games that are commonly sold as used games at Gamestop stores. This technology comes from its acquisition of Gaikai earlier this year.

Microsoft and Sony are both moving toward implementing these game streaming technologies in some capacity, cutting out retailer middlemen between them and game consumers. This allows potentially lower prices for gamers and a bigger cut of the sales for the console manufacturers and game publishers/developers. For these reasons, the streaming alternatives will be compelling for all parties and only detrimental to the retailers such as Gamestop.

Gamestop acquired Spawn Labs in early 2011 to develop its own game streaming offering. Since the acquisition two years ago, the only news to come from it appeared in the Fiscal 2012 10K: “Spawn Labs is developing a streaming service which the Company may deploy in fiscal 2013 depending on consumer demand and other factors.” It claimed a year ago that it would have a beta test of its system in homes across the country. The latest 10K in May had no updates on this.

With Sony and Microsoft having a direct connection to living rooms with its hardware and technology further along than Gamestop’s, it is hard to see where Gamestop’s Spawn Labs product can get a foothold in the game streaming marketplace.

Gamestop is a Late, Minor Player in Digital Downloading:

The leader in digital game downloads is Valve’s Steam store, which in 2010 had an estimated almost $1 billion in revenue and $300­$400 million in profit for Valve. Steam holds approximately 70% of the digital download market, compared to Gamestop’s Impulse service’s 10%.

In its filings, Gamestop claims $630 million of “digital receipts” in fiscal 2012. This number is deceptive because it includes the in­-store sales of “DLC” cards, which are “downloadable content” points for Microsoft and Sony network stores. While this business has 38% gross profit margins, these points can be bought in numerous places and directly from Microsoft and Sony. By grouping the Impulse store sales with these DLC cards into an “Other” and “Digital Receipts” category, Gamestop is able to gloss over the underperformance of Impulse. The fiscal 2012 10K states the above $630 million in “digital receipts” but $593.4 million in “Other” in­-store sales, a category including the brick-­and­-mortar digital content sales. The $36.6 million gap is possibly attributable to Impulse sales (this is not made clear in the 10K). Assuming Gamestop’s cut of the store revenue is similar to Steam, then Gamestop’s gross profit from Impulse is approximately $10 million to $15 million, an almost insignificant amount compared to its $2.651 billion in annual gross profit.

Competition from big box and online retailers:

This argument is straightforward: Gamestop does not offer much that other retail stores do not. Wedbush Morgan analyst Michael Pachter has stated that, based on the previous hardware cycles, “It appears that once hardware supply was sufficient to satisfy demand, gift givers tended to purchase hardware when it was convenient, causing a market share shift from destination specialty retailers in favor of more frequently visited mass merchants,” said Pachter. In other words, Gamestop will play a significant role this Fall in selling new console hardware, but over the hardware lifecycle, Wal­Mart and Target reach more consumers.

Amazon has already sold-­out its allotment of pre­-orders for the Xbox One and Playstation 4. The advantages of Amazon as a retailer for most physical goods, including videogames, is well-­known, especially around ordering and shipping convenience and product availability.

Over-­reliance on Pre-­Owned Software:

A lot has been written on how Gamestop’s business is driven by used game sales. In the latest 10K for Fiscal 2012, Gamestop showed that 44% of its Gross Profit comes from pre-­owned game and hardware sales, which have 48% margins. All of the previously listed threats to its business would ultimately hurt the availability of used games.

A great breakdown of the problems Gamestop will face if its pre­-owned business suffers was done by Gamasutra writer Matt Matthews:

“In terms of New Software, as GameStop has repeatedly noted, customers put $7 out of every $10 in trade value back into new game purchases. If the margin on pre-­owned software is reduced, then GameStop could respond by offering less trade value to consumers ­­ and that would reduce the available trade credit to go toward new games. Therefore when consumers are trading less in at GameStop, publishers can expect to see retail sales of their new games go down as well.

Alternatively, if GameStop continues to offer aggressive trade­-in values, it can still retain some of its pre­-owned product margins by raising the price it charges the consumers who then buy those pre-­owned games. However, raising its selling prices would make GameStop’s pre-­owned products less attractive to consumers, and decreasing the net sales in its Pre­-owned Product segment.

Even GameStop’s Other segment, where it puts its digital revenue, could be harmed by a change in its pre-­owned business. GameStop has been at the front line of attaching DLC purchases to games sales, both new and used. If either new or used software sales decline at retail, it is quite likely that retail DLC sales will go down as well. Consequently, harming GameStop’s pre-­owned segment also diminishes its digital business.“

Next: Discounted Cash Flow Vocabulary
Previous: Introduction and Thesis

Is Gamestop Overvalued? – Introduction and Thesis

Note: This blog series describes an investment idea in retrospect that was analyzed and predicted months ago.

As evidence that the research and pick was made in June 2013, I directly reference those that saw this analysis last year.

Bill Babeaux – Instacart
Adam Millat – Millat Industries
Andrew Virata, Marisa Mulac- JPMC
Kateryna Parke – Houlihan Lokey
Mintai Wang – Factset
Nate Palmer – Diamond Hill Capital

If someone had shorted Gamestop as this research suggests from the date in the email below to Bill (August 4, 2013) to today, they would have earned 25.28% compared to the S&P 500 return of 7.55%.

Email Evidence with Bill Babeaux for Gamestop

After talking to some of these individuals about the stock’s tanking the past few weeks, I have decided to turn this research into a series of blogs.

As an employee of JPMorgan’s Investment Bank, our trading and social media presence is supposedly limited. However, since I am not on the side of the business that would deal with Gamestop’s stock and the move has already occurred, I feel that blogging my research is worthwhile.

These guides are meant to be informative so you can use them to learn finance and value companies yourself. Stocks are constantly moving. Although I believe Gamestop still has further to drop, the analysis presented here is already somewhat out of date.

Last note: The research is also available for download.

An Introduction to Discounted Cash Flow Analysis:

How do I know if a stock price is too high or too low? How do I know what to buy and sell? These are the basic questions most people ask about stocks. My goal is for this blog series to give my readers a glimpse into the techniques investment bankers and professional investors use to answer them.

A lot of people have heard of “financial models”, but have no understanding on what the term means. While there are numerous meanings for the phrase, most models involve using pre-existing information, putting the information into a formula, and the formula will give you the answer to your question. If, as a layman, it sounds intimidating, don’t fear; it’s mostly arithmetic.

The one particular model we will learn about is a system for taking information about a company with publicly available stock and how to determine the value of the stock: Discounted Cash Flow Analysis.

Discounted Cash Flow (DCF) analysis is predicated on one core idea: A company’s value is determined by how much cash it will make for the foreseeable future. Hence “Cash Flow analysis”. The “Discounted” word means that cash the company earns in the future is worth less than cash they earn today because the future is unknown and risky, so we “discount” future cash. This principle is called the Time Value of Money.

The next question: How do we know how much cash a company earns? This question and answer should be split into two parts: First, how do we know how much cash a company has earned in the past, and second, in the future?

Answer one is that every company with stock that is “publicly traded” (available for anyone to buy) must file publish their accounting statements with the Federal government’s Securities and Exchange Commission, the agency responsible for enforcing legislation regarding financial markets. Often companies publish these reports on their websites as well (our example company, Gamestop, maintains a website for investors). Companies have to release their financial information by law so that individuals such as ourselves and professional investors can make the very investing decisions we will make in this essay.

However, since we obviously do not know how much money they will make in the future, we have to do some predictions. This is when we can use the DCF model.

To demonstrate the use of a DCF model, I will analyze a stock I believe to be overvalued: Gamestop, the video game retail store.

Stock Price Predictions:

“Current” Stock Price (as of August 4, 2013 when analysis was finalized):

$50.29

Today’s Stock Price (February 4, 2014):

$33.83

My DCF Model Stock Price Valuation:

$23.78

Thesis:

Gamestop is the self-described world’s largest multi­channel videogame retailer. They sell new and pre­owned video game hardware, physical and digital video game software, accessories, as well as PC entertainment software, new and pre­owned mobile and consumer electronics products and other merchandise.

The original research was inspired by the idea that what had happened to movie, music, and book retailers would happen to videogame retailing as well, specifically the loss of sales to big box and online retailers with broader reach in terms of marketing and logistics, improving game streaming technologies supported by the console makers, and the digital distribution of games.

The results of the research show that Gamestop is overvalued. The management has a strong retail background and has paid down all of the company’s debts, but little to no technology expertise. Despite a large cash reserve saved from boom years and still strong free cash flow, management has elected to return this cash flow to shareholders via stock buybacks and dividends. This is a move I disagree with, as it signals to me the company is not investing enough on addressing the long term trends that will, but have not yet, devastated its core retailing business.

Next: Supporting Arguments

Is Gamestop Overvalued? – An Applied Primer on Discounted Cash Flow Analysis

This is the Table of Contents for my blog post series “Is Gamestop Overvalued? An Applied Primer on Discounted Cash Flow Analysis” where I walk through how to value the stock price of a public company based on its publicly-available accounting statements.

  1. Introduction and Thesis
  2. Supporting Arguments
  3. Discounted Cash Flow Vocabulary
  4. Starting the DCF Model
  5. Net Working Capital
  6. The Future
  7. Valuing the Stock
  8. Extending the Research
  9. Conclusion