GameStop is not an ordinary stock, nor is it a failing brick-and-mortar retail chain like Wall Street previously thought.


From: https://www.linkedin.com/pulse/gamestop-ordinary-stock-nor-failing-brick-and-mortar-retail-michal/

Costing hedge funds over $6bn in losses over the past six months, GameStop is not an ordinary stock, nor is it a failing brick-and-mortar retail chain like Wall Street previously thought. It is however, a very well financed and positioned startup tech-company with grand plans in the foreseeable future.

GameStop is well known for selling new & used video game hardware and software, as well as accessories through its e-commerce platform and 4,816 stores worldwide. As seen below, Hardware, Software & Accessories account for more than 90% of GameStop’s revenue, while Collectibles account for around 10% of its revenue stream. Recently the company has aggressively expanded its product range with additional categories such as computer-gaming and other hardware. As of January 30, 2021, GameStop has approximately 47.1 million members in their PowerUp Rewards program where 15.2 million members have purchased or traded at GameStop in the past 12 months.

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GameStop’s revenue has been fluctuating with no steady growth the past few years, with a heavy decline in revenue in 2020 due to the impacts of Covid-19. In addition, its net income has been declining steadily in the same period, with an income loss of 215 million in 2020.

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However, GameStop released its better than expected revenue results in its 2nd quarter of 2021 with a revenue of 1.18 billion, a 26% increase compared to its prior year. In addition, the company has virtually no current debt while having $1.7 billion cash on hand due to being able to capitalize on the recent price movements with two large equity offerings earlier this year.

The company has also recently announced an expansion of its fulfillment network with a new entry into a lease of a 530,000 square-feet facility in Nevada, as well as a lease of a 700,000 square foot facility in York, Pennsylvania. These facilities are expected to be fully operational in early 2022, and are set to help GameStop grow its product range, as well as increase inventory turnover.

Chewy co-founder Ryan Cohen joined the board in early January and hired over a dozen of executives with a strong background in the tech industry. This includes former Amazon executives Matt Furlong as its new CEO, Mike Recupero, as chief financial officer, and Jenna Owens, as chief operating officer. It is believed that the company will undergo an intense transformation in the coming months, turning into an upcoming tech company leading its e-commerce efforts that will compete with Amazon.

Financial Statement Analysis

Income Statement Analysis & Forecast

GameStop makes most of its revenue in Q3 & Q4 (Gamestop, 2021). For instance, during fiscal years 2020 and 2019, the company generated approximately 42% and 34%, respectively, of its total sales during the fourth quarter (Gamestop, 2021). In addition, GameStop had an increase of 25% in sales the past 26 weeks, compared to the same period in 2020. Net sales so far are 2,4b, compared to 1.9b (Gamestop, 2021). A 25% increase of last year’s revenue of $5.1bn would therefore result in $6.2bn in revenue. In addition, a new console cycle began with the launch of the Sony PlayStation 5 in November 2020. Combining these factors with an aggressive growth in terms of its e-commerce channels, the company may see its revenue increase to over $7bn for the 2021 fiscal year.

The forecasted revenue for the next 3 years is based GameStop’s expansion resulting in an increase in online sales and the total amount of historical sales from stores, as per market data and SEC 10Q filing, the company is forecasted to increase their revenue of 11%, 8% and 8% for the years 2022, 2023 & 2024, respectively (Gamestop, 2021). The company is forecasted to have an average of 25% online sales annually (Statista, 2021), but this number may increase due to the company’s transformation by the newly appointed senior executives from Amazon, as well as Ryan Cohen from Chewy, both with significant background in tech and e-commerce. The company has stated in its 10Q-filings that underperforming stores will no longer operate (Gamestop, 2021), and the company’s number of stores can therefore expect a 5.77% reduction yearly. The company’s COGS average historical value is around 70% of its revenue, while SG&A are assumed to account for 25% of its company revenue. The company’s number of employees are also expected to decrease, however COGS and SG&A are still assumed to be increasing due to GameStop’s e-commerce expansion and global brand transformation.

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Balance Sheet Analysis & Forecast

GameStop is currently sitting on around $1.7bn in cash due to its recent sale of equity, the balance sheet for the 3 months ending 7/31/21 have therefore been included. The company stated it would use the proceeds for corporate purposes, as well as for investing in heavy growth initiatives in addition to maintaining a strong balance sheet. The latest historical ratio of current assets, non-current assets, and total assets to revenue was applied in order to forecast the ratios for the next 3 years. Based on current shareholders equity, reverse mathematical calculations were computed in order to forecast the future liabilities (current & non-current).

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Cash Flow Analysis & Forecast

In terms of Cash Flows for the forecasted years, the average historical cash flow and the last historical cash flow were combined in order to calculate and forecast such values. Due to recent sale of equity, the 3 months ending 7/31/21 have therefore been included.Total Cash Flows from Operations are forecasted to increase drastically, while capital expenditure is set to decrease by 20% annually, resulting in the company growing its free cash flow steadily over the next 3 years.

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Stock Price

The two charts below  outline the price of GameStop, relative to the NYSE Composite index, as well as percentage change, respectively. The stock prices and composite benchmark index were collected from Bloomberg Terminal, with the closing monthly price from the last 5 years.

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Drivers of Stock Price

The past few years drivers of GameStop’s stock price have had a significant influence from the console cycle. Previous consoles (Xbox & Playstation) were released in 2006, 2013 & 2020. GME shares experienced bullish movements in the last quarter of each beginning of the new console cycles. It has to be noted that GameStop’s consistent low share price the past years is due to heavy shorting, more specifically; naked shorting. The chart below  shows the short interest for GameStop for the previous 5 years. According to Bloomberg, GameStop has a float of 63.9 million shares. As of the 31st of December 2020, a total of 71 million shares were sold short, which means 110% of its float was shorted.

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In January 2021, GameStop recently reached an all time high of $483.00 due to a short squeeze from $5.00, as seen below.

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The short squeeze ended with several brokers illegally halting all trades & implementing “Closing Transactions Only” due to liquidity issues with the DTCC (Depository Trust & Clearing Corporation). This event has resulted in hearing in Congress, and is currently an ongoing investigation involving Citadel Securities where communication showed the market maker pressuring Robinhood into halting trades (The Wall Street Journal, 2021). It is firmly believed that shorts have not covered/closed their position yet, due to synthetic shares exceeding GameStop’s float & FTD’s. A failure-to-deliver occurs when a buyer/seller is not able to meet one’s trading obligations (Fotak, Veljko, Raman, and Yadav, 2012). If shorts had covered their position, there would not have been an increasing number of FTD’s as we have seen throughout the whole year of 2021.

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In addition, recent exchange data, shows that most of the volume traded by institutions is on the dark pool, hence not affecting the share price. It should be noted that at one point, the dark pool volume exceeded GameStop’s float by almost 200% as seen below.

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Furthermore, GameStop’s current growth and stability in share price is a reflection of the investors optimism and expectations of future growth due to Former Chewy co-founder Ryan Cohen and recent Amazon Executives joining the board of GameStop.

Porter 5 Forces

1. Competition in the industry

The video-game industry is extremely competitive and therefore due for changes in customers preference as new products are introduced. GameStop currently competes with major software publishers such as Sony, Microsoft, Nintendo in terms of direct selling & digital downloads. In addition, GameStop has major competition with electronic retail chains such as Walmart, Best Buy, Target and Amazon. Such pressure may force GameStop to reduce their prices, as well as increase its spending which would ultimately result in lesser profits.Retail online sales are set to grow at around 10% annually, hence why the capitalization on its e-commerce channel is exceptionally important.

2. Potential of new entrants into the industry

The gaming market was worth well over $151 billion in the fiscal year of 2019. It is set to grow to $256.97 billion by 2025. However, entry barriers into the industry are extremely high and competitive due to a few handful companies having a large market share.

3. Power of suppliers

Unforeseen events could delay products to be delivered from its suppliers. GameStop’s suppliers are primarily in Asia, and any event with a result of a disruption of imports & exports can reduce the supply of products and therefore negatively impact GameStop’s business operations. In addition, GameStop’s ability to receive profitable terms from its suppliers may also impact its financial results. GameStop’s largest vendors are currently Nintendo, Sony, Microsoft, U&I Entertainment and Ubisoft, these accounted for 31%, 22%, 9%, 3%, and 3%, respectively, of its product purchases in 2020. Unfavorable terms from these vendors such as prices and volume provided may therefore restrict GameStop’s ability to offer competitive prices for such products.

4. Power of customers & Threat of substitute products

The gaming and entertainment industry is constantly changing and evolving, so are customers preferences and product choices. GameStop must continue to respond quickly and efficiently to both market and technological changes in order to keep up with customer demand and preferences. Failure to do so may result in a negative impact on business operations.

Weighted Cost of Capital (WACC)

The weighted cost of capital shows the company’s cost of its capital where each category is weighted proportionately (Arditti, 1973). An increase in WACC would result in a valuation decrease, as the risk increases. GameStop’s only debt is a Covid-19 related low-interest loan from the French Government.

In order to calculate WACC, the cost of equity was calculated from the 10-Year Treasury Note, currently quoted at 1.58%. The average market return of 5%, combined with a market beta of 1.39 resulted in a cost of equity at 6.34%. The beta shows the stocks volatility, in relation to the overall market (Michael, 2003).

With a current effective tax rate just below 21%, GameStop’s cost of debt lies around 2%. With a 14B market cap, its current debt and equity weigh at 0.03% & 99.97%, respectively.

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Absolute Valuation – Discounted Cash Flow (DCF)

A company’s free cash flow shows its cash that is free of any obligations and is free to use (Kruschwitz & Löffler, 2006). Current calculated forecasts show that GameStop is expected to generate over 600m in free cash flow annually in the next few years. The DCF calculation below has been discounted by WACC and shows intrinsic value of $769 per share.

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Relative Valuation

Relative valuations shows the value of an asset in comparison to the values assessed by the market for similar and comparable assets (Damodaran, 2002). Price-to-book ratio valuation was used to compare GameStop’s capitalization to its book value with its competitors Amazon, Walmart, Target & Beest Buy. The median price-to-book value between the competitors was 8.85. Gamestop’s Price-to-book value is valuated to be 6.6. A P/E value less than the niche industry’s average of 8.85 may suggest the stock is undervalued and has enough room to grow in the future, which seems to be the case with GameStop.

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Recommendation

Current share price is consolidating at around $183, with strong support at $175. Fundamentally, the DCF valuation gives the stock an intrinsic value at $769, making GameStop severely undervalued. From a technical perspective, the share price has just reversed from its support line, in addition to the MACD crossing towards an upward movement, this may indicate a bullish up-trend in the nearest future. The current recommendation is therefore a BUY. It should also be noted that Vanguard has recently increased its position by 9%. According to Nasdaq, 135 institutions increased their positions, while 123 decreased their positions. In addition, 51 out of 309 institutions have held their positions this past year.  Furthermore, a total of 69 institutions have taken a new position in the stock, while 49 have sold out of their position.

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Conclusion

Given the new structured management team from Chewy and Amazon, GameStop will proceed to increase their e-commerce presence utilizing its loyalty program with over 47 million customers. GameStop has multiple assets that will increase their success with turning into a tech company. ROA (Return on Assets), ROE (Return on Equity) and Profit Margins are all forecasted to increase for the next 3 years. Additionally, debt to equity ratio is forecasted to decrease to a healthy level. The company has been producing better than expected revenue results in 2021 by 26%. With a stock-price valuation of $769, senior executives with an amazing track record, and a balance sheet of around $1.7 billion in cash with virtually no debt, GameStop is set to increase their market share and share price in the coming months, whether it is due to another short squeeze or not.

References:

Financial Equity Data – Retrieved from Bloomberg Finance L.P.

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Retrieved October 15th, 2021 from https://news.gamestop.com/news-releases/news-release-details/gamestop-continues-expansion-fulfillment-network-new-facility

The Washington Post. (2021). GameStop Has Big Advantages Technology Startups Would Die For

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Retrieved October 15th, 2021 from https://fintel.io/sftd/us/gme

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Retrieved October 15th, 2021 from https://www.cnbc.com/2021/06/22/gamestop-jumps-9percent-after-the-original-meme-stock-cashes-in-again-with-1-billion-share-sale.html

Arditti, Fred D. “The weighted average cost of capital: some questions on its definition, interpretation, and use.” The journal of finance 28.4 (1973): 1001-1007.

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Retrieved October 15th, 2021 from https://hypebeast.com/2021/3/gamestop-fourth-quarter-earnings-e-commerce-sales

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Kruschwitz, L., & Löffler, A. (2006). Discounted cash flow: a theory of the valuation of firms. John Wiley & Sons.

Damodaran, A. (2002). Relative valuation. Investment Valuation.

Published by

Michal Gregersen
Aspiring portfolio manager & equity trader.
1 article
Costing hedge funds over $6bn in losses over the past six months, GameStop is not an ordinary stock, nor is it a failing brick-and-mortar retail chain like Wall Street previously thought. It is however, a very well financed and positioned startup tech-company with grand plans in the foreseeable future. hashtagGameStop hashtagtech hashtaghedgefunds hashtaginvesting hashtagGME hashtagcitadel

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