Shares of video game retailer GameStop (NYSE:GME) have fallen off a cliff since peaking in late 2013. The stock has lost nearly three-quarters of its value since then as the market soured on the company's long-term potential.
Some good news finally showed up for weary GameStop investors on Monday. Reuters reported that GameStop has received interest in a potential buyout and is currently holding talks with private equity firms. The chance for a turnaround is pretty much nil, in my opinion, so a buyout looks like the best option for the company and its shareholders.
What's wrong with GameStop?
GameStop is not only a retailer with more than 7,000 stores being disrupted by e-commerce, but the core product it sells can be completely replaced by a digital equivalent. PC games went almost entirely digital long ago. Console games will eventually follow suit.
This digital disruption leaves GameStop in a bind. Re-selling used games is a cash-cow business for the company, with gross margins around 45% and more than $2.1 billion of sales last year. But the very concept of a used game disappears along with physical discs. That's a gigantic problem with no easy solution
GameStop has attempted to diversify, buying up stores that sell mobile phones and other devices. But the company vastly overpaid for that diversification. When GameStop reported its fourth-quarter results earlier this year, it booked asset impairment and goodwill impairment charges totaling $390 million. As I pointed out at the time, that's equivalent to more than five times the adjusted operating income generated by the technology brands segment last year.
Some other product areas are doing better. The company's push into collectibles is doing well, with $636 million of revenue last year, up nearly 29% year over year. But collectibles account for less than 7% of total revenue, not nearly enough to offset what's to come in the core business.
GameStop's new strategy is to pause investments, cut costs, focus on customer loyalty, and expand its customer base to more casual gamers. None of that solves the core problem.
Why would anyone want to buy it?
Despite the long-term uncertainty, GameStop is currently profitable, and the stock trades for peanuts. In 2017, the company produced $339 million of adjusted net income and $325 million of free cash flow. The balance sheet is also solid, with a bit more cash than long-term debt. GameStop is valued at about $1.55 billion after the buyout rumor-driven surge on Monday, less than five times annual free cash flow.
I doubt many buyout firms are all that interested in turning GameStop around. I'm not sure it's even possible. But because the next generation of game consoles isn't likely to arrive for a few years, an awful lot of cash could be extracted from GameStop before the core business faces its reckoning. And it's possible that the next generation of consoles could support discs, which may drag out the decline of the physical games business. GameStop doesn't have to be saved for a buyout firm to make money on a deal.
For GameStop investors, the alternative to a buyout is hoping that the company can figure out how to offset the continued decline of its core business. With a strategy that doesn't seem to recognize the problem, and with no permanent CEO since May, that doesn't look likely.
Timothy Green has no position in any of the stocks mentioned. The Motley Fool owns shares of GameStop and has the following options: short July 2018 $14 calls on GameStop. The Motley Fool has a disclosure policy.