Does GameStop Have a Path Forward?

GameStop (GME 3.20%) sells video games, and that's a market that's moving online. The company has seen a big drop in its share price, and that's partly because the market for used video games has slowly gone away. It's possible there's a bottom to sales moving to digital, but it's equally likely that selling physical game discs is going to disappear. That does not mean the company isn't a value for investors today -- even though it has a bleak future. Bull Jim Gillies and bear Dan Kline weigh in on the prospects.

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This video was recorded on May 21, 2019.

Nick Sciple: GameStop, obviously, most people will know, video game retailer. If you've been to a mall in the past 10 years, you've probably seen it there. Traditionally, it's been a business that has driven a lot of its sales of used video games and those sorts of things. You come into the store, you trade your games in, and you buy some used games on the cheap. However, as video game sales have moved online, its operations have really started to struggle. Shares are down 71% over the past three years and 36% year to date.

First off, again, you look at those preowned video game products, that's 22% of their sales in 2018, down 13% year over year. Their highest-margin part of the business. As you see that starting to deteriorate on the operational side of the business, what do you guys as analysts think when you take a look at that? I'll let Dan go first off the top.

Dan Kline: In my opinion, this is a company that's being managed really well to zero. I know there might be a bottom for the end of the physical video game. We all talked about books, "No one's going to buy a book." Well, it stopped at about 50%, but there's a sort of something lovely about owning a book. There's nothing lovely about owning a CD. There's no benefit. They don't even give you a booklet half the time anymore. I download most video games I buy because if you buy it in the store, you still have to do the three-hour update. As internet connections get better, more and more people are going to do it this way. There's no reason to go to GameStop other than to buy the lowest-margin games. And when you're looking at Microsoft saying they might move to a model where you lease an Xbox and it doesn't have a disc player, that's a big piece of the market. And it just seems to me that there is no reason we need physical discs. They're going to go away. And then, what does GameStop sell? A couple of T-shirts and some collectibles?

Sciple: Yeah, that appears to have been the move, to try to focus more on collectibles and accessories. Obviously, Fortnite has been a huge thing, all the rage in the past year or so. That's driven a lot of sales in video gaming accessories, headsets, things like that.

Jim, as you look at the operational part of the business, like Dan said, you're going to see physical video game sales appear to trend down over time. They do have some opportunities in collectibles and accessories. When you look at their operations big picture, what are your thoughts on their prospects moving forward and whether they have a chance to stabilize by moving into these other verticals?

Jim Gillies: If we're going to play a role here with Dan as the bear, I'll be the tepid bull. I will say tepid because I've been maintaining an options strategy on GameStop for going on 10 years now on and off in the various services I operate. That options strategy has been to basically sell the upside. You probably don't think there's much upside, this. But beyond that, I'll talk a little bit about the arguments that Dan is making. I don't necessarily disagree with them, to be honest with you. But I would counter that with saying that 10 years ago, when I first started doing this strategy that I've employed along the way, those were the same arguments -- physical games are going to go away, everything will be downloaded, the PlayStation insert number here or Xbox whatever number they're up to will come without a physical drive, everything will be downloaded. And that has not yet happened. The next generation, Microsoft itself leasing, sure. But, as a rebuttal, PlayStation for the PlayStation 5, which is looking like Christmas 2020 rough delivery, they're saying that they will continue to have a drive, they will continue to use physical media, and they will actually be making it backwards compatible with the PlayStation 4. All of those games that you're going and buying from GameStop for $5, that retailed for $70 a year earlier, GameStop will still be getting that piece.

I don't necessarily disagree with the direction of the company. I think you'd be very hard pressed to disagree with it, to be honest with you. But I perhaps disagree with the speed. I have disagreed with the speed for most of the time --

Kline: I'm not making any call on speed. It's kind of like, Grandma's 90, she's in really good health --

Gillies: [laughs] But she's 90.

Kline: But she's 90. You've seen some GameStop stores, we talked about earlier, that have done a transformation, that have changed their merchandise. I've been in, I'm going to say 15, 20 GameStop stores in multiple states, multiple ones in the state of Florida where I live, and they're all about the same. They're all that 2,200 square feet, crammed with games, hard-to-find stuff. There's no ability to play. They might have the station where you can play, but it's turned off because they don't want kids playing. You said they updated the one at the mall near you. It's much bigger, it's in a great location. I haven't seen a company commitment. They have a new CEO. They talk very vaguely about transformation, but so far, their transformation has been to talk about transformation. I don't see what they could pivot to, the way Barnes & Noble has stabilized by adding a whole bunch of other categories -- and even then, stabilized, not done well.

Sciple: To square that off, management agrees that operations are going to continue to deteriorate. If you look at their guidance for fiscal year 2019, they're calling for comp-store sales down 5% to 10% and total sales down around the same amount. But just because the operations of a business are deteriorating over time does not necessarily mean that there's not some value to be squeezed out of the business. Everybody hears about Warren Buffett, when he was up and coming, the cigar butt stocks -- companies that don't have much of a future, but you're buying $1 for $0.50 today. There's some argument to be made that there's a little bit of that there with GameStop from a value investing point of view. This is a company that has $800 million in net cash on the balance sheet, and it's trading at a market cap of $800 million. When you take a look at that from a valuation point of view, Jim, what opportunities do you see here to maybe buy a cigar butt here with GameStop that's left for dead, but there's a little bit more juice to squeeze out of it before all is said and done?

Gillies: I'm going to commiserate a little with what Dan said there. The location near me has improved, but they lost a year, and they were diversifying, they were trying to pivot, to use Dan's vernacular. They went into their tech brands thing, where they were selling AT&T services, DirecTV services, some Apple stuff through their Simply Mac stores. And they had some issues there and they've ultimately now divested themselves. So they lost some time trying to do what Dan was asking, what could they do.

The other thing is, they hired, clearly, the wrong CEO, because he was out in three months. So, they've now brought in a new guy. We've literally seen nothing from him. Those things have probably made their circumstance worse.

But, as you say, $800 million in net cash on the balance sheet, stock's selling for $800 million right now. I like to joke it's a free company. But the issue is, what is the future going to bring? Last year, depending on how you want to measure it, they did about $230 to $250 million in free cash flow. They had a 19% dividend yield. That's not me stuttering or something, I actually said 19%. That costs them $155 million to fund. So, on a looking-backwards basis, they've got money to spare.