On this week's downer geek-themed episode of Industry Focus: CG, host Nick Sciple and Motley Fool analysts Dan Kline and Jim Gillies take a close look at these two nerd-culture companies. No one is arguing that GameStop isn't troubled, but Jim has a fair case for it being a value play (albeit a risky one). Meanwhile, Funko is trying to branch into more than just bobbleheads, but nothing is sticking as much as it needs to. What happens next for these companies? Plus, toward the end of the show: a totally unrelated-to-investing discussion of the best video games.
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This video was recorded on May 21, 2019.
Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Tuesday and we're talking about GameStop and Funko -- video games and toys. I'm your host, Nick Sciple, and today I'm joined in-studio by Motley Fool contributor Dan Kline, and via Skype by lead advisor for Motley Fool Canada Jim Gillies. So excited to have you guys on today! How's it going?
Dan Kline: This is a weird one. We were talking to Jim earlier today just to get some background. And effectively we were doing a show in a conference room, so we invited Jim on. Jim, it was very nice to meet you! Glad to have you here!
Jim Gillies: Good to make your acquaintance, finally! I've seen your writing a lot, Daniel.
Kline: Appreciate that!
Gillies: Just, one weird thing led to another, and we're going to talk about one of the more interesting names in my universe, at least.
Kline: And we're going to argue about it a little.
Sciple: We'll do GameStop off the top. On the back half of the show, we'll talk a little bit about Funko. 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 through 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 pre-owned 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.
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 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?
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. 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, 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. So 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-foot, 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 it'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 million 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. The problem is, looking forwards, this year will probably be fairly lean. And then 2020, with the next console cycle, what does that look like? What level of physical games are being maintained at that point?
When I say "free company," I mean literally when the company's enterprise value is less than its net cash balance. There's a bit of a trick there, obviously; a lot of their cash comes in around the holiday season, and they don't pay for their working capital until after the holiday season or the current quarter. That $800 million is going to fall over the first half of this fiscal year. They'll probably burn about $400 million, $450 million maybe, over the first two quarters. It's hard to say because they did divest those other operations. And then they ramp up in the tail end of the year, and that's when the cash flow comes.
But it's hard to call a valuation. You can say, "Oh, they're trading at 1.5 times enterprise value to EBITDA" [earnings before interest, taxes, depreciation, and amortization]; any valuation ratios you quote make no sense right now, and have made no sense for a while. On a discounted cash flow basis, they still make no sense.
If you assume they will continue to be free cash flow positive, then they've got no problem getting rid of all of their net debt as it comes due. The next one, I believe, is March 2021. And it's still throwing up cash flow. But to go back to Dan's earlier point, how fast are they being managed to zero?
Kline: Right. One of the challenges is, a lot of times, you look at a company like this that's struggling, and you can see a logical pivot. The only logical pivot here was pay-for-play virtual reality, in-store gameplay. And more and more malls have those as stand-alones, [but] the GameStop footprint largely doesn't lend itself to that. They're generally smaller, crammed stores. I've been in retail, I've run a toy store, we've talked about this a lot of times. You look and go, OK, what's the retail niche that they could jump into that would be adjacent? Hot Topic T-shirts? There's no obvious play here. Will they add self-serve frozen yogurt to all the stores? Sell gelato? Just, since they got out of the cellphone business, which was a logical adjacent, it doesn't seem like there's anything other than little incremental things. And if you don't need a video game, I doubt you're going to GameStop to buy Pokemon cards or whatever other thing they might sell.
Sciple: Yeah, I think this is one of those where, if there is a meaningful floor up underneath these operations at some point, like what Jim was talking about with backwards compatibility, that's going to keep people coming back and put a floor up underneath that decently high-margin used business; there's clearly some valuation here. However, if we continue to see that decline, and the free cash flow that they're generating starts to stutter or move down, the valuation may fall apart.
But I think what this company is an example of, at least in my experience: If you're going into investing when a company has a value play, and you feel super, super comfortable that everything's going to work out perfectly, it's probably not as good of a value as you think it is.
Before we move on to Funko, any last things you guys want to mention on GameStop, and what to pay attention to going forward with this company?
Kline: It's not an immediate risk. I think this isn't Radio Shack, this isn't a company that's out of money on its fifth chance. It really is "healthy Grandma." If she falls ill, it might be three years, it might be 10, but she's not going to live to be 140.
Gillies: Yeah, I...I'm struggling with the "healthy Grandma" metaphor right now. I feel like we're talking down Grandma. But, no, I think, watching the new CEO, what he does, he does have -- I believe they called it "substantial retail experience" in the glowing press release when they hired him. But we really don't know anything about him or what his strategy is going to be. They just filed their proxy statement last week; I have not had a chance to read it yet. We literally know nothing about what his strategy is going to be. Now, I would presume -- and this may be dangerous -- I would presume they hired this guy because he was able to go into the job interview and lay out a vision for where he thought GameStop could go. I would hope they would hire a CEO based on that criteria.
Sciple: [laughs] Right.
Kline: [laughs] They went based on height.
Gillies: Yeah, like, he knows a guy who knows a guy. But, I would assume that he went in with some sort of a vision, and that we are going to see in the weeks and months ahead the initial steps for that vision coming to fruition.
I don't disagree terribly much with what Dan says. There's no obvious pivot. The pivot they did try to do -- obviously, the other pivot too is, I'm old enough to remember GameStop before the collectible stuff. And now collectibles are everywhere. In certain stores, they're cluttering the place up. In other stores, as I said earlier this morning on our private call, the store in my town at the mall, it's a couple of miles away from the house, they went from a small, cramped store, well-packed-in, to a store that's easily two times the footprint, and...everything that Dan is not seeing in Florida, everything he's saying he's not seeing in these stores, I'm like: "Come to Guelph, Ontario; I'll take you to the one in the mall downtown." It's exactly what you're calling for. If they're going to go for those types of remodels, you go and you can play the games, that sort of thing.
I want to see what the CEO does. A 19% dividend clearly says the market does not believe that your dividend is adding any value. You may as well cut it to, oh, I don't know, 8% to 10%, which is still far more generous than anything else out there, as long as you're going to use the cash for something value-accretive. They have a $300 million stock buyback. The only thing I know from the proxy, which was, as I said, just released last week, the only thing I checked, they have not bought back any stock between announcing that program and the proxy that came out -- a little disappointed in that.
The last thing I would say is that they had a couple of very small activist investors sniffing around. Somewhat strangely, GameStop welcomed two of their director nominees to the board. Because these guys don't own enough, I would have thought they would have brushed them away; I think they only own about 1.5% total shares. But they welcomed a couple of new people on the board. I'm assuming they're not there to collect $50,000 a year in director's fees. Again, I'm assuming that someone has a plan. One of those small hedge funds, the activist, I think he's been an investor since 2012. I'm looking to see anything concrete from these guys. Do you have ideas? Because right now, Dan sitting here saying, "There's no obvious idea": OK, GameStop, there's the gauntlet -- it's thrown down by Dan Kline.
Kline: Now, if I said there was an obvious idea, will they put me on the board? [laughs] Because it really seems that they are looking for ideas.
Gillies: They are looking for ideas, because the one that they did go with, the tech-brands initiative, the rug got pulled out from under them there.
Kline: Walk-in medical clinics? Cannabis sales?
Gillies: Hey, cannabis sales! But, no, I'm watching to see what's going to happen. I'd like to see things that, obviously, are value-accretive. In a world where Redbox can get acquired -- which, I mean...Redbox was acquired, I think, at about 4.5 or 5 times EBITDA. GameStop is trading way below that, and yet they couldn't sell themselves. Find me a more pessimistic stock out there that has the quality of balance sheet and cash flows currently. Clearly, people are suspecting or seeing that there is no future here. They're all on Dan's side, is my point.
Sciple: Yeah. For our listeners, we are taping this on May 21st. You'll get this episode probably right after GameStop has reported earnings by the end of May. It's very possible that, by the time you hear this, GameStop's management has laid out their entire reorganization strategy and makes us all look really dumb. But we'll see how things go. Really interesting business. Classic valuation story, where the company's left for dead, but there could be some real meaningful opportunities to squeeze some more value out of these assets.
Jim, you mentioned how collectibles are becoming really hot and a bigger and bigger part of what people are consuming. That ties in right to the company we're talking on the back half of the show, and that is Funko, FNKO. I think both of y'all are collectors when it comes to these sorts of things. Before we dive into this company, do y'all own any Funko Pop figurines or any of those sorts of things in your own personal collections?
Gillies: I'm staring at one right now.
Kline: I don't, only because when we moved from Connecticut to Florida, I downsized dramatically. Everything I bring home, I have to throw something out. Or else, yes, I absolutely would have some Star Wars Funkos.
Sciple: Funko was founded in 1998, went through several rounds of ownership. The founder sold it in 2005. It's bounced around through a few private-equity holders, but it IPO'd [had its initial public offering] in 2017. Fell more than 40% on its first day of trading, was the worst-performing IPO since the year 2000 when it came onto the market in November 2017. Closed at around $7 on that day, but has since tripled, and today trades around $21. Which goes to show, we hear about Uber and all these other IPOs -- now, I have my own skepticism around these companies -- but just how you perform on your first day of trading does not necessarily mean where the stock will end up long-term.
To give an intro into Funko if folks aren't familiar with it, 81% of their revenue comes from Funko Pop figurines. They're little bobblehead toys stylized with a bunch of different licensed characters that they use to sell their products. They call themselves a leading pop-culture consumer-product company, that they are an index fund of pop culture. They have over 672 active properties sold in 2018 -- talking about Star Wars, Harry Potter, NFL, video games.
It's interesting when you look at this company's story. They sell themselves as this index fund of lots of different brands, but at the same time, it's a one-product company where 81% of revenue is coming from this one product. When y'all look at this as an analyst, what are your thoughts?
Kline: Let me give you a little context here. This is a product that costs between $7 and $25 depending on the exclusivity, a little bit of the workmanship, that you can't play with, that you don't need. This is Pogs 2.0; these are Beanie Babies with Star Wars faces. It is a fad that will pass, and at some point, kids won't think these are cool. I'm not saying it goes to zero, because 45-year-old men may still think they're cool; again, we're pretty good at that. [laughs] And there might still be a market for the Star Wars and the Game of Thrones and some of those licenses. I see zero way[s] this is a pop-culture phenomenon on the level it is -- it may still grow, but it's going to burn out. There is a long history of fads like this burning out. This isn't Hot Wheels cars.
Sciple: I remember, when I was growing up -- I'm a child of the '90s -- I remember the Beanie Baby explosion, when all those sorts of things were happening. You can definitely see the comparisons there to Funko. However, it was interesting to me how you think of a company like this that pushes out a lot of different exclusives or different variations of products, that long-standing brands -- brands like Harry Potter and Star Wars -- make up almost half of their revenue. They're less driven by these cyclical pops of "Avengers is in the news this year," and that drives a lot of sales. That was interesting to me.
Another interesting thing to me was their retailer breakdown. We talked about GameStop on the front half of the show. GameStop is their largest retail customer, a 9% customer. Also, one of their largest customers is Hot Topic. We just spent the first half of this show ragging on GameStop and legacy mall retailers, their prospects going forward. When you see that a meaningful -- at least, if you combine GameStop and Hot Topic together -- a meaningful part of their business is from those companies, does sales slowing over time concern you when you look at this company? Obviously, you compared it to Beanie Babies, but when you layer that on top of their retail strategy, what are your thoughts there?
Kline: I'll let Jim go first because I talked on the last one.
Gillies: First of all, I don't know if you've got the camera on, but I'm going to hold up my little Funko here of Boba Fett. I live in a collector house. Dan says 45-year-old men still think these are cool. I will disclaim that it's not the man in this house who's the main collector. My partner is a rabid collector of a bunch of things. I think she's trying to keep GameStop in business. But, we're on Funko here.
Because I go to the comic cons, people are rabid for these things, and I'm not sure why. But I can tell you, there are several dozen of those in this house alone, because people do love them. And some of them, yeah, I think Dan said they're $7 to $25, I wish some of them were $25; if you get a rare enough one, you're paying more. And people seem to love them. Maybe people loved Pogs -- I don't really remember the Pog craze. I certainly don't hear from Pog much anymore.
I said earlier privately between us, today is the first day I've known that they are public. I had no idea these guys were public. I look at them as such a one-hit wonder I just figured they were owned by one of the giant toy behemoths, or by private equity that has a perfectly good little business: It's hot, you're selling them. But knowing these are public, the first thing that came to mind was, I would be scared out of my mind to own this thing stand-alone, because I look at it and say, "That is a one-trick pony that they're offering."
The breadth of their offerings is massive. Yes, you get Star Wars, Harry Potter. You can get Princess Diana and the Royal Family if you want. You can get any pop culture. They're everywhere. And they continually are releasing new series. The one I have here that I held up a minute ago is from Star Wars like series eight, but there's a bunch more, focused on this movie, or the classic characters, or Rogue One or Last Jedi or whatever.
Kline: Boba Fett dressed as Santa. There's every level of gimmick here.
Gillies: Yeah, there really are. You loved the second Fantastic Beasts and Where to Find Them movie, now you can buy the Johnny Depp knockoff. I can't imagine how many of those they made, but you know they had to make some run.
Kline: And they're going to have to take buybacks, or you're going to see -- and you're seeing it now in Five Below -- the oddball ones that didn't sell, Johnny Depp's sidekick in Fantastic Beasts, or not R2-D2 but R2-B4: Those are showing up in Five Below, and you're going to start to undercut the market. It's very hard to maintain a hot product. Give me one example ever of that happening if it's not a playable product: Barbie, Hot Wheels, but those are toys. This isn't a toy.
Sciple: Yeah, it's going to be interesting to see how this progresses. I don't know what the right word for it is; I've heard "nerd culture" thrown around. It's becoming a bigger and bigger influence in our society today. You look at Funko, this company's been around since 1998, and for me, I only really started noticing these toys in stores maybe the past three or four years. It's really started exploding in the past few years. Again, talking to those trends, in an analyst report that Funko sent out, they called out the average age of their customer as 35 years old; to Jim's point earlier, 51% female, which surprised me. I had the image in my mind of what Dan was talking about, of more of a nerdy, masculine type of buyer.
Kline: But, female, not necessarily buying it for themselves. Mom buys the birthday gifts in a general, broad, super-stereotypical sense. Again, having been in a toy store: During the week, Mom comes in; Dad comes in on the weekends. There's a much better chance Dad's buying himself a model or a collectible, and Mom is buying it as a gift. So, that stat's probably a little misleading.
Sciple: Yeah. Again, if you look at some of their operating metrics, net sales have been moving consistently up and to the right over the past several years; gross profit as well. However, net income has been more or less flat the past several years. You look at this, this is a toy company trading at 53 times earnings. Again, we've shared our doubts about it being more or less a one-product company. Do either of you see a path to where this could justify this valuation? Or, is this just one of those we think is going to fizzle out?
Kline: No, Mattel's going to buy them.
Gillies: I was going to say... but, the only problem is, Mattel and Hasbro, both of those have been struggling in the past little while. I follow Spin Master, which is a Canadian toy company. They have been struggling in the industry, and yet they're positive free cash flow and they're at least moving earnings in the right direction, as opposed to the big two, Mattel and Hasbro, which have really struggled. I'm hard-pressed to remember which one has done worse recently if I looked at all three of them, with Spin Master.
Yeah, Funko will get sold to someone. Again, if they are the Pogs 2.0, as Dan calls them, I would hope they would have the great good sense to sell before the bell tolls midnight. I have a research report up on the one screen here, and looking at some of the consensus estimates going forward, I won't bore you with numbers, but I'll summarize it as, they're dreaming in Technicolor if they think they're going to get these numbers here. Like, the net margin is going to go from 1.5% to 12% in the next three years?
Kline: They also talk a lot about diversifying their product base, but the way they talk about it, historically, has been a challenge. One of the areas they're saying is, "We have all these licenses, let's build games." Again, toy-store experience: People buy games based on gameplay. There is a very limited market for Star Wars Trivial Pursuit. There is a very limited market for games set in the Harry Potter universe. It's very hard to have a sustained hit in general in games. I don't see this, like, very obvious pivot. Now, they could make action figures. They could do other things. But those are different licenses, they're different fees. They are kind of looking for the next hit in an area that -- who would have predicted the first hit? I mean, they're bobbleheads. It's a stupid product. [laughs]
Gillies: As an owner of Star Wars Trivial Pursuit, I'm going to defend that a little bit.
Kline: Me too.
Gillies: The original, not the recent one.
Kline: I have the one where R2-D2 is the die.
Gillies: Is the die, yes, yes. That's the one I've got. I've got to hold it up here, that's your typical Funko. It's a squat little figurine based on whatever pop culture you're looking at. I have seen in some of the stores I've been in recently, they are trying to branch out into not bobbleheads, but almost a playable action figure. I usually look at them and go well, "That's not a Funko, that's not a Pop." I'm in agreement with Dan here. Everything to where they need to go is...
Kline: Just to quickly wrap up, because I know we're running out of time, the one potential saving grace here -- and the technology is not there yet -- is if they could move to a 3D-printing in-store model, and all the stock ones. The problem is the cost of that, and the time. You might put in, "I want my R2-D2," and then walk around the store for 10 minutes. You're not going to put it in and come back a week from Wednesday, like buying glasses. So, as much as that technology is possible for one-offs, it isn't there for mass production. But if it ever is, toy stores are going to be one of the first places where you see printing of stuff like this, because it gives you inventory control. That could be a saving grace for the company, but it will be a division of somebody else by then.
Sciple: Yeah, it will be interesting to watch. One last thing to call out, you talked about acquisitions. There's still, at least from what I saw on S&P Capital IQ, over 40% of their shares are held by private-equity, venture-capital-type investors. Of course, those types of folks, sooner or later, are going to be looking for a liquidity event of their holdings, and obviously, selling the company would fit to that narrative as well.
We'll see how things go. I think, both of these companies, you take them together, are very interesting. You've got Funko, part of this trend toward more collectibles as being part of culture -- Avengers, Star Wars, all these sorts of things. The operations of the business really are moving up and to the right in a significant way. But the valuation looks a little iffy. You compare that to a GameStop, where the operational part of the business is clearly deteriorating over time, but the valuation might look appealing on some of those metrics. Two examples of companies touching these trends, video games and collectibles, that are really becoming bigger and bigger parts of our culture, and two different sides of those trends.
Thank you guys so much for coming on the show! We'll look forward to having you guys on again soon.
Gillies: Thank you!
Kline: Thank you!
Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass! For Jim Gillies and Dan Kline, I'm Nick Sciple. Thanks for listening and Fool on!