GameStop Buyout??? Not Likely

Saw this (below) in Barron’s over the weekend and felt compelled to address it

Interested in an industry-leading company with a strong balance sheet and trading for just five times earnings?

Then consider GameStop, the nation’s top videogame retailer. Its stock fetches about $17, or 5.4 times estimated 2012 profits of $3.15 a share. The debt-free outfit, which operates more than 6,600 stores, has about $2.50 of cash per share and pays a 3.6% dividend.

“GameStop is stupidly cheap,” says Michael Pachter, an analyst at Wedbush in Los Angeles, who has an Outperform rating and $33 price target on the stock (ticker: $GME). “The mentality on Wall Street is that all physical media for entertainment is going away. Hedge-fund managers who are short think everyone will download. They assume everyone in this country is like them, with state-of-the-art everything. They need to ask their drivers and nannies how they get their content,” Pachter adds.

Let that sink in. “How they get their content”. I think maybe we could start by asking them where they get their movies from? Blockbuster? Hollywood Video? Any other of a dozen video stores that no longer exist in their neighborhoods? Maybe we could just as easily ask when/where the last time they bought a CD was? Tower Records? …the easy answer is both are virtually exclusively downloaded. As I have said before, I agree not ALL content is going to download, it is just that the physical content delivery of just video games isn’t a $2.4B business.

It does appear that $GME know this, despite what Mr. Pachter may think as they have move themselves into the download/online game space  AND are diversifying away from physical delivery of games in trying to become a second hand seller of used “refurbished” $AAPL products.

ANOTHER RETAILER WITH AN even more challenging outlook, Best Buy, received a takeover bid last week from its founder, Richard Schulze. With the possible help of private-equity firms, he’s proposing to pay $24 to $26 a share for the 80% of the company that he doesn’t already own.

GameStop also could attract private-equity or other financial buyers, given its digestible stock-market value—$2.2 billion versus Best Buy’s $7 billion—and super-low valuation. The stock is near a seven-year low, having slid 18% in the past year, even though GameStop made $2.87 a share from operations last year and expects to net $3.10 to $3.30 in profit this year. Annual sales top $9 billion. Any bid probably would be at least $25 a share.

Now, we have to admit there is a large difference in the $BBY founder not wanting his 20% stake, valued at ~$1.4B to evaporate so yes, he made an offer to buy. With $GME, insiders as a group own 1.2% of the outstanding shares and no one individual owns more than .3%. The math there is more than a little different. Plus, the very people who would take a large stake in the company are the very people referenced in the beginning who are short it. Where is a buyer coming from?

Popular Destination

At least three million hard-core gamers—mainly teenage boys and young men—visit GameStop every day, an industry insider estimates.

“Few companies have managed adversity so well and done as poorly in the stock market,” observes Ross Margolies, the founder of Stelliam Investment Management, a New York firm that holds the stock, which is heavily shorted. Sentiment could improve if second-quarter results, scheduled to be reported Thursday, top expectations of 14 cents a share and if GameStop is upbeat on the second half.

Really? Same store sales fell 12% in Q1 and are forecast to fall 5% for the full year (I will say right now they will fall more than that). We should also note that in March the company said SSS would be up for the year then only two months later admitted they would be down. So yes, while it is “popular”, it is becoming less so. While the company “expects” YOY profits to increase, YTD they are in fact down despite the prodigious buybacks mentioned below and based on current sales trends, it will take a very large percentage of the cash they hold (also mentioned below) to manufacture earnings anywhere near last year.

That scenario, (using large amounts of cash to meet EPS targets) eliminates the dividend increase (mentioned below) as cash will begin to be drained (already happened YOYin Q1). While it may work for this year….it leaves a massive hole for next year.

One thing GameStop could do to lift the stock is to significantly boost its dividend. The company has consistently returned nearly all its free cash flow to shareholders, but almost exclusively through stock buybacks; it has repurchased 40 million shares for $823 million since early 2010. GameStop did initiate a 15-cent quarterly payout in February, but Pachter contends that it could comfortably support an annual dividend of $2 a share. That would provide a 12% yield—probably driving the stock well above its current price, given investors’ hunger for yield.

While GameStop continues to take market share, industry conditions are tough, with sales down 20%-30%, year over year, in recent months. One problem: Sony ($SNE) and Microsoft ($MSFT), probably won’t introduce new consoles until 2014, although Nintendo (7974.Japan) plans to roll out the new Wii U this year.

Among the major risks to GameStop is that console and game makers will de-emphasize physical games in favor of downloads with the next generation of consoles, and that gamers will opt for the free or inexpensive games available on mobile devices or iPads.

Margolies thinks physical games will stay popular. So does game maker Electronic Arts, which gets 60% of its sales from such games. “We love what retail does for us,” Peter Moore, EA’s chief operating officer, said on a recent conference call. “We love the ability of them to create massive launches and excitement. GameStop in this country probably sees three or four million hard-core gamers walk through their stores every day, and that’s a marketing opportunity for us.” He notes that many game buyers don’t have credit cards–mostly because they’re too young to qualify. That makes it tough for them to buy games online.

Industry sales are down 20%-30% yet $GME maintains its annual guidance despite missing their estimates for Q1? How? Yes $EA gets 60% of its sales from physical games, that percentage is shrinking. In Fact:

EA Labels head Frank Gibeau had a very straightforward conversation with GamesIndustry International recently where he talked about the future of publishing, and how going all-digital is an inevitability for his company.

“It’s in the near future. It’s coming,” he said.

“We have a clear line of sight on it and we’re excited about it. Retail is a great channel for us. We have great relationships with our partners there. At the same time, the ultimate relationship is the connection that we have with the gamer. If the gamer wants to get the game through a digital download and that’s the best way for them to get it, that’s what we’re going to do.”

Since Barron’s quoted Mr. Moore…..we should note what he said just this weekend:

EA’s business model is evolving as it increases revenue from online and mobile gaming, COO Peter Moore said in an interview. The Redwood City, California-based company publishes games including “Battlefield,” “Star Wars” and “FIFA Soccer”.

“There will come a point, whether it is two or three years from now, when we say. ‘We are doing more in digital media now than we are in physical media,’ and it’s clearly… not far away,” Moore said, citing the rise of EA’s digital revenue for the trailing 12 months to $1.3 billion.

As Barron’s should/does know, it is ‘t the current numbers that matter but the direction they are going in. For $GME, they are headed in the wrong direction both on a company level and on a industry level for what they do. $GME simply has far too many location as the switch to digital comes about. As they close stores they also lose out on their most lucrative business, selling used games. Fewer store mean fewer console sales etc…

The Bottom Line

GameStop, now trading in the mid-teens, could fetch $25 or more in a buyout, say bulls on the stock. The shares also could rise if the company boosts its dividend significantly.

GameStop customers may grouse about getting little for used games, but many cash-strapped teenagers are glad to receive $10 for an old Call of Duty or Halo to partially pay for a new $60 version. GameStop estimates that PowerUp members are sitting on $1.8 billion of buying power in used games. And hard-core gamers like the engrossing shoot-’em-up experience that mobile games don’t offer.

GameStop’s digital sales might hit $675 million this year and $1.5 billion by 2014, Pachter estimates. These often involve add-ons to existing games, downloaded over the Internet. And revenue from games played on mobile devices could triple by 2014 from the current $150 million.

So, the game is far from over for GameStop shareholders, who just might be big winners in the end.

Mt bottom line? Why would someone, without significant skin still in the game like the $BBY founder pay a near 50% premium for the company? There was value in Blockbuster, Circuit City, Hollywood Video etc etc etc before they all went under. While, again, I am not saying $GME is going extinct, I do think if it does survive,  (they probably will for now balance sheet still ok, unless they ruin it in a effort to prop up EPS/dividends) it does so at a fraction of its current size. Every trend in the business $GME operates in is moving away from the physical store model.

Any buyer would have to do just that, shrink the store base dramatically and focus on digital. That would coast a pretty penny and I doubt because of that the premium that is being bantered about is possible.