Short Interest Draws My Interest: Gamestop (GME) Analysis

I’ve been reading The Art of Short Selling and I was inspired to put it into practice a bit by this post:

The author’s review and arguments in both articles seem poorly backed and though-out, but the author did reveal something interesting: the enormous short interest on Gamestop. There’s short interest of 35M on a float of 145M, which comes out to 24%. On the surface it looks like a straightforward value investment and I’ve seen it pop up on other sites, like on Barel Karsan and the “magic formula” screen. I’ll be working backwards here to try to dig up the red flags that brought in so much short interest and see if they’re worthwhile.

From what I can gather, these are possible red flags that shorts might be seeing: (a) the move to digital delivery, (b) disappointing same-store sales, (c) potential new competitors, (d) inventory inflation, and (e) unusual insider selling

Digital downloads would presumably be a major problem for a primarily brick-and-mortar business, especially one that relies on the resale of used games to make a substantial fraction of its income. Thing is, I think investors are a little early on this one. Critics are making the opposite mistake of music companies: assuming that technology will immediately change everything. I think internet connections simply aren’t fast enough right now. Games are huge files compared to music or even movies – a full game can run upwards of 10GB. Even with a good internet connection, that’s a lot of waiting. The last time I tried downloading a file that size that it took forever for the file to finish and had my connection running at slug-like speeds all the while. The appeal of downloads is supposed to be convenience, but right now the convenience is limited. The company is also aware of the need to stay technologicaly relevant, unlike companies like Blockbuster that went the way of the dodo. It also to produces significant free cash flow and, again unlike Blockbuster, isn’t burdened by much debt, so it can adjust its business model more easily via acquisition or internal development. Management could always blow it, but right now this fear doesn’t pass the sniff test.

The same-store sales issue seems a lot more relevant by comparison. Same-store sales were down 7.9% in 2009. For 2010, they were down 1.6% in Q1, up 0.9% in Q2, and up 1% in Q3. 2008 saw comparable store increases of 12.3%, which was also a drop compared to 2007’s increase of 24.7%. Investors have already acknowledged these changes to some degree – P/E fell from the 40s in 2007 to around 9x earnings today – so the current short interest isn’t for a big valuation-based short. The period of wild growth and the post-slowdown contraction of the earnings multiple are both past. Shorts might be betting that growth will continue to stagnate or remain negative. Both GME and general retail numbers seem to have a positive trend in recent months and short interest has only risen in the face of optimistic retail news, so I’m guessing that shorts are expecting long-term problems with the business model combined with a lack of growth in the meantime. The latter might be a real concern, since they’ve already got more than 6,400 stores and might soon run out of room to expand via new stores if they haven’t already. Checking FCF/store might give a sense of whether GME continues to get consistent returns from newly-opened stores:
2009: $480M/6450 = $74,418/store
2008: $366M/6207 = $58,965/store
2007: $327M/5264 = $62,120/store
2006: $290M/4778 = $60,694/store

Interesting result…after a couple years of steady per store numbers, GME saw a big jump in a year of “stagnant” sales. TTM numbers are down a bit ($68271/store), but still higher than even the go-go high growth years. According to the latest 10-Q, GME expects to open 400 stores in 2010 on total cap-ex of $200M. Figure 25% of that goes to the distribution and information system upgrades, leaving $150M for the 400 stores (pretty much in line with the expenditures of previous years). That’s $375,000 per store, so they’re getting a pretty solid return on investment there: a cash return on invested capital (CROIC = FCF/Invested Capital) of 18.2%. Even at the old FCF/store level GME was getting a 16% CROIC – not exactly a sign of a faltering business, especially given that cash flows are harder to fudge. So, summing up, sales might be flat but return on capital and free cash flow are growing. Neither seems like a short signal.

Competitors, like downloads, might be an overblown fear. The key to GME’s profitability (used game sales) has been clear for some time now, but it hasn’t been copied successfully. I wonder if perhaps competitors either can’t or won’t – why else allow it to continue when it’s clearly a pretty lucrative business? They seem to be hot and cold on the idea, trying and bailing out only to try again. For details:
In: Kiosks in ‘09
Out: …?
Perhaps the company has a pseudo-moat from economies of scale. A secondary market needs enough supply and demand to function efficiently and since none of its competitors make game sales their primary business, their customer base might be too thin (or too gamer-thin) to get a good supply of worthwhile game turnover. Competition is a real fear, but judging by past efforts it will be some time before competitors can make a real dent.

Days inventory is high at the moment (98.71 for TTM) and inventory for this quarter is at what looks like an all-time high in absolute terms, which might be the red flag the shorts are looking at. In relative terms inventory still looks okay, though. It’s only at 37.25% of assets, as opposed to 34.43% in 2009. When you consider that they have several hundred new stores and that same-store sales are up slightly in recent quarters, that seems like a pretty reasonable allocation. There doesn’t seem to be any reason to suspect an inventory pileup.

Last up, we’ve got corporate governance and insider activity. Insiders have been acting screwy all year and investors might be getting nervous. GME is on its second CFO since August ‘09, with the first replacement only lasting from August to February. Not only that, but there have been two big waves of insider selling. The first came at almost the exact time of the first replacement CFO’s resignation. That doesn’t look great. The second came in October. This one was much larger, with several directors making sizable sales. They were led by Leonard Riggio, who sold $64M worth of stock. The independent directors made sales that had a much smaller absolute value but amounted to fairly large portions of their total stake in the company. Of the two moves the latter is probably more worrisome. Riggio currently holds 37.8% of Barnes & Noble and, judging by the agreement he signed with B&N management, he is merely waiting for the company to exhaust other options for a sale before making a bid of his own. The shares that Riggio sold would cover a large portion of the money that he would need to raise to take full control of the company. In that context his large sales seem less suspicious. There’s a clear (well, semi-clear) outside motivation. For the other directors, a motivation is less apparent. When you combine that with the CFO turnover (and the turnover sales) it looks downright strange. I suspect that this more than anything is driving up short interest.

There are a few accounting practices that I wondered about: recognition of foreign currency derivative/contracts in operating expenses despite the fact that they seem to function as hedges and probably ought to go under OCI, as well as inventory reduced by vendor marketing allowance. These seem a little unusual and the second might be used to minimize inventory buildup, but neither one seems sufficient to manipulate earnings or the balance sheet in a major way.

Financial Integrity
Atlman Z-score of 3.49 suggest that the company is financially sound. Current ratio is 1.11, a little lower than the historical average. There’s plenty of spare credit in the revolver to cover any short-term needs, though, and it looks like the company is typically flush with cash after the holidays. GME produces loads of free cash, so it shouldn’t need to tap the capital markets much, except for the occasional use of the revolver. The company has been steadily paying down debt and long term debt is now down to $249M, a little more than .5x FCF.

The company sells for only 1.2x book value, but it doesn’t have a lot in the way of hard assets. 40% of GME’s assets are either goodwill or intangibles, which means that there isn’t a lot of hard value to support the company in the event that earnings drop off.

This could be what shorts are expecting, but it seems like a poor bet if it is. GME is in a far stronger financial position than the beleaguered brick and mortar giants of the past, so bets on its decline are premature. Still, extremely cautious investors seeking value from both earnings and assets might steer clear.

As noted above, the company is in a deceptive place earnings-wise. Same-store numbers aren’t exciting, but cash flow production is excellent. In addition to the store production mentioned above:

FCF/Enterprise Value = 451/(3200 + 249 – 181) = 13.8% FCF Yield, or…
EV/FCF = 7.2x

The company likewise gets a good CROIC from each of its stores, which is especially impressive given the number of stores GME has out there. FCF/store is down a bit for the TTM period, but it’s probably best to wait until the Q4 results come in to judge the results of such an obviously seasonal business.

Overall, the company really does seem like a genuine bargain and the short concerns look either overblown or premature. Current price: $21.26

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