GME: From Deep F*ing Value to Growth
The power of reflexivity
I know you’re tired of reading about GameStop (GME), but you’ll have to indulge me because there’s an opportunity here.
Before the big short squeeze, there was a fundamental thesis behind GME, predicated on the company successfully turning around its business to survive digital downloads.
This thesis is playing out. Two factors to consider:
1) Ongoing Shift to E-commerce/Digital
In January, GME announced three new directors were joining its board, including Ryan Cohen. Ryan founded Chewy, an e-commerce pet food retailer. He holds +12% ownership of GME and wants to transform the company. This interview and this article give a good idea of Ryan’s management style and potential vision for GME—customer obsession, low prices, fast shipping, large scale, long-term focus. Recently, GME created a CTO position and hired an ex-Amazon.
In Q3/20, GME’s e-commerce sales increased by 257% y/y. During the holiday season, growth accelerated to 309% y/y. E-commerce is now 34% of total sales. This growth comes on the back of a new console cycle, which began in late 2020.
So here are some facts:
GME is investing in digital. Management could unveil a new corporate plan with Ryan Cohen’s activist presence on the board.
E-commerce sales are growing and already are a significant portion of total sales.
A new console cycle has just begun.
The gaming industry is growing.
The argument presented by shorts is that the future holds no market for a game retailer as new consoles go diskless. Consumers can buy and download their games straight from the console. GME is unnecessary.
This is a valid point. Digital downloads are a challenge because much of GME’s earnings power relies on game sales (used and new). However, I think there’s space for collectibles and hardware sales (not only consoles but also PC gaming) and different ways an intermediary can exist in this environment.
GME has a well-known brand and millions of customers in its loyalty program. The company can monetize these assets under a new business model. It isn’t going to be easy. That’s why the stamina and experience brought by Ryan Cohen and his crew are crucial for GME’s future.
2) Low Bankruptcy Risk
GME is closing stores, reducing SG&A, and improving inventory management. The business is much healthier than a year ago. The Company finished Q3/20 with $600mm in cash and $485mm in debt (excluding leases), and since then, it has repaid $125mm in debt. GME’s liquidity position is strong, and given its higher stock price and rise to fame, the company can tap the markets if needed.
Now let’s talk about something else that’s happening with GME.
The Power of Reflexivity
Reflexivity refers to changes in investors’ perceptions and fundamentals in a self-reinforcing cycle—a feedback loop1. The usual thinking is that fundamentals determine prices. What’s counter-intuitive about reflexivity is the understanding that prices also impact fundamentals.
Behind this intuition is the fact that human reality is mostly subjective, that is, determined by how we think about it. Markets are the foremost example of a subjective reality. Given imperfect information and human biases, prices aren’t a signal of value but of perception of value.
When I first started investing, I thought that stories were a way to separate investors from financials, an objective reality. That’s a naive understanding of how people are wired. Stories determine the way we think about and shape reality. Companies are a construct of collective belief.
Consider Elon Musk. Tesla is one of two US automakers to have never gone bankrupt because a sufficient amount of people believed (and still believe) Tesla’s story even when objective reality didn’t support it (yet). Musk amassed capital, attracted the best engineers, and made them work like crazy, thus bending reality to overcome nearly impossible challenges—a narrative come true.
As Ben Thompson puts it (I recommend you read the entire piece here):
It turned out, though, that TSLA was itself a meme, one about a car company, but also sustainability, and most of all, about Elon Musk himself. Issuing more stock was not diluting existing shareholders; it was extending the opportunity to propagate the TSLA meme to that many more people, and while Musk’s haters multiplied, so did his fans. The Internet, after all, is about abundance, not scarcity. The end result is that instead of infrastructure leading to a movement, a movement, via the stock market, funded the building out of infrastructure.
But a meme alone isn’t enough to take us to Mars. When perception gets too disconnected from reality, or there isn’t enough time, or it’s impossible for reality to catch up with belief, the feedback loop breaks. Elizabeth Holmes may testify to that.
Investing used to be a game played by a few. But now, trading apps and the free flow of information in platforms such as Reddit and Twitter have changed that. Price formation isn’t the same as before because this is a world where professional and individual investors share their ideas (and stories) with millions of others.
Reflexivity has gained force.
I think GME is a case of reflexivity; investors’ perceptions are altering the company’s fundamentals. The stock is a battleground for many. Whatever the new role of reflexivity in the markets, GME will suffer an outsized impact from it.
For example, GME now has cheaper access to capital and a stronger shareholder base. The company can leverage this position to raise money, invest in its digital transformation plan, and play a long-term game, untethered by quarterly expectations.
Then there’s GME’s management and employees. The spotlight helps attract talent and align incentives. The free publicity also helps with customers.
There’s value to reflexivity. It just won’t show in GME’s balance sheet.
Back to Fundamentals
Given reflexivity, here’s what I think we can expect from GME:
Better chances of executing a digital transformation plan
Easier and cheaper access to capital
Higher trading multiples
This is a good investment set-up as long as we can pay a good price.
How Much?
GME is the world’s largest video-game retailer and has over 55mm customers in its loyalty program, PowerUp Rewards. Management is expanding its market to include PC gaming, computers, monitors, game tables, gaming TVs, etc. There’s plenty of opportunity in digital as long as you get it right (e.g., sponsored ads, streaming, esports, online trade-ins).
Though sales declined from $9bn in 2016 to $5bn today, over the last holiday season, same-store sales increased 4.8%, a positive sign from the new console cycle. E-commerce is already +30% of sales and is growing +300% y/y.
I don’t think historical financials are particularly useful in this case, but let’s take a look at them. Excluding the last couple of years, the company is stable and profitable, with EBITDA margins of ~9% and FCF conversion from EBITDA of ~60%. Moving to a digital-first omnichannel could see margins expanding as GME foregoes expenses associated with operating too many brick-and-mortar stores and leverages its scale better.
With bankruptcy out of sight and a reinvigorated management team, GME has a credible path to return to profitability. Considering the current sales level—and if GME’s track-record is of any use—the company could produce +$200mm in FCF/year on a normalized basis. Assuming an EV/FCF of 15x, the company would be worth +$3bn.
Historically, GME traded at an EV/EBITDA multiple of 5x and a P/Sales of 0.3x. After the stock price volatility eases and things go back to normal, I think GME will trade at higher multiples because (1) the market loves e-commerce and omnichannel stories as they have better growth prospects, and (2) reflexivity. Historical multiples reflect the market’s perspective of GME as an outdated brick-and-mortar retailer that was soon out of business. That isn’t the case now, given the perspective of a turnaround and a non-bankruptcy outlook.
Here are some e-commerce/omnichannel retailers:
It isn’t a stretch to see GME trading at a P/Sales range of 0.5x-1x. In this case, GME’s market cap would be anywhere from $2.5bn to $5bn.
With these data points (sales, margins, multiples, reflexivity, management), I value GME at $2.5bn, or +$30/share. To me, anything below $23/share is a good entry point.
How I’m Playing GameStop
GME is trading at $50/share now. It would need a correction larger than 50% to reach my entry point. The stock price may get there soon; meanwhile, I’m selling puts.
A put option with a strike price of $25 and an expiry date for March 12 is selling for ~$3. That means that each contract, tied to 100 shares, sells for ~$300.
If I sell one contract and it is exercised, I have to buy 100 GME shares at $25/share for a total of $2500. This strategy makes sense for me because, right now, I have too much cash available (and no idea where to invest it), and I think the stock would be a good buy at $22/share ($25 minus the put premium).
Risk-reward
Because I would buy the stock at <$23/share anyways, the main risk I’m assuming is if material changes to my investment thesis happen between selling the put and the put’s expiry date. I’m willing to take that risk, given the large margin of safety to my fair value assessment.
George Soros popularized the application of this concept in the markets.
Great article. I've been selling 20s and 30s too. The crazy thing is that the premium received selling these were the most when the stock was > 150. Insane. Good luck!