GameStop: Longs Should Run A Proxy Contest

Summary

• GameStop is a global, multichannel video game and licensed consumer products retailer, operating over 5,800 stores across 14 countries.

• The business is in decline.

• The CEO has no credible plan and should buyback stock.

GameStop is a global, multichannel video game and licensed consumer products retailer, operating over 5,800 stores across 14 countries.

The company’s success is dependent on a handful of suppliers. The company’s largest vendors are Nintendo, Sony, Microsoft, Take-Two Interactive and Activision Blizzard, which accounted for 23%, 22%, 10%, 6%, and 4%, respectively, of products carried by Gamestop.

In the current business climate, video game hardware sales are declining and consoles are declining significantly at a rapid speed. One of the major reasons for the decline is that the Playstation 4 (PS4) and Xbox One are approaching the end of their life cycles.

Q4 Industry Results

In the Q4 fiscal year result, Microsoft reported a decline of 48% in Xbox hardware revenue primarily due to a decrease in volume of consoles sold. Earlier this year, Sony reported a decline in PS4 console-sales volume which declined by 1.2 million units in 2018 compared to 2017.

According to The NPD Group, a firm which tracks hardware sales, hardware spending in June 2019 dropped 33 percent when compared to a year ago. Moreover, year-to-date hardware spending has declined 20 percent versus a year ago.

Company Results Reflect Industry Declines

GameStop’s “New video game hardware” segment’s revenue declined by a whopping 35% in the recent 1st quarter of 2019. Moreover, given the fact that Sony’s next generation of PS and Sony’s ambitious Xbox Project Scarlett are rumored to be launched by Christmas of 2020, it is clear that the company’s new video game hardware is not going to improve in the near-term.

Pre-Owned Video Games

Pre-owned and value video is declining drastically and pre-owned video, which accounts for 28% of revenue, is the most profitable business segment which accounted for roughly 46.3% of gross profit.

This cash cow segment’s sales are rapidly declining since 2016. In the last four quarters, the segment’s sales are declining at double-digit rates. Furthermore, in the most recent quarter, the segment revenue declined by 20%. Also, the gross margin declined from 46.3% in FY 2016 to 43.4% in FY 2018.

Digital games, which are downloaded directly through the online store, are slowly replacing physical discs. Also, the lack of blockbuster games is affecting the used-video game market.

In last year earnings call, Robert Alan Lloyd, CFO told analysts that: “It does have to do with how customers can get some of those older titles, the very inexpensive titles that you can get through either subscription memberships or online in a pretty heavily discounted mode.”

The Move To Disc-less

Microsoft’s disc-less move is a long term threat for the companyRoughly four months ago, Microsoft announced a new model of its Xbox One console, a digital-only version that will not be able to play discs and costs $50 less. Moreover, Microsoft has partnered with Sony to help power PlayStation's streaming efforts.

The company’s digital store is unlikely to become a major hubSubscription services, including services such as PlayStation Plus and Xbox Live, that offer video game downloads each month, are a long-term threat to the company.

Now, starting April 1st, 2019, Sony prevents retailers like GameStop from selling digital download codes for PlayStation 4 games.

In the most recent quarter, the company’s Digital sales declined 11% and in the last 3 out of 5 quarters, digital sales declined.

The Future Is Bleak And The Company Still Has Life

The future is bleak but business is not going away soon. After the sale of its Spring Mobile business, GameStop is currently focusing only on the video game industry. The company is now a pure-play gaming business.

Even though the long-term outlook is negative and business is shrinking, Microsoft and Sony are making new game consoles that come with games disc. This makes it clear to me that the company still has life.

The crux of the question is – what are they going to do with the cash?

The CEO Does Not Have A Credible Plan.

Given the massive problem faced the company in every nook and corner of the business, the new CEO is not addressing the core problem.

First of all, the company’s newly appointed CEO outlined his goal of improving the operating profit by over $100 million. If revenue continues to decline, the cost-cutting and profit improvement plan will not matter. For example, if the pre-owned video segment (which accounted for 22% of 2018 revenue) continues to decline at 20%, it will shave off roughly $125mm to $150 million in gross profit in a year. This is significantly more than the expected improvement in operating profit.

Secondly, in July 2019, the company, under the guidance of the new CEO, hired a global design firm R/GA to develop new and streamlined physical store concepts, introducing new ways for gamers to try new titles before they buy them, and giving stores a unique layout and purpose that appeal to gamers.

This proves that the CEO has not realized the fundamental problem of the company. The core problem is not that customers are walking into competitor’s retail shop for their fancy store concept – the fundamental problem is vendors like Sony are shifting to digital and there is no reason for the gamers to visit a physical store.

Third, in the recent conference call, the CEO talked about “new revenue stream” nearly 5 times, but the fact is that he is yet to “figure out” how.

"We’re evaluating new revenue streams and how we can and should participate in the digital economy, particularly given the significant number of loyal customers we bring the publishers and console makers. This will take time but is a necessity to enable us to continue maintaining our position as the leader in the video game space."

- George Sherman, CEO, Q1 2019 earnings call

Overall, it is clear that the company’s new CEO is clueless and is squandering the company’s cash.

Michael Burry’s Suggestion

Michael Burry, the founder of Scion Asset Management, was among the few who predicted the 2008 subprime mortgage crisis and was featured in The Big Short, a Michael Lewis bestselling book. He is now long on GameStop.

In his recent letter to the management, he urged the company to fully execute the $237.6 million remaining on its current $300 million share-buyback authorization. He has argued that it was the right time for the company to buy back its shares and expressed his belief that both Sony and Microsoft would keep physical optical disk drives.

Given the market capitalization of GameStop at ~$400 million at the close on September 23rd, completing the authorization would retire over 80% of GameStop’s outstanding shares. Depending on the timing and quality of execution, such a repurchase would increase earnings per share dramatically – far more than any other possible action on a per-share basis. On the most recent earnings call, the CEO appeared to say that he was considering using the company's cash on acquisitions. Shareholders that want no cash used for acquisitions and all cash used for share buybacks may have no choice but to run a proxy contest to get a new board of directors in place.

Nautilus (NLS) Needs An Activist

Summary

• Nautilus is a potential activist play.

• Activist involvement in Nautilus could unlock value.

• I believe it's likely that Nautilus will sell some of its business lines as part of completing an operational turnaround.

Activist investing comes in many flavors. After an activist investor gets one or more shareholder representatives on the board of directors, those board members may lead the board in selling the entire company. Alternatively, those board members may lead the charge for a long-term operational turnaround using a leadership or consulting methodology such as Tribal Leadership which has been used by many companies and was recently highlighted in Business Insider.

Some of the best activist investments utilize a combination of these initiatives. A hypothetical example could include, transforming the organizational culture, selling off certain lines of business for cash and then using that resulting cash inflow to buyback undervalued stock and/or to reinvest in remaining business units.

There is no one size fits all solution. The best activist investors carefully evaluate board candidates and choose the right candidates for the job. In addition, these activists will get those board candidates on the board which is a different game into of itself. Usually, activist investors have to start the proxy battle process, and at some point in the process, the incumbent board will realize they are heading for an election defeat and settle. But sometimes the incumbent board members refuse to settle and the process goes to a vote. If the activist has selected the right target and has run the election campaign the right way, the end result is a victory for the activist and his or her respective choice of board members get onto the board.

The new board members selected by the activist need to take their time and carefully analyze all of the possible options for the company going forward. I believe one of the potentially most promising activist targets today is Nautilus (NLS). Nautilus stock is down from around $25 a share to around $2 a share today. Needless to say, with this dismal performance, most Nautilus shareholders are ready for change. There appears to be a number of avenues of value creation available to newly elected activist board members. The brand names that Nautilus owns still have real value, and are among the most recognizable worldwide in the fitness equipment space. A Chinese manufacturer of fitness equipment, for example, might be willing to pay a substantial price to own those brand names.

As of today, Nautilus is trading for an EV/Revenue of under 15%. This kind of EV/Revenue multiple is extraordinarily low for any sort of branded products company. Furthermore, it would be reckless to speculate as to exactly what price could be realized for Nautilus in the M&A market and each investor should do his or her own comps analysis.

One possible path forward for Nautilus is the sale of some of its business lines while holding on to other business lines and completing an operational turnaround.

Activist investors have had success with this strategy before. For example, The Stephan Company (OTCPK:SPCO) had an extraordinary run of terrible performance under its legacy board of directors. The Stephen Company lost money every quarter for more than 30 quarters in a row. After this run of terrible performance, a large number of very successful activist investors came together to replace the entire board of directors and turn around the company. The new board is essentially a 100% activist board, and this new board has successfully turned around the company, with solid free cash flow. The current board is shareholder-oriented and uses almost all the free cash flow for either share buybacks or returning cash to shareholders.

Nautilus is larger than The Stephan Company, and the situations are by no means identical. However, when hungry aggressive determined activist investors decide to make changes to a board of directors, there is often the opportunity for dramatic share price appreciation.

Nautilus is Struggling While a Startup is Flourishing

Over the last 13 months, Nautilus stock is down over 90% due to poor financial performance. In January 2019, the company’s stock crashed over 40% after the company warned investors about poor fourth-quarter results. In the next month, the stock crashed 24% after the company warned investors that weak sales would continue through the first half of 2019.

Amid this poor performance, Peloton, a startup firm, captured the consumers with its creative advertisement. Peloton bikes are not cheap. It costs $1,995 for a stationary bike which comes with an attached wifi-enabled tablet. Additionally, it cost $39-a-month for its subscription service, which lets users access live and on-demand classes. With over 400,000 bikes sold, Peloton is valued roughly $4 billion.

Max Intelligence Platform Fails to Lure Consumers

In November 2018, the company launched Max Intelligence platform, an artificial intelligence-powered training and coaching system to ride along with its Bowflex Max Trainer M6 and M8 cardio machines.

However, in the last two quarters (4th quarter 2018 and 1st quarter of 2019), the company’s revenue declined by 10% and 26% respectively due to slower-than-expected adoption rates. Moreover, the company’s profitability, which was continuously declining since June 2018, registered a net loss of ($8.5) million in the first quarter of 2019.

We had expected to see stronger sales in the direct segment for the fourth quarter, but this was not the case...while overall we received strong positive feedback from purchasers, the product is at a slower start than anticipated.

- Bruce Cazenave, CEO

Nautilus is currently being forced to figure out how to market its product.

We need to find ways to break through and explain this in a way that is better suited for a 30-second and 60-second ad...so once the folks who did purchase the product and went through and got educated, there’s general satisfaction it really is more. How do we tell that story more effectively and drive web traffic to the site to learn more? And that’s part of what we talk about when we say we want to retool some of the marketing.”

- Bruce Cazenave, CEO

Unfortunately, Nautilus does not have the time or money to compete against Peloton, at least in the short run.

The company has a few strong brands. TopTenReview which is reviewing elliptical machines since 2011 has ranked the company’s Bowflex as “Best Console”.

Given the strong brand value, the company is better positioned for M&A. I believe that the strong brand combined with the current low multiple given by the market today provides an opportunity for an activist to come in and help facilitate a partial or full sale of the company.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: If you want to discuss shareholder activism in general, or in particular if you want to discuss specific micro-cap stocks and nano-cap stocks that desperately need the attention of an activist, please contact the writer. 

For legal reasons, I am obligated to publish the following disclosure. Nothing written here constitutes investment advice. The writer is not now and has no intention for the future in joining a group with other investors to pursue activism. Any time there is a proxy contest or a competitive solicitation, shareholders are required to carefully read all proxy materials and think all of the issues through before casting their vote.