Trade Update – $GME: Selling Long Stock for 10% Gain

by Enis September 16, 2014 12:14 pm • Commentary

I bought GME nearly a month ago ahead of the company’s Q2 earnings report, with the following thoughts and structure:

We like the fundamental situation, so we are going to buy GME stock here after the nearly 15% selloff of the past 3 weeks.  However, given the earnings event on Thursday, we are going to pair the stock purchase with a long weekly put position in case guidance disappoints this week.  We are willing to lose the 1.35% in premium to protect against a large downside move:

TRADE – Buying to Open GME for $40.10
TRADE:  GME ($40.10) Buy the Aug22nd 37.50 Put for $0.54

The weekly put ended up expiring worthless, and I remained long GME with a cost basis of $40.64 ($40.10 purchase price + $0.54 cost of weekly put protection).

The earnings report was a strong one.  I discussed the details in a COO post after the event, with the following broad takeaway:

My impression from reading the Q2 earnings release and the conference call transcript is that GameStop continues to maintain or increase market share in almost all selling channels even as gaming becomes more digital.  The company sold more than 50% of all PS4 or XBox units sold in the second quarter.  Granted, the second quarter is the least important from a seasonal perspective, but it’s still encouraging to see that market share strength.

GME has moved higher since that report, but has encountered resistance around the critical $45 technical level:

GME daily chart, courtesy of Bloomberg
GME daily chart, courtesy of Bloomberg

Analysts have modeled in quite high expectations for the second half of 2014, with consensus EPS over the next 2 quarters expected at $2.93.  That compares to $2.48 for the second half of 2013, and that included the launch of the Playstation and Xbox consoles, as well as Grand Theft Auto V’s debut.  On top of all of that, the Xbox One has run into serious problems due to a noise problem in the past couple of weeks (see here and here).  The issue does not seem to be limited or contained, so it could impact sales figures for the holiday season.

As a result, with the stock near technical resistance and expectations elevated, I’m going to sell my GME stock here and keep an eye on it over the next couple of months.


Action:  Sell to close GME at $44.67 for a $4.03 gain, or about 10%



New Trade – $GME: It’s All in the Game

GameStop remains a highly controversial stock with one of the highest short interest levels of any name in the S&P 500 index.  The short interest is still around 27.5% as many traders continue to view GME as a company that is at risk of going the way of Blockbuster – selling physical games in a digital world.

President Tony Bartel addressed the potential threat from digital in a VentureBeat interview in June:

Bartel: I’m not sure there’s exactly a “threat” in digital. The key is all about consumer adoption. We view it as just another consumer option for purchasing a game. If consumers want it digitally, they’ll be able to get it that way, whether at GameStop or directly through their console. The issue of discovery is still important, whether you’re digital or physical.

The other thing about a digital good that the publishers and platform holders are going to need to consider – and this is something that we see more than anyone else in our customer base – is that people who buy a physical game attribute $20 in residual value to that game. If you have no ability to develop a similar program on the digital side, where you give them that $20 of incremental value for a trade-in credit, then it’s going to be difficult for a digital game to sell at the same price as a new game, or even to sell above $40. As an industry, we need to sort that out.

Given that we make $12 on every physical game we sell, there’s a value proposition that has to be considered there. Customers buy a lot more physical games today. They like that model of being able to speak with someone who can help them discover the game. They like to have a physical disc that they can take wherever they want to. They don’t have to wait for a download at any point. When they’re done, they can trade it in and get some additional value.

If people want to go digital, we believe they’re the best place to buy digitally. They can pay with numerous forms of currency. They can generally talk to someone who’s knowledgeable about the game. They can talk to someone who can walk them through the download process, which is an important piece of the transaction

Granted, GameStop’s President is not a man who is likely to concede that his company’s business is facing a severe threat from technology, so we must take his words with a grain of salt.  However, when I look at the numbers, the existential concern among the shorts in GameStop seems hard to justify.

In 2009, GME had revenues of $9.1 billion, and those revenues have remained between a low of $8.8 billion (in 2012) and a high $9.6 billion (2011) in each of the past 5 years.  Analysts have projected sales of $9.8 billion 2014 and $10.7 billion in 2015.  Earnings Per Share has grown from $2.29 in 2009 to $3.12 in 2013, with $3.56 projected for the full year in 2014, and $4.34 projected for the full year in 2015.

In the meantime, interest in GameStop brand and traffic at GameStop stores has broadly increased even as the digital gaming industry has expanded as well.  Google Trends is one exhibit of the continued engagement in GameStop over the past few years:

Screen Shot 2014-08-18 at 10.26.56 AM

My main takeaway from this chart is that while interest in searching for GameStop stores has been relatively flat since 2011, it remains significantly higher than it was 5-7 years ago, which is one more indication that the rise of digital has not been such a major impediment to retail store traffic at GameStop.

The main concern about the lack of growth over the past few years is a legitimate one, as revenues have not grown much in the past few years, and EPS gains have been due to cost cuts.  But as we noted in a NTT post in late May, GME’s valuation more than reflects the recent stagnation:

Part of our skepticism on GME was exactly the transformation of the gaming industry to the digital space.  But the new console cycle could indeed be a confirmation of at least one more cycle where physical games dominate digital games.  At the moment, many market participants still seem to view GME as a dying brand, as short interest sits at around 27% of the float, though that’s actually down quite a bit from 2011:

GME short interest, Courtesy of Bloomberg

GME is a 12 P/E stock with earnings growth of 10-25% over the next few years.  Clearly, investors are quite skeptical about those earnings targets.  However, if last week’s earnings report and management’s optimism is to be believed, GameStop could be much better positioned for growth than the market thinks.  With a low valuation and low bar, we like the odds of further upside in GME over the next 6 months.

At a EV/EBITDA of around 5x, and a strong console cycle as a tailwind, valuation seems to offer enough cushion to offset the downside risk of a weaker-than-expected holiday season later this year (GME gets about 60% of annual EPS from the 4th quarter).  Moreover, my impression from reading about the video game industry is that the digital gaming growth is not necessarily taking share from overall gaming industry growth – rather, it’s a reflection of a secular trend towards more time spent on video games across the world and among consumers.

GME reports earnings after the close on Thursday.  The options market is implying about a 7.5% move, vs. the 4 quarter average of about 6%, and the 8 quarter average of 5.25%.  The large implied move is a bit surprising considering that the 2nd quarter is the slowest of the year on a seasonal basis, though investors are going to be very focused on guidance for the upcoming holiday selling season.

We like the fundamental situation, so we are going to buy GME stock here after the nearly 15% selloff of the past 3 weeks.  However, given the earnings event on Thursday, we are going to pair the stock purchase with a long weekly put position in case guidance disappoints this week.  We are willing to lose the 1.35% in premium to protect against a large downside move:

TRADE – Buying to Open GME for $40.10
TRADE:  GME ($40.10) Buy the Aug22nd 37.50 Put for $0.54

– Buy 1 Aug22nd 37.50 Put for $0.54

Break-Even on Aug22nd Weekly Expiration:

Profits:  below $36.96

Losses:  Between 36.96 and 37.50, lose up to 0.54, lose the full 0.54 at 37.50 or above

Rationale:  The weekly put purchase is merely a cheap way to take away the downside tail risk on the earnings event.  We would be happy for it to expire worthless and GME to move higher this week.  If GME does move below 37.50 this week and the earnings report does not reveal any significant long-term fundamental changes, then we would sell the long put position to close and keep our long stock position after the event.