Netflix may have taken the initial steps to enter the video-gaming market. Even as the digital streaming of games may have already signaled the death knell of GameStop’s lucrative physical used-game business, that Netflix may be moving into video games may further truncate not only GameStop’s longevity, but also have ramifications across the entire video-gaming landscape. Private equity may be interested in GameStop, nonetheless.
By Brian Nelson, CFA
The video-gaming complex was upended June 13 when Netflix (NFLX) announced that it would be producing “an interactive Minecraft series for kids and licensing Stranger Things for a video game.” Netflix said it doesn’t “have any plans to get into gaming,” but we think it only makes sense and is likely inevitable. Outerwall, which owns the Redbox movie rental kiosks, has been facilitating the rental of video games from its locations for as long as we can remember, and this has been a huge untapped source of revenue and customer retention for Netflix. Even if gaming may not trigger a price increase at the movie-streaming giant, it may keep customers on its platform longer, especially given the rise in gaming interest of late.
We think the end game is becoming clearer for GameStop (GME). Though the company generates considerable free cash flow, on average $400 million, during the past three fiscal years, and has a relatively net-neutral balance sheet at fiscal-year ends, it continues to face an uphill battle, as total global sales fell 5.5% during its fiscal first quarter, almost wholly attributable to a same-store sales decline, though it did face a difficult comp given Nintendo’s (NTDOY, NTDOF) launch of the Switch in the prior-year quarter. GameStop’s adjusted earnings per diluted share came in at $0.38 versus adjusted earnings per diluted share of $0.63 in the prior-year period, and we would expect year-over-year weakness to persist, despite what is traditionally a back-end loaded fiscal year. We think GameStop may be of interest to private equity as a wind-down story, but its technicals are atrocious for it to qualify as one of our best ideas.
The rest of the gaming landscape hiccupped after the Netflix announcement, with Activision (ATVI), Electronic Arts (EA) and Take Two (TTWO) experiencing volatile, but generally positive trading. The video gaming industry is experiencing tremendously high demand, and reports of professional gamers making $500,000 a month may be only attracting more and more gamers. We think if Netflix does decide to move more heavily into video gaming, it may likely have to license games from the publishers, a short-term win for gaming-makers. However, as with what happened with Netflix and movies, we can’t rule out Netflix working with publishers to eventually make its own video games. We’d view this as a long-term negative for the videogame publishers, but certainly not something that will impact performance in the very near term.
We continue to watch Netflix’s equity price move higher, and while we raised its fair value estimate more recently, we still believe shares are built more on castles-in-the-air than on a firm foundation. The company did show in its most recently-reported quarter that its business does have earnings leverage, but the degree of which remains why we have such a large fair value estimate range. The hit-or-miss nature of video-game development, in general, makes the video game publishers less attractive as long-term investments, in our view, if only relative to our existing ideas in the simulated Best Ideas Newsletter portfolio. The gaming end market remains incredibly healthy, however, and it will likely only get stronger as the coming generation continues to embrace gaming technology.
We think GameStop’s shares are undervalued, but our fair value estimate may likely approximate what private equity may be valuing the equity at, rather than what the marketplace is willing to pay for shares. If we assume GameStop doesn’t lever up and generates half of its annual run-rate free cash flow into perpetuity ($200 million), approximating a gradual decline into obscurity, a discount rate of 8%-10% implies an equity market value of $2-$2.5 billion, about in-line with our in-depth fair value estimate calculation, which values shares north of $20 each. If private equity steps in, GameStop could be a winner from current levels. If not, its equity price could languish for years.
Related: UBSFY, ZNGA, GAMR, SNE
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Brian Nelson does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.