Michael Burry, the boss of hedge fund Scion Asset Management, rocketed to public prominence in the years following the financial crisis thanks to his leading role in Michael Lewis's bestselling "The Big Short" and the subsequent film of the same name. Burry took a contrarian position, betting against the U.S. housing market by buying credit default swaps against investment-grade subprime mortgage bonds. In the end, he both profited handsomely and gained a reputation as a contrarian to watch.
Burry has recently unveiled his latest contrarian play: going long on GameStop Corp. (NYSE:GME), a battered video game and electronics retailer.
Bottom of the cycle
Burry's GameStop bull thesis is based on two key elements. The first involves the cyclical nature of the video game console business, which tends to take off when next-generation gaming consoles come to market. Even now, with most console platforms looking rather long-in-the-tooth, 90% GameStop's stores remain cash flow positive, a sign that the industry is not quite as moribund as pessimists believe.
With the next round of console releases imminently approaching, Burry sees room for GameStop to rise . Indeed, while GameStop stores' cash flows tend to dry up in the years following new console platform launches, they always rebound when the cycle begins again. With leading console makers Sony and Microsoft Corp. (NASDAQ:MSFT) getting ready to launch their next-gen offerings, now may be the time to buy.
Burry's second point deals with the long-run technological trends affecting video game consumption. There is an undeniable long-run trend toward downloading video game content, rather than buying physical game disks. At the same time, sales via alternative channels, such as online retailers like Amazon.com Inc. (NASDAQ:AMZN), threaten GameStop's retail business model. These twin forces have led many analysts to start a veritable deathwatch for the company. But Burry says this is a mistake.
Indeed, while the days of physical video game disks may be numbered, their imminent death is likely exaggerated. The vast majority of consumers of the most expensive -- and profitable -- game content, so-called Triple-A (or AAA) games, still opt for the physical option, according to a survey conducted by gamesindustry.biz and Ipsos last year:
"When it comes to AAA launches, an estimated 75% of an average game's sale still comes via physical goods sold via Amazon, GAME, GameStop and the rest."
A perfect storm creates opportunity
According to Burry, the confluence of various market fears, coincident with a cyclical bottom, have led to the struggling niche retailer getting beaten down too far :
"The streaming narrative dovetailing with the cycle is creating a perfect storm where things look terrible. [But] it looks worse than it really is."
GameStop shares are down 80% from their highs, but Burry believes 2019 will likely prove to be the near-term bottom as next-gen consoles emerge and the cycle revs up. At the same time, Burry sees an opportunity for the company to buy back shares at the current depressed price levels:
"Technical factors driving the stock to lows has created an opportunity for substantial buybacks at below private market prices. There is no better use of capital."
GameStop currently operates under a $300 million buyback authorization, but has thus far bought back only $62.4 million. Last week, Burry took a newly activist tone, issuing a letter to GameStop's board calling for a more aggressive buyback strategy :
"We're at low tide on the cash balance. The balance sheet checks out for me."
With a high level of short interest in GameStop, a surprise to the upside could pop the stock significantly, as could a reinvigoration of its stock buyback program.
Buying a dying business
This is undoubtedly a business in long-term decline, even if it is at a cyclical bottom. As Mark B. Spiegel, an irreverent and pugnacious hedge fund manager, has pointed out, it can be hard to find a dying sector appealing:
" This Michael Burry [GameStop] long call is the ultimate 'cigar butt' stock, as in 'Why bother?' Post-Internet, the yellow pages companies were DIRT cheap on current metrics and no one cared, and then they disappeared...A great value investor buys stuff that's really cheap but has great upside, so when the growth reignites there are lots of people to sell it to. If everyone knows a company is a cigar butt with a few puffs left, everyone then knows the universe of future buyers is much smaller."
Spiegel's criticism that the upside may be priced in is not unfounded, but it does not appreciate the dynamics facing GameStop itself, or the niche industry in which it operates. We see upside based on the somewhat chunky nature of the video game console cycle, as well as relatively limited coverage of GameStop and the niche retail industry.
Burry makes a very strong case that GameStop is underpriced at present. There is still a strong market for physical games, and GameStop's ability to act as a trade-in and resale nexus gives it a degree of survivability thanks to its particular niche. At the same time, the next cycle of consoles, with next-gen technologies, games and capabilities, will lift GameStop's financial prospects, at least for a while.
That being said, we are still skeptical of the long-term viability of the business, as retail gradually melts away in the face of online alternatives, and as physical games diminish in relevance and market share.
In sum, GameStop represents a solid short-term valuation play. GameStop's stock has surged somewhat since Burry made his activist play known, but there should still be considerable upside through 2020, especially if the company follows Burry's advice and reignites its buyback program with vigor.
Disclosure: No positions.
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