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“I skate to where the puck is going, not where it has been.” – Wayne Gretzky
On first glance you wouldn’t think of RH (RH) and GameStop (GME) have much in common. However, GameStop is where RH was in 2017 and if GameStop were to employ what I’ll be calling The Gary Friedman Playbook. I’m writing this article to use RH as an comparable retailer to show there are paths to prosperity, show how GameStop is positioned similarly to RH in 2017, and note how several actions could plow the road for GameStop to its future mode. The short interest in GameStop has become irrational (89% of all shares) and short sellers are exposed to risks similar to the man picking up a quarter in front of a street sweeper.
Why Compare GameStop with RH of 2017?
GameStop and RH are both niche retailers that fell victim to some near term headwinds, operational mistakes and a narrative that anything brick and mortar will fail. RH successful transition of its model should serve as a guide for the potential that retailers can compete with internet only companies.
I began following RH in 2016 their stock price had fallen from $100 a share to $30. They faced several headwinds and had made some internal missteps that were solvable in launching a new product line. In this article I’ll go over the key steps that their CEO Gary Friedman led that has transformed their business, greatly improved their profitability and defeated the irrational short interest that existed in 2017.
I am confident that doubling down on its current strategy and looking to the example of Gary Friedman could set GameStop on a similar trajectory.
First, a few similarities the companies faced (positively and negatively)
- High level of available cash relative to their market cap
- Operational models that can be rationalized
- Fanatical customers that can be engaged in ways beyond selling products
- Irrational level of short interest based on claims of “the death of retail”
- Investor bias toward revenue growth and management bias toward cash flow and profitability
- Past missteps by management that eroded confidence in a turn around
- Businesses that have real risks and need to evolve their business models
Now, let’s get into the Gary Friedman playbook.
Step 1: Generate cash flow while market cap is irrationally discounted
In Q2 2020 GME reported a net income loss, but produced free cash flow of $181.9 million, not bad for a company that had a market cap under $300 million during the quarter. In 2016, RH market cap hovering around $800 million to $1 billion and ended 2016 with inventory of $725 million. Friedman being an astute capital allocator knew that cash flow on hand could be deployed to buy his underpriced shares. RH began liquidating inventory from its outlet stores, sacrificing near term margins to maximize free cash. In 2017 RH generated $432.8 million in free cash flow, over half its market cap.
Game Stop’s recent quarter reminds me of a similar situation. Current management is focused on generating free cash flow by reducing inventory, limiting Capex and pursuing asset sales. While there was disappointment with revenue and net income in Q2 2020, GameStop generated $181.9 million and reduced inventory 50% from the prior year. GameStop has also had asset sales that have and will add around $90 million in additional cash. The cash balance at the end of Q2 is $735 million relative to a current market cap hovering around $400 million. Management also confirmed an additional $40 million from a sale leaseback transaction in early Q3. Good job to Sherman/Bell and team!
Step 2: Execute a bold and intelligent share repurchase program for at least an additional 20% of shares
GameStop’s stock is inhabited by short sellers. As of 9/24/2020 short interest was 101.9% of outstanding shares. With GameStop management sitting on $735 million in cash, plus the additional $43.2 million from the sale lease back transaction that closed in Q3, GameStop has ample firepower to use a small portion of cash to make GameStop a less pleasant place for short sellers to inhabit while creating tremendous value for existing shareholders.
Gary Friedman’s next step was to authorize a $300 million share repurchase in February 2017. He bought swiftly at these low prices and announced the completion as well as an increase by $400 million, a $700 million total while the company market cap hovered around $1 billion.
The only reason for a share repurchase program is if management is buying the company at a discount in the open market. Due to both GameStop and RH in 2017 being priced for bankruptcy, these are the times management can add more value by buying back shares than by reinvesting internally.
RH 40 million shares outstanding and reduced to a little over 20 million at year end. Short sellers had around 15-18 million shares borrowed to short the company during 2017 which put the short interest well above 50% of all shares outstanding. Considering Mr. Friedman owned close to 30% of shares, this put near term pressure that available shares were hard to come by. At the time, I received messages from Charles Schwab asking me to participate in their asset lending program. I just received a similar email in regard to GameStop. Consider the downside those short sellers were holding onto now that we’ve seen the company increase in value by 16x as it went from a price of $25 per share in 2017 to $400 after it reported Q2 2020 earnings. This is the equivalent to picking up a quarter in front of a street sweeper.
GameStop Short Interest – 89% of All Outstanding Shares as of 8/31
As of 9/24/2020, the short interest in GameStop was at 101.9% of all outstanding shares. In this situation, instead of Mr. Friedman holding a large portion, GameStop has attracted investments from significant value investors like Chewy co-founder Ryan Cohen (RC Ventures – 9.6%) and Big Short Michael Burry of Scion Capital for example. The point is, there are not a lot of shares available and with the level of cash GameStop has on hand, they won’t be retiring anytime soon.
As Michael Burry wrote to shareholders in fall of 2019, management has a golden opportunity to take even a minor portion of their cash holdings and repurchase shares to buy back the company at a significant discount. Management has more than enough capital to satisfy inventory demands for the new console cycle and to weather the storm.
Economics of an intelligent share repurchase:
There are various ways to gauge the effectiveness of a share repurchase, in this scenario GameStop has ample cash on hand for additional inventory related to the console cycle. The console cycle should also produce free cash flow for the business, so if we look at a market cap of $636, cash after the sale leaseback of around $775 million and $500 million in inventory that may be converting to cash, each $1 of shares repurchased buys $1.21 of cash on their balance sheet. As additional cash is added from the release of the consoles this $1 buys cash today and cash tomorrow.
Short sellers may not have studied Warren Buffett’s career very closely. If they had they’d realize that he and Ben Graham focused on companies where their net assets greatly exceeded their current market cap. Reminds me of this Warren Buffett quote: “I like to go for cinches. I like to shoot fish in a barrel. But I like to do it when the water has runout.”
Management has done a great job of freeing up cash. Now its time to follow Gary Friedman’s playbook and take what the short sellers are giving you, which is a once in a lifetime opportunity to seize a large portion of their business and let the short sellers know they can stay as long as they’d like, but you’re happy to take the other side of their trade. If the business ultimately fails, it won’t be due to buying back 20-30% of the company while its market cap trades under cash on hand.
Step 3: Rationalize business and focus company toward core customers
GameStop management has been rationalizing their business model and footprint with a focus on free cash flow. In GameStop’s rapid expansion they’ve built a network of stores that is no longer warranted. Just look up GameStop on your local map and you’ll see stores blocks apart from each other. GameStop’s revenue is not a problem, they have over $5 billion in sales at the end of a 7 year console cycle, they have an optimization issue. Even look at companies like Starbucks who regularly close underperforming stores as part of a “pruning” process.
GameStop’s plan may face critics who see headlines about declining sales and think “this confirms” my thesis, they are the next Blockbuster, but when you take a look under the hood, GameStop has plenty of business flowing through their stores and they need to focus on providing a better customer experience and optimize their portfolio of stores. Due to the short term leases and how they might reinvent the business, this is a solvable issue and will take place over time but doesn’t mean its the end of the game.
In 2017 RH management team began to re-architect their operating platform and rationalize it based on their new store models. They took a fine comb to not only reduce costs but to simplify the operations by reducing SKU’s that added revenue but little profit, they consolidated fulfillment stores, streamlined outlets and backend logistics (shipping furniture is expensive). These moves were met with criticism from analysts because it looked like the business was shrinking, when in fact they were optimizing and refocusing on the highest value aspects of their business to position the business for future highly profitable growth. In Q2 2020 RH announced they see a clear path to 25% operating margins! Just a few years ago analysts doubted they could make a profit, then when they got to 10% operating margins they thought it was a fluke, then last year they hit 15% and this year 20%. There will always be doubters and nay sayers, but this is noise to a good management team (exceptional management team in RH’s case)
Step 4: Create an ecosystem of products, services and experiences that gamers can’t live without and suppliers must participate in
GameStop’s next step is not clear but they have optionality due to their cash and the entrance of Ryan Cohen.
In 2017 RH was still tinkering with larger format stores and later rolled out a capital light prototype they could use to expand RH has been piloting with larger format stores since about 2012. These larger format stores allow them to pivot from selling pieces of furniture to the common public to selling floor to ceiling rooms and spaces with professional interior design to the wealthiest individuals in the country who own multiple homes and would prefer extra time to paying a little extra to turn their home into an incredible place.
While many saw RH building “big stores”, they were building a reinforcing platform or flywheel. For RH to attract the high end consumer, they needed to also attract the high end designers. Their stores are a physical platform that differentiates their models from online or smaller furniture retail stores. This elevates the brand of RH, it elevates the brand and price point for the suppliers and make the best suppliers more likely to place products with RH than other retailers. Inspired by Apple’s App Store which attracts the best developers, RH created the best luxury furniture design platform.
I believe there are several paths GameStop can take to evolve their model and please enter Ryan Cohen, co-founder of Chewy and over 9% shareholder in GameStop. Ryan Cohen’s vision for creating a niche online experience for pet owners seems like a credible path that GameStop could use to take GameStop’s knowledge and expertise of gaming and create a differentiated online experience for how consumers buy and quickly receive games.
Below are several ways GameStop’s management can look to provide experiences to customers in the future world of gaming.
Gaming is thriving and Esports seems like a way that GameStop could be the hub for in person gaming events. RH began closing multiple stores in a city and building a four story design gallery. I’m not arguing GameStop needs four stories, but as commercial real estate flounders there may be opportunities to create gaming stadiums where events and leagues are hosted to drive traffic physically but allow customers to purchase online.
Bundled services for gamers. Creating a one stop shop where gamers sign up for leagues, tournaments and in person experiences but also gain loyalty rewards when making direct purchases or having the option to pay a monthly membership fee to have discounts and access to all of GameStop’s offerings. Think Amazon Prime or even the limited movie pass that AMC rolled out last year prior to the pandemic. This recurring revenue and ecosystem of gaming experiences, products and services would be a powerful flywheel.
By creating this ecosystem of gaming, GameStop like RH would become the platform for gaming and draw in new innovative experiences from the likes of Sony, Xbox and other gaming suppliers. By creating a sticky customer base, this would give GameStop positive leverage to be more profitable.
Ryan Cohen Playbook
Lastly, and the most likely change that can take place with Ryan Cohen as a major shareholder is the Ryan Cohen Playbook.
In speaking about Chewy’s strategy back on Aug. 13th, 2019, Ryan Cohen said:
The strategy from the beginning is replicating the experience I had in the neighborhood pet store but doing it online and doing it at scale… showing our customers we care about them, we care about their pets and we don’t want them dream of shopping anywhere else for their pet products. Pet owners are fanatical, that’s the ecosystem we’ve built, the foundation and soul of the company and being focused on this category is a huge differentiator against some of our other competitors.
We don’t know what will come next with Ryan Cohen’s involvement, if anything, but I believe he brings confidence to GameStop’s ability to create a strategy and path beyond the current gaming console launch. All of the strategic principles he talks about when building Chewy apply to a future in person and online experience gamers can go to.
One commonality after studying Gary Friedman as a CEO is that both he and Ryan Cohen have a unique blend of a value investor meeting an entrepreneur and both frequently cite and emphasis on cash flow and cite Warren Buffett’s investment quotes. I know this is a stretch for most folks but typically entrepreneur idea guys don’t dial it back to talk about prudent cash flow management.
I strongly believe the future of GameStop is in management’s control and these lessons from RH and Chewy are simple playbooks management can use today to:
Evict the short sellers who have been inhabiting the stock since its peak at $40 a share and have irrationally borrowed 101.9% of total shares outstanding with an intelligent share repurchase that pushes the stock to fair value or buys 15-30% of shares outstanding. Short sellers have lost credibility to talk about business model risks when they expose themselves to massive downside risk like this.
Optimize the footprint so that new console sales produce more cash flow to the bottom line. Use future cash flows and excess cash to create an in person and digital ecosystem that gamers can’t live without.
In closing, GameStop and RH are not without risk, sentiment is extremely negative and the path forward looks foggy. But both company’s challenges are solvable.
I am reminded of this quote I believe is attributed to Benjamin Graham but can’t confirm the source and exact detail: “Rising businesses may fall and the dead may rise again.”
Disclosure: I am/we are long GME, RH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.