Gamestop bonds: A better play than the stock

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Gamestop BondsThis has been a brutal year for retailers. Just last week, questions were raised about Sears’ ability to continue as a “going concern” and rumors began swirling that Payless may file bankruptcy as early as this week. Then on Thursday, Gamestop announced their full year earnings for 2016 and provided guidance for 2017 that disappointed investors.

The stock is currently down 12% which may lead contrarians to consider purchasing shares. With the fall in the share price, the dividend yield is now above 7% and the P/E multiple is at 5.5x. Those valuation metrics will likely land this stock on a value screen but this stock looks like a value trap to me. A better way to play Gamestop is with their bonds but since they are a private placement issue, only qualified institutional buyers are able to buy them.

Gamestop Bonds

Gamestop has two bond issues: one of them is a $350 million 5.5% coupon with a maturity on 10/1/19 that is trading around a yield of 4.45%. The other is a $475 million 6.75% coupon with a 3/15/21 maturity which last traded around 4.72%.

Gamestop has a bond rating of Ba1 from Moody’s and BB from S&P which places them in high yield or “junk” status.

Gamestop Credit Outlook

The long-term outlook for Gamestop is in question due to the secular decline of brick and mortar retailers. Gamestop faces an even greater challenge in the transition away from physical disc video games to digital downloads. Since their core business revolves around selling video games, this is not something I think they will be able to counter in the long-run.

In the short-term, they have added AT&T retail outlets, began focusing on collectible merchandise, and have their own online gaming platform known as Kongregate. This diversification will help extend the life of the company but I’m not sure that it will be enough to stop the bleeding from the loss of video game sales.

Gamestop bonds

The company’s EBITDA was $779.8 million for last year which was just slightly below their total debt outstanding of $815 million. They also have an ample amount of cash at $669 million. Those credit metrics alone would make them investment grade but they also have a substantial amount of operating leases for their stores.

Their leverage ratios are very low even when including operating leases at just over 1x debt (and leases) to EBITDA.

The problem is the company uses quite a bit of cash on dividends and buybacks. They have been very shareholder friendly. The two bond issues were used to finance share buybacks. In 2016, they spent a combined $348 million on buybacks and dividends.

Most importantly, the company currently has the cash flow to continue covering interest payments on their bonds and their operating leases. Interest expense for 2016 was only $53 million and their current year operating leases total $344 million. By adding the $344 million to their EBITDA of $779.8 million and then dividing by their interest expense and their operating leases we come to a fixed charge coverage ratio of 2.83x. The company has already announced they plan to close some stores which should reduce their operating lease expense and help improve their coverage ratios.

Gamestop has several catalysts to help drive sales over the next few years including new console releases such as the Nintendo Switch, the upcoming X-box “Project Scorpio” from Microsoft, and the Sony Playstation VR.

Gamestop Bonds vs. Gamestop Stock

The bonds may not offer a yield as attractive as the current market implied stock dividend yield of 7.14% but the short maturity schedule of just 2 or 4 years makes the bonds more likely to return full principal value than the stock. The company has reported disappointing results as of late but they are nowhere near immediate bankruptcy. Sears/K-mart managed to survive much longer than most people thought they would.

The bonds offer a lower risk way to add investment income from Gamestop while being careful with preserving your capital. The stock might have some upside in the short-term with new console releases but I view equity investments from a long-term perspective. The idea of locking up capital in the stock while there is no end in sight for the negative market sentiment around retailers does not appear to be worth the risk.