<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="At the 2012 Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) shareholder meeting, Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) were asked how they value declining businesses, such as their World Book encyclopedia business in the 1990s when it was disrupted by Encarta, a product sold by Microsoft (NASDAQ:MSFT). Here’s what they said:” data-reactid=”11″>At the 2012 Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) shareholder meeting, Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) were asked how they value declining businesses, such as their World Book encyclopedia business in the 1990s when it was disrupted by Encarta, a product sold by Microsoft (NASDAQ:MSFT). Here’s what they said:
Munger: “Want me to answer that one? They’re not worth nearly as much as growing businesses. But they can still be quite valuable if a lot of cash is going to come out of them.”
Buffett: “Generally speaking, it pays to stay away from declining businesses… If you really think a business is declining, most of the time you should avoid it. Now, we are in several declining businesses. The newspaper business is a declining business… We will pay a price to be in that business, but that is not where we’re going to make the real money at Berkshire. The real money is going to be made by being in growing businesses, and that’s where the focus should be. I would never spend a lot of time trying to value a declining business… The same amount of energy and intelligence brought to other types of businesses is just going to work out better.”
Let’s look at a current example that has been in the press lately: GameStop (NYSE:GME).
Last month, investor Michael Burry of Scion Asset Management disclosed he owned 3 million shares of GameStop (roughly 3.3% of the company). He also sent a letter to the board of directors urging them to immediately execute the remaining $238 million on their share repurchase authorization. In his letter, Burry said the following:
“As mentioned in our previous letter to the board, we have concerns regarding capital management at GameStop… We submit that when share prices are at or near all-time lows and more than 60% of the shares are shorted despite cash levels much higher than the current market capitalization, lack of faith in management’s capital allocation is the default conclusion.”
Interestingly, Burry doesn’t seem to disagree with the market’s conclusion. If anything, it sounds to me like he agrees (for example, he noted that the company missed out as “the new paradigm came into clear view over the last five years”). In addition, he doesn’t really say much about the core business. I think that’s noteworthy because GameStop reported horrendous results in its most recent quarter, with same-store sales down 10%. By the way, management does not expect the situation to get much better in the near term (guidance calls for a 5% to 10% decline in same-store sales in 2019). Burry only discusses the short-term impact he expects from the new console cycle in 2020 and 2021. What he expects in 2022 and beyond is anybody’s guess.
In a nutshell, Burry says he does not have faith in management’s ability to allocate capital or turn around the business.
“But what is happening now in the stock is about more than late cycle doldrums or even the streaming paradigm – shareholders do not have faith in current management and have not been inspired by new leadership policies,” he said.
So if he doesn’t like the business or the management team, why the heck is he buying the stock?
Personally, I don’t think Burry is particularly concerned with what happens to GameStop in the long run. The fact he glossed over where this company should try to be in five or 10 years is noteworthy. Instead, he is focused on the cash that can be generated – and wrung out – from the business over the next several years.
And he has a point. The business clearly faces significant structural headwinds. In addition, it’s fair to question whether management will intelligently allocate both the cash sitting on the books and any future free cash flow generated by the business. For that reason, in the eyes of owners like himself, there’s a case to be made for effectively liquidating the business and returning the remaining capital to shareholders.
It’s probably helpful to quantify his bet. GameStop generated roughly $230 million in free cash flow in 2018. Let’s assume free cash flow declines 25% in 2019 to $175 million. Using that as a starting point, here’s what the cumulative free cash flow looks like over the next decade (2019 – 2028) at varying rates of annual decline.
Relative to a market cap at the time of Burry’s letter of less than $300 million, a few of those scenarios look pretty good. Of course, with the stock at something like two times free cash flow (on that 2019 estimate of $175 million), that should not be too surprising. And this is all before considering the nearly half a billion dollars in cash Burry estimates GameStop is holding.
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But beyond the timing and magnitude of future cash generation, there’s another big question to answer: How will these funds be used? This is where I start to question the thesis. As I noted in a recent article about retail cigar butts, there are reason to be skeptical of an orderly liquidation:
“At the end of the day, these investments essentially rest upon the idea of a timely liquidation. Assets used in current operations can be sold, with the proceeds distributed to owners. But that outcome requires management to fire thousands of employees, admit defeat and ultimately put themselves out of a well-paying job. Unsurprisingly, few managers accept such a fate (especially managers without a significant financial interest in the long-term per-share value of the stock). Instead, they slowly close stores generating inadequate returns – a list that grows over time. In addition, they lean on the best-performing boxes for cash that is spent in an effort to try to reinvent the business.”
We haven’t heard from either the board or management since Burry sent his letter, but I’ll make a prediction: there’s almost no chance they will come out and commit to his plan. (To be clear, I am not saying that’s the right decision.)
And if you want some support for that conclusion, here’s what newly appointed CEO George Sherman said three months ago:
“We believe we will transform the business and shape the strategy for the GameStop of the future. This will be driven by our go-forward leadership team that is now in place, a multi-year transformation effort underway, a commitment to focusing on the core elements of our business that are meaningful to our future, and a disciplined approach to capital allocation.”
Finally, here’s the chairman of the board, Daniel DeMatteo:
“The board is confident that redirecting capital towards debt reduction and transformation initiatives will create shareholder value over the long-term.”
Call me crazy, but it doesn’t sound like either of them will be interested in Burry’s proposal.
<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Conclusion” data-reactid=”59″>Conclusion
Munger once said, “It’s the nature of things that some businesses die… you shouldn’t fight it. There is no logical answer except to wring the money out and go elsewhere.”
You could argue that applies to GameStop. Even the bulls are unlikely to argue that the legacy retail business will be anywhere near its current size a decade from now. Continued growth in digital downloads, as well as other risks like subscription services, are a major problem for GameStop (“New Software” accounted for 30% of revenues and 23% of gross profits in 2018). Long term, the business is in trouble. Given that reality, what should be done?
Based on what he said in his letter (or really, what he didn’t say), I think Burry believes they should let it die. And that strategy could work for shareholders. If management accepts reality and effectively liquidates the business over the next five to 10 years, the cumulative capital returned to owners over that period could exceed today’s market cap by hundreds of millions of dollars.
But for the reasons mentioned above, I don’t think that is likely. It goes against human nature. Management won’t fold willingly. Instead, they will probably try and win despite a bad starting hand. They will try to save the business and keep themselves employed. Buffett is right: “If you take the equation of the manager, he or she may be far better off ignoring that reality than accepting it”.
We’ll see how it works out for Burry. Personally, I just don’t have any interest in this kind of investment, and that’s not for a failure to appreciate how the numbers could work (particularly if this is in a basket of like-minded bets). But it’s just not in my wheelhouse. I agree with what Buffett said at the 2012 shareholder meeting: “The same amount of energy and intelligence brought to other types of businesses is just going to work out better.”
Disclosure: Long Berkshire Hathaway and Microsoft.
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