Shares of GameStop Corp. (NYSE:GME) have appreciated dramatically over the past year, which has led many investors to question where they go from here. What is interesting is that lately, the company has had awful fundamentals, yet has continued to rise. GameStop is operating at a loss, creating poor cash flows, and seeing less foot traffic in its stores, yet it has continued to grow in value. The way I see it, there are a few ways to trade GameStop now- each in different time horizons:
1- Short GME from roughly $42 down to $38 for a gain about 10%
2- Go long @ $38 and hold until the end of 2013
3- Remain on the sidelines until Q4 2014, then go long
1. Short Game Stop in the Short-Run
GameStop has fought its way to a new 52 week high, and is now resting about 140% above its 52 week low. If you have been an owner over the past year, this is a stock that has probably carried your portfolio and provided some serious alpha. However, at current levels, the bull case is running dry and the bear argument seems to be the more legitimate thesis. As can be seen in the chart below, the share price is at the top of a strong trend channel. It is also trading significantly above each of its moving averages. Although analysts from Oppenheimer, BB&T, and Sterne Agee have recently raised price targets into the mid-$40s, I feel that it's more likely to pull back in the near term. Also, note that the short interest is roughly 30% currently, so this trade sentiment seems to becoming a popular one.
Risk- With this trade strategy, we are relying heavily on the chart above. If the price does continue to rise in the very near-term, we may see support developing at roughly the current levels. To address this downside risk, I strongly recommend a tight trailing stop- maybe 5%. A tight stop will prevent a tough downside loss in the event that shorts begin to cover their positions in masses. In the event that GME breaks this price channel and seems to develop strength, reverse your position and go long.
2. Go Long at $38.00
Sit back and wait for a more favorable valuation before going long. We will likely see a pullback to roughly $38.00. At this price, the shares will be sitting at 12X forward earnings, which is more reasonable than the current 13.5 P/E. There should also be support at the 50-day moving average, which is roughly at the $37.70 level. At this level, I think investors can feel comfortable taking a bullish stance going into the year's end. This entry point also represents the lower bound of the price channel.
During the second half of this year, there are numerous large-scale game launches that GameStop will be able to cash in on. The first of which is Madden 25, the world's second most popular sports video game, which is set to release on August 27th. Next, we will see the release of Grand Theft Auto V and NHL 14 in mid-September, followed by NBA 2K14 and Call of Duty Ghosts in October and November. Typically, video game retailers bank roughly $12 in income for each new ($60 retail) game, and around $25 for each lightly used game. In fact, GameStop earns more than 45% of its net income from these used game sales. It should be noted that a majority of GameStop's used video game software sales occur two months after the original release of each game (Kotaku.com). Therefore, the second half of the year will likely be strong for GameStop, as the market will flood with new highly popular games.
The bottom line is that the second quarter will likely be tough for GameStop. In the company's forward looking statements, executives stated that second quarter comparable store sales could sink as much as 16% and that diluted earnings per share will range from $0.01-$0.07 (compared to $0.46 in Q1). This will likely provide investors with a more attractive entry point around $38.00 per share. My recommendation is to hold this position until the end of 2013.
Risk- If either Microsoft or Sony provide significant changes to their respective gaming platforms (such as the ability to stream new games as well as older ones), GameStop is in muddy waters. This is a looming risk in the industry that could potentially destroy the company's profitability.
3. Wait Awhile
Over the next full year, releases of new gaming systems from Sony (NASDAQ:MSFT) will slowly squeeze the brick-and-mortar new and pre-owned game stores. In the company's most recent quarterly report, forward looking statements claimed that "Typically, following the introduction of new video game platforms, sales of new video game hardware increase as a percentage of total sales in the first full year following introduction." As these new sales represent the largest portion of overall sales at 37.7%, the lower average margin could significantly decrease the company's overall margin. Further, "the net effect is generally a decline in gross margin percentage in the first full year following new platform releases and an increase in gross margin percentage in the years subsequent to the first full year following the launch period." Basically, as sales and earnings increase due to these new hardware launches, margins will decrease until the proportion of revenue from each category levels off around historical averages. A normal product mix generates about 15% of revenues from new video game hardware, about 35% from new video game software, 30% from used video game software, and 20% from other sources such as peripheral hardware, ad sales, social gaming, and more.
GameStop's largest income producing segment will likely feel some pain as a result of the upcoming video game console launches. For example, Sony's PS4 will likely provide backwards compatibility for gamers, meaning that PlayStation games from previous generations will still be playable on the new system. However, these games will not be compatible in their current disk-form. Rather, the games will be streamed to a user's system via WIFI and will not require the use of hard-disk storage. This new trend in moving from physical disks to WIFI streaming games will be detrimental to GameStop's model in the coming year as gamers will be purchasing fewer games in stores and will increasingly start to stream games.
Where is the trade opportunity here? Well, I don't see one until Q4 of 2014; there are simply too many variables here. Between the new game console releases that will contract margins, the release of many new games that carry a low margin for the company, and the pain that could potentially be felt due to the streaming of older games, GameStop could make some dramatic moves during 2014. I say wait until Q4 2014 because, by then we will see the true implications of the previously mentioned risks. Unless GameStop provides significant plans to combat lower future used game sales, I think it's too dangerous to go long until margins begin to grow in the end of 2014. I predict that margins will come back at the end of 2014 because the boom of new game systems and product releases that carry low profit margins will be mostly subsided, leaving room for GameStop to potentially cash in on its primary margin boosting categories. It would also be nice to see the company start to generate cash flow before putting faith in their growth. Next year will be a volatile year for GameStop, and investors will likely need more information from management before there is enough of a reason to go long.
Risk- What is the risk here? Well, there isn't much. If we sit this one out for a bit and "play it safe", we will learn a lot more about the future of GameStop. If we miss the long-term opportunity, oh well- we didn't lose money.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.