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The days of walking into a retail location to purchase a video game are numbered. With the proliferation of online sales, brick and mortar retailers are losing market share. Certain retailers are faring better than others, but one thing is clear- shopping is moving online. Coupled with the online shift, the video game industry is changing to downloadable content; they are cutting out the middleman, Gamestop. We believe that in a few years, Gamestop (NYSE:GME) will be bankrupt.

The cloud is the way of the future and there will soon be no need for physical video game discs. Sony is the first major company to take a large step towards this end. Sony announced the launch of a cloud-based gaming service, Playstation Now. The project will allow gamers to play Playstation 3 and Playstation 4 games without having to purchase the physical disc. Gamers will not be limited to just new games and will also be able to buy older games which is the real blow to Gamestop as they have very high margins on used games. Sony is launching a beta version in the U.S. in January and expects to roll out a full version by mid-2014. We expect other gaming platforms to follow suit and alter their distribution methods as well. The cloud has made Gamestop unnecessary.

By examining the fundamentals of Gamestop, it is apparent that the company is facing pressure. Margins which are essential for any retailer have been suppressed. EDITDA Margin has decreased from 9.34% in 2009 to just 7.96% in 2012. Each year, GameStop is losing profitability. From a liquidity point of view, GameStop is losing ground as well. In 2008, they had a quick ratio of .72 which has fallen to just .44 in 2012. The quick ratio is an essential liquidity measure for a retailer because it shows short term assets minus inventory divided by short term liabilities. If this ratio were to deteriorate further, GameStop's solvency would become questionable. Furthermore, the Return on Equity has decayed from 9.64% in 2009 to just 6.88 in 2012. An investor would get a decreasing return on their investment which is always a red flag. Finally, GME is investing in the wrong avenues. The market is moving online, while GME has increased its property and equipment from $1 million in 2009 to over $1.5 million in 2012. Brick and mortar has been losing market share each year and GME is investing there!

GameStop just reduced their current guidance for the fourth quarter and have reduced their estimates for the earnings per share to be in the range of $1.85-$1.95. Wall Street was projecting $2.14 per share. Clearly, the market is beginning to unravel for them. At a time when two new consoles entered the market and demand for video games was very high, GME was not able to capitalize. This is the first sign of many more disappointments to come for this archaic business.

How to trade it:

Shorting a stock is always a risky venture. The threat of a margin call is always a possibility and since the days to cover is around 10, a prudent investor should limit their risk by investing in put options. We suggest buying out of the money put options on GME. Depending on your level of conviction, you can vary the strike price as well as the expiration date. A shorter expiration date carries more risk since the option would expire worthless if it doesn't reach the strike price. We suggest buying the January 17th 2015 expiration date at a strike price of $18. Although this is a risky trade, we believe that Gamestop will soon be in a downward spiral and this trade provides significant upside.

Source: A Sweeping Change That Is Disrupting An Industry: The Inevitable Fall Of Gamestop

Additional disclosure: I am short through put options.