Regardless of whether GameStop (GME) beats estimates when it reports earnings this week, fundamental changes in the industry have rendered the business model obsolete. It is only a matter of time before it is GAME OVER for the company. While the stock seems cheap trading at 7.7x trailing earnings, I believe that this is a classic value trap. My five year price target is $1.00.
The company is experiencing threats to its business model on all fronts. The accelerating pace of technological change will only exacerbate the demise of the company.
On the hardware side, the single purpose handheld video game player is likely to disappear and along with it the plug in game cartridge. The new paradigm is to have a multipurpose device like the iPod Touch. Investors only need to look at the dynamic of the cell phone market to see the future. Handset makers have already consolidated phone, camera, and mp3 player and gaming device. The iPod Touch sells for significantly more than the Nintendo DS, but look for that gap to narrow as the price of electronic devices trends down. Google’s purchase of Motorola Mobility in order to control the device design offers a glimpse of the competitive landscape in the future. Google (GOOG) v. Apple (AAPL) fighting for dominance with Nintendo 3DS and Sony PSP with their game cartridges relegated to the trash heap. The game developers are adapting to this future by developing app stores. The current offering for Android and iPhone games through app stores is anemic, just browse EA Electronics Arts (ERTS) store http://www.ea.com/iphone. I expect that offering to improve dramatically very quickly as game developers adapt to the new distribution channel. Not only will Game Stop be cut out of the sales channel, the company will also lose the trade in used games for hand held devices
While I am not predicting the extinction of the game console, the battle for control of the television screen is raging. The key fight is over how content is delivered to the screen. How content is delivered to the flat screen television in the home is much more complicated than the handheld market and there are many more players, but the result for GameStop will be the same. Game Stop’s business will be collateral damage in that conflict. Ultimately, it matters neither whether the digital media is delivered through cable, internet, wi-fi or 4G cellular nor what device controls the interface, tablet, cable box, gaming system or pc. The paradigm shift will be the ease of direct connectivity to a multitude of digital content sources including games. Unlike NetFlix, GameStop has no way to insert itself into that process. Consumers will download software directly to their gaming device and will play on websites like Zynga and Flonga bypassing GameStop completely and eliminating the market for new games.
Investors should be cognizant of just how rapidly these changes can affect the company. I point to three examples, Blockbuster, Borders and Motricity. Blockbuster was founded in 1985 and declared bankruptcy in 2010. The stock was trading at $20 as late as the end of 2003 and $10 in 2005. Overlay the history of Netflix on the time line to see how fast the competitive environment changed. Netflix launched in 1997 and didn't start offering streaming until 2007. Blockbuster's stock had declined long before Netflix started hammering the nail in the coffin with its streaming service. In 2008 Blockbuster still had revenue of over $5 billion but by the end of the fiscal year ended Jan 2, 2011 revenue had plummeted to only $3.2 billion. The stock declined from over $20 to essentially zero in about 7 years. The story is a case study in the competitive disadvantages of a brick and mortar distribution strategy. Borders Group was trading at over $20 as recently as the beginning of 2007. Amazon introduced the Kindle at Christmas in 2007. Less than 4 years later, Borders Group filed for bankruptcy and is in liquidation. Borders is a case where the product transformed from a physical unit to digital content. Finally Motricity, the stock had an IPO last year and shot up to over $30. The company offers content delivery to non-smart phones. Last week, the stock traded under $2 in response to a faster than expected worldwide adoption of smart phones. The rate of stock price decline in response disruptive business practices and new technology is accelerating. GameStop embodies all three bad attributes, brick and mortar locations, physical content and an older technology platform.
Further if as I predict GameStop encounters operating difficulties, the company is at risk for both an inventory write down and goodwill impairment. GameStop carries inventory of $1.3 billion. The number is not out of line with sales but, it is a significant amount of exposure to a potentially soon to be obsolete product. Hopefully the company would react to any changes in the industry by paring inventory in advance, mitigating some of the negative impact. However, a 10% write down would eliminate about 25% of annual EPS. More concerning is the $2.1 billion of goodwill. Companies are required to test for impairment periodically. Impairment tests are pro-cyclical in a downturn. Meaning it is more likely that if EPS and the stock price are declining, the asset is impaired leading to a further decline in EPS and stock price.
In the short term, GameStop is generating cash, paying down debt and buying back stock which are all good things from a shareholder perspective. (If I were a stock holder, I would prefer a dividend since only selling shareholders capture a portion of the cash flow.) The problem is that with the changes on the horizon there is no long term. With the stock trading at a P/E of 8x , the implied pay back period for buying the company is 8 years. I think that sales will decline long before then and it will be GAME OVER by 2014.
Source: Game Over for GameStop
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
