By David Sterman
At first blush, video-game retailer GameStop (NYSE: GME) looks like a great value stock. The company has been buying back huge amounts of stock, its shares trade for less than 10 times trailing earnings, and the company's $3 billion in tangible book value is not far below its entire $3.5 billion market value.
So it's curious to discover GameStop is a favorite of short sellers. They hold 38 million shares in their short accounts, which is 28% of the trading float and the equivalent of 10 days of trading volume. Short sellers typically target richly valued stocks. Why are they going after this seemingly attractively priced stock? Likely because they see potential for a long-term erosion in the business model that eventually sends GameStop to the same fate of other retailers such as Blockbuster and Circuit City -- bankruptcy court.
A wrenching transition to digital
GameStop has been expanding its retail foot print for the past decade. The company now has more than 6,600 stores in 17 countries. Sales are likely to reach almost $10 billion in the fiscal year that ends this coming January.
Yet as you examine the company's income statement, some red flags start to appear. For example, same store sales fell 9% in the quarter ended July, which management attributes to a light schedule for new software releases compared with the prior year's quarter. Might sales also be slumping because consumers are starting to seek other forms of entertainment at the expense of console-based video games?
Management tacitly concedes as much by working aggressively to boost GameStop's presence in the digital-download market. Digital-download revenue rose an impressive 69% in the fiscal second quarter (though the company declined to report an actual revenue figure. A review of the company's 10-Q also shed no light on the revenue breakdown, although management will have to break out digital sales figures when they comprise 10% of sales). Digital-focused initiatives include the development of a download app for tablet computers, the sale of iPads in its stores, and investments in up-and-coming digital players such as Playjam.
There-in lies the rub. As consumers increasingly embrace downloads, GameStop's massive stores are starting to suffer from negative de-leveraging. Retail stores have a high amount of fixed costs such as rent, utilities and labor, and the real profits accrue only when incremental revenue exceeds the fixed costs. Yet a drop in traffic starts to render these stores practically useless as profit drags. Of the company's 6,600 stores, how many can handle a 10-20% drop in foot traffic and remain profitable? Put another way, at what point does management start closing the weakest stores to preserve profit margins?
This can lead to a death spiral that firms like video rental chain Blockbuster went through. Blockbuster started closing the weakest stores only to find that it had reduced buying power and scale economies when it came time to service the remaining open stores. What started as a slow trickle of store closures eventually became a tsunami.
Will GameStop suffer a similar fate? Not this year. Not next year either. But short sellers are watching for signs that a process of retrenchment has begun.
What size slice of the pie?
GameStop is just beginning to compete with companies like Zynga that are gaining traction in the mobile game space. It also has to share the traditional video game market with new players. Earlier this year, Coinstar (Nasdaq: CSTR) began to offer video-game rentals along with its Redbox DVD-rental kiosks. Netflix (Nasdaq: NFLX) has given mixed signals on an effort to start offering video-game rentals by mail, but it would present a formidable threat to GameStop, due to aggressive pricing and the convenience of the games-by-mail business (or video-game streaming, as the case may be).
Gaming is unlikely to go away as a consumer hobby, but GameStop's gate-keeper role in the industry has clearly begun to erode.
Risks to Consider: Short sellers are betting that GameStop's quarterly results will steadily deteriorate as time passes, so if the retailer delivers better-than-expected results, then shares could get a boost from short covering. It's best to short this stock with a long-term perspective, acknowledging that shares could actually spike before heading into a long-term decline.
Broken retail business models don't collapse overnight. But the mere sense of a long-term decline is enough to start hammering shares. Same-store sales declines are the key metric to watch. They fell sharply in the July quarter, probably stayed even in the quarter that ends this week (October), and at that point, investors will give close scrutiny to the all-important holiday selling season.
How do short sellers place a target price on a stock like this? They don't. The bet against the stock is that it could head lower and lower as time passes, but there is no specific set of metrics that point to an appropriate valuation such as $20, $15 or $10.
Disclosure: Neither D. Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.