There has been a lot of discussion in the investment community about the prospects of GameStop Inc (NYSE:GME), a specialty retailer focusing on the sale of video game software, hardware and accessories. The stock has caught a nice bid since its recent lows (post-earnings) on news that software sales have been strong (buoyed by Modern Warfare 3) and on GameStop’s recent announcement that their Apple (NASDAQ:AAPL) product “trade-in” program has exceeded expectations (at the time of this post, the stock is down on the company’s holiday sales report). Additionally, the stock is buoyed by constant takeover chatter as stock pundits laud its free cash flow yield. It is my view that this positive uplift is temporary respite in what will be a gradual and then expedited decline.
1) Bulls like GameStop because it creates an ecosystem in which gamers can use their existing inventory to trade for new games. It has even created a market for old Apple products. In theory this business model makes sense, but I believe that GameStop has stretched itself too thin with this recent Apple trade-in program. Consider the debits and credits of the transaction.
- Old Apple iPad 2 gets traded into to GameStop for store credit
- The consumer takes store credit and buys a new video game. GameStop books the sale, records the profit, all is well until….
- GameStop has to resell the old iPad 2. This is where I see the Ponzi scheme breaking down. GME is paying up to ~$400 dollars for the top-shelf iPad 2 (64GB with 3G) and reselling the product for $700 dollars. Sounds like a great deal for GME until you take into account that a) you can buy the same iPad 2 brand new at Apple for $800 and b) Apple is rumored to be dropping the price of the iPad 2 and releasing a new model. Logic would dictate that GameStop will be stuck holding the bag on this one. Look for its inventory to be increasing as this trade-in current gets stuck in limbo.
2) Video games will become downloadable and bypass the need for physical stores. No one can deny that at-home entertainment (music, movies and video games) is increasingly digitized. First it was music. The war over the digitization of movies and television is waging as content providers cling to their DVD sales and advertising dollars but I think we can all agree where it will end up. I would argue that video games will break that barrier quicker. There is a lot of incentive in television to maintain the status quo (see above points), whereas those barriers do not exist in the video game industry. No video game content provider is earning valuable ad dollars from the proliferation of the current distribution system. In fact, video game content companies are losing margin by selling to GME at wholesale prices and having to manufacture the hardware version of the game. What is good for GME shorts is the catalyst for this change is on the horizon in two very real forms:
- With the continued build-out of the fiber and 4G wireless networks, the inhibiting size of a game download will be mitigated.
- While no certain plans have been confirmed, we believe that the next-gen video game platforms will feature substantial upgrades to their online stores (Microsoft (NASDAQ:MSFT) and Electronic Arts (ERTS) are already doing this with X-Box Live and EA’s Origin which sells game directly from EA’s website.
We can talk all day long about how great GameStop’s cash flow yield is (cash flow yields are always great on businesses that are going away) but I think you risk missing the forest through the trees. The competitive threat that will end GME’s business is on the horizon and its solution for stemming the tide is nothing more than a way to kick the can down the road for a few more quarters. GameStop will go the way of all the large specialty electronics retailers before it (HMV, Blockbuster, Borders, Circuit City etc.); it is just a matter of time.
Disclosure: I am short GME.