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The Dividend

GameStop (NYSE:GME) has announced that it will begin paying a quarterly 15 cent cash dividend. Is GameStop buying friends amidst the sea of shorts? What does this mean for investors?

Attention Shorts: Dividends Are Bad For You

Unlike say, the WWE, who at one point paid a dividend that exceeded its net income, GameStop has paid its long term debts and its dividend amount appears sensible enough. They're not giving out free cupcakes to attract investors.

GameStop is also making a shrewd move regarding investors and scaring some shorts. Paying a dividend will keep away some of the shorts (remember shorts: you're stuck paying that if you have the stock on ex-div date). I'm extremely curious what will happen on the ex-dividend date, February 21st. This may change the perception of the stock, which is one of the biggest shorts going. Why?

The Short

GameStop is a heavily shorted stock. In fact, in December, it was the most shorted on the Street (and the short is still 35.7% of the float). It is deeply misunderstood by the Street. It has a business model that is not much different than a pawn shop. It resells used games and systems at a profit. On a popular new title within 30 days after its release, GameStop buys cheaply (about $20-30 on a $59.99 title), then resells for as much as possible (generally $54.99 for a new, popular title, like Skyrim). It also generates similarly solid income from reselling apple devices.

GameStop's stores also make money on new games and hardware, but the margins are less. It can compete on even terms with loss leaders like Walmart (NYSE:WMT) and Best Buy (NYSE:BBY) because of the fact it sells used games and systems (and it has significantly lower overhead per store).

Why short? Some people on the street short GameStop because they don't have a sufficient understanding of the games business e.g. they erroneously disbelieve that consumers will purchase a used item for an 8-10% discount over new. There is also a group who, somewhat justifiably, short GameStop because they are in a slowly dying sector.

The Next Big Thing

The Street is a wellspring of hope and optimism. It's currently obsessed with Zynga (NASDAQ:ZNGA), a relatively insignificant video game company that produces one good and decently successful online game for Facebook, Farmville and has triple digit multiples. Much like Dexy's Midnight Runners, who also had one truly great hit, they will be remembered. Reminiscences are rarely as profitable as new hits, though.

Digital distribution and online gaming is the "Next Big Thing" on the street, taking over "the Cloud" of last year as the least understood and most heavily broadcast technological concept. "The Cloud" isn't being heard of quite so much anymore in the wake of Amazon's (NASDAQ:AMZN) Lady Gaga fiasco and the realization that security is problematic for government agencies (the federal government is a large client for Cisco, Juniper, Brocade and other computer equipment companies). The technology is not all there, but FedRamp and other standards are a step in the right direction.

Online gaming, on the other hand, is a concept the street has latched onto that is ready for prime time. It is likely that PC games will be completely distributed online within the next 5 years. Many already are. Console games are distributed online, to a lesser degree, and we will see more digital distribution on consoles in the future.

The Next Big Thing vs. Gamestop

There's one notable thing that distinguishes the average GameStop consumer from the average digital downloads consumer - 70% pay in cash. As far as I know, no other retailer or digital distributor made any allowances for this fact when they got into digital distribution.

GameStop has forward thinking management that realize the importance of digital gaming, so they recently acquired Stardock's Impulse for that purpose. There are problems with this acquisition, though.

First, Impulse is a relatively weak entry in the field - with Steam and direct2download.com being far stronger entries with greater downloads and better interfaces. Even Stardock/Impulse's own CEO (quite liberally) estimated that Impulse only had 10% of the market in 2009. This was not a major company.

Second, in a major marketing faux pas, payment is fairly complicated if you're not using a credit card and requires an account and several steps. Impulsedriven is unlikely to be a success. If you can buy the same product in-store, why jump through additional hoops to download it?

On the other hand, on consoles, GameStop also realized their customers pay cash, and their DLC (downloadable content) for console games is doing a brisk business, as mentioned above. Unlike the PC segment, it's streamlined and requires no additional accounts (beyond what the console manufacturer requires).

Another bright point for GameStop is the dawn of several new consoles and handhelds coming out - like the Sony Vita on February 22nd and Wii U which will be launched by year end. Consoles drive sales, especially around Christmas time. You cannot digitally download a new Xbox. This company has at least another solid year or two of this level of performance.

Optimism is Cowardice

Where does this leave GameStop? Console manufacturers and publishers will want to cut out the middleman and directly sell games to consumers. In the future it's likely this will eventually render hard copy games obsolete except for gaming antique collectors, but this will take time. A small faction of gamers is resistant to the notion that they are paying for a license and not a product and may continue to request hard copies of games.

EA's Origin.com already has taken out the middleman - as has Microsoft (NASDAQ:MSFT) with Xbox Live and Sony's (NYSE:SNE) Playstation with PSN. The shorts have a point here. Even without any debt, without any games to profit from, that doesn't leave much future.

In short, GameStop is a profitable dinosaur. Like Radioshack (NYSE:RSH) in the aftermath of online hardware sites, it will likely limp forward for many years, but doing tolerably since it has taken several digital steps to hedge its future.

Cash Flow

I was recently chatting with another insightful Seekingalpha contributor about GameStop's DCF. GameStop's fundamentals are great, its P/E's below 10. It has no debt and its cash flow looks nice - but this is a sector that's headed for extinction. Like the T-Rex, it's going to be big and bad, until the meteor hits. The problem is knowing when. Predicting your cash flow is only as good as your inputs. It is too heavily discounted by the street, but there's a valid reason it's discounted. I still don't think it's a value trap.

Conclusion

Am I recommending GameStop? On technicals, I would be reluctant to buy it for a long portfolio (at least without puts) when it is shorted so heavily and since the long-term outlook is poor. I really, really wouldn't short it though either, especially since it has such strong fundamentals, no debt and a dividend.

This is a (somewhat risky) stock to look at for active investors who are looking to buy low and sell after 4Q earnings reports of this year (4Q 2012 will be profitable, a beat is likely) or in the case of a short squeeze on the February 21st ex-div date.

Source: What GameStop's New Dividend Means For Investors