Why You Should Sell Or Short GameStop

| About: GameStop Corp. (GME)

Summary

GameStop faces stiff competition in the current market.

The competition will only increase as hard drive capabilities improve and prices decrease.

Both brick and mortar and online distribution of competitors is superior to GameStop's offering.

GameStop Corp. (NYSE: GME) has been a strong force in the video game and video game platform distribution market for some time now. However, as technology advances, the industry will leave them behind. Just as online programming left Blockbuster in the dust, the advent of other forms of online media along with advancements in hard drive technology will be GameStop's undoing.

GameStop's CEO Paul Raines recently claimed that the firm would increase revenues by 3 to 5 percent over the next four years. In order to reach this mark, the company will make use of its core competency, physical video game sales as well as diversifying into other markets (Kezar). But therein lies the problem - digitally-bought video games are on the rise, and their physical counterparts are quickly fading away.

Source: GameStop 10-K. Other than an anomolous year in 2013, operating earnings have remained relatively stagnant, as has gross profit and net sales. Financials are steady, but I advocate that the threat of online video game sales will prove a significant threat to future earnings.

Joost van Dreunen, CEO of SuperData, an industry analysis firm, expressed that for the first time, digital video game sales will exceed physical sales. This comes after a 7% growth in sales of digital games in 2015 to $5.5 billion (Beres). The core competency of GameStop is quickly being overtaken by digital distribution, in which other firms such as Microsoft (NASDAQ:MSFT), Sony (NYSE:SNE), and Amazon (NASDAQ:AMZN) are far better equipped to compete.

Raines expects his firm to reduce the weight of physical sales from 65-70% of sales to 50% by 2019. Digital sales by GameStop are not expected to increase even by its own analyses. The firm is branching out into buying and operating AT&T (NYSE:T), Cricket Wireless, and Simply Mac stores (Kezar). What GameStop has excelled at in the past is disappearing, and unless they find better alternatives than operating other firms' stores, it is doubtful that they will find success in the future. Can earnings be sustained when a firm is actively divesting what its CEO refers to as its core competency?

If one were to consider the rivals and substitutes for what GameStop offers, the list is formidable and seemingly endless. From a brick and mortar standpoint, larger retailers have and will continue to take away a portion of the video game market. Many of the traditionally brick and mortar retailers have in fact advanced in their online distribution capabilities as GameStop has remained stagnant. Taking a quick glance at the websites of Wal-Mart (NYSE:WMT), Target (NYSE:TGT), and Best Buy (NYSE:BBY) and comparing them to GameStop's would be evidence enough of this trend.

Even more worrisome for GameStop than the advancement of their brick and mortar competition is the quickly advancing hard-drive technology market, which has developed alongside Microsoft and Sony's online distribution networks. As recently as a few years ago, many customers would choose to buy a physical copy of their games purely because they did not have enough space on their hard drives to hold them. Now, one can buy an Xbox One with a one terabyte hard drive attached. Using a second hard drive of equal or greater size is as simple as plugging in a USB cord.

When many distributors are selling the same product, the demand for convenience often becomes more pronounced. If I buy a physical copy of a video game from GameStop, I will have to drive there, buy it, drive home and put the disk in my system to install. Then, every time I want to play that game, I will need to put the disk back into the system. If I download a game from the Microsoft Store, I need to push one button to play the game whenever I desire. Even worse, a disk can be scratched or lost easily, while using digital media mitigates that risk.

Source: GameStop 10-K. Sales of used games account for a quarter of net sales over the past three years. Digitally distributed video games are a danger to these sales in the future.

A large source of GameStop's revenue comes from selling used games. They take in used games at a minimum price and sell at a maximum. Per GameStop's 10-K, the firm believes it is the largest distributor of pre-owned games in the world, and considers it a viable business strategy to expand on this business segment. While playing the role of a broker with all the buyer and seller power in the world has been a great source of revenue, that trend will decrease as games are more and more often bought in digital formats.

GameStop's 10-K specifically states "…that future growth in the electronic game industry will be driven by the sale of video games delivered in digital form..." yet the firm plans to invest further into the re-sale of physical video games. Instead of making bold attempts at investing in what the future will likely bring even by their own account, the firm clings to what will maximize earnings in the short term. My suggestion: sell it or short it, because GameStop faces tough competition in the present, but will only be further challenged in the future.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.