GameStop: The Long And The Short

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 |  About: GameStop Corp. (GME)
by: Saj Karsan

Is there a more polarizing stock than GameStop (NYSE:GME) right now? The short interest in this company is almost 50% of the company's float! At the same time, the company's strong cash flow relative to its price makes it attractive to a number of value investors. So who's right?

The short case is pretty simple. As GameStop is primarily a seller of videogames on physical media, its days will soon be numbered thanks to the Internet. Publishers can skip GameStop's markup by selling directly to consumers, and consumers can save time and money by downloading games through their consoles instead of buying physical media at the store.

Furthermore, marginal gamers are likely to be wooed away from expensive consoles and their expensive games by all-purpose smartphones and tablets. These devices can be used to download cheap or even free game apps, further pressuring sales in the traditional videogame industry.

These are reasonable and compelling arguments. But while the world has changed and is changing around GameStop, GameStop has hardly been standing still. Though its management team has been dealt a tough hand (there are no tailwinds in the bricks and mortar physical media distribution industry), it has taken a number of steps to transform the company into one that can potentially participate meaningfully in the next console cycle and beyond.

Here are some of the steps GameStop's management has taken which have improved the company's market position:

  • Developed a used game market

This is not a new initiative, but is worth mentioning because it illustrates how successfully management dealt with competitive threats in the past. With Walmart (NYSE:WMT) and Best Buy (NYSE:BBY) encroaching on GameStop's market, retail margins began to erode. GameStop created a "used game" model that allowed customers to sell their games back to GameStop in exchange for credit that can only be spent at GameStop. With a large inventory of used games, GameStop now benefits from a network effect that competitors have found difficult to match. The proof is in the margins, as the used business accounts for only a quarter of GameStop's total sales, but almost half of its profits!

  • Recognized that many customers don't have credit

Digital downloads require some form of electronic payment, acting as a barrier for young gamers, a large part of the videogame demographic. GameStop allows customers to pay cash or store credits for codes that can then be used to download digital content. As such, GameStop has made itself a valuable part of the digital value chain.

  • Developed a used phone/tablet market

This is a new initiative, building on the strengths of the company's aforementioned "used game" market. The company intends to use the refurbishment centre and pricing and inventory processes it already applies to the used game market to allow consumers to trade-in popular consumer devices. Since this is a new and growing industry with frequent product refreshes, this could be a new source of profit for years to come if GameStop can benefit from the same network effects that it does in the used game industry.

  • Developed a rewards program that captures customers

Not only does GameStop's PowerUp Rewards program drive increased market share (since the program's points system encourages all videogame spend to be spent at GameStop), the company is now able to sell to its best customers without them having to show up in store. The company can sell digital content or send updates on used game or device availability, keeping itself relevant.

  • Entered the digital business

Rather than sit still, GameStop has used its strong cash flow to buy strategic digital assets. As a result, GameStop's digital receipts grew 57% in 2011 to $453 million, and the company expects this number to grow another 50% in 2012.

  • Moved to a safer capital structure

Gamestop has now paid off all of its debt, and now sits on $655 million of cash. Its future lease payment requirements are also on the decline, as the company has been mining the information from the aforementioned PowerUp Rewards program to situate stores closer to its customers without sacrificing profits, resulting in better returns on investment.

The shorts appear to be winning in the market, as GameStop trades for just over $3 billion despite $655 million of cash and free cash flow of $450 million. But that's exactly why the shorts need to be careful, as expectations are so low that the odds appear tilted towards the longs.

GameStop often gets compared to Blockbuster as a potential dinosaur. But if this transformation is effective, a better comparison for GameStop may be Netflix (NASDAQ:NFLX). Netflix started with physical media, but then became a market darling when it added its streaming service. GameStop has the potential to be successful with some of its digital assets, especially with the network benefits it can create with its loyalty program, its credit currency and its pre-owned software and devices. Shorts may be taking a big risk if this management team's track record is any indication.

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