In November, I published an article about going short on GameStop (GME) as the company's value proposition, selling video games, will not be as prevalent in the future as video game consoles will eventually move to a download model. As of May 4th, GameStop shares were down 14.63 percent since that article was published while the S&P 500 was up 9.24 percent. In this article, I explain why it is still a good idea to short GameStop stock.
GME is among one of the most shorted shares on the stock market. As of April 13th, 64.89 million shares of GameStop were shorted, which represents 53.1 percent of the total float. The number of shares shorted was up 5.15 percent from the previous month.
In terms of new game sales, GameStop relies heavily on the PlayStation 3 and Xbox 360. Selection for Wii games has dwindled in the past year as the system has begun to lose popularity. Most GameStop stores no longer sell PC games, although they are still available for sale on GameStop's website.
GameStop's cash cow recently has been the buying and selling of used games. Of its $9.55 billion in revenue in 2011, $2.6 billion of it came from used games. In addition, there is a much higher markup on used games so these used game sales account for around half of GameStop's gross profit.
The successors to the PlayStation 3 and Xbox 360 are referred to as "Eighth Generation Consoles". Sony's (SNE) successor to the PS3, code named "Orbis", reportedly will restrict second-hand games. This means that users can only download their games and each download will be assigned to only one player. The same may be true for Microsoft's (MSFT) successor to the Xbox 360.
The next generation of video game consoles have the ability to cut GameStop out of the equation. This will cut into their new product sales immediately while its used game sales will lose out in 2 to 3 years. While these reports have not been confirmed by Sony and Microsoft, GameStop's stock price suffered a loss of 7 percent in the two days that the rumors were spreading.
GameStop's new strategic play is to exploit its retail footprint and buy and resell used Apple (AAPL) products. The company will pay up to $500 for an iPad, $380 for an iPhone, and $180 for an iPod according to its website. A presence in second hand electronics may be a good idea for the company's survival, but the business model is too easy for competitors to replicate. In addition, Ebay (EBAY) and Amazon (AMZN) already have a strong presence and track record in this space. There is already a boom of new online companies buying used electronics and a fixed pay schedule for Apple products will not be as effective as the market model that Ebay and Amazon employ.
In conclusion, I believe that GameStop will no longer be profitable in three to five years. What will be left to salvage will not cover its current market cap of $3 billion. I put a one year target price of $16 on the stock. I believe its actual market cap should be around $2 billion after looking at liquidation value and the amount of time GameStop has left to be profitable. It will continue to be one of the most shorted stocks on the market until an adjustment takes place. Since there is not a lot of stock left available to short, I suggest going short on GameStop by buying medium to long term puts and renewing your position once they expire. A good strike price to go in at right now is $19 to $20 as the major drops that I expect are probably still 2 to 5 years away.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.