Throw This Stock Away

Every week in this space, I recommend a stock that investors should consider dumping from their portfolios. Every week, I also nominate three stocks to take its place.

I ruffled some feathers last time around, when I suggested that the leading video-game retailer is starting to take on the paunch of the bloated DVD-rental dinosaurs. Now I'll take that suggestion one step further this week -- and probably ruffle even more feathers -- by making that rapidly growing chain the focus of this week's installment.

Come on down, GameStop (NYSE: GME  ) .

Game over
As a video-game buff -- and the father of two boys who are growing into diehard gamers -- I've spent plenty of time in GameStop stores. I'm not exactly a fan, since I prefer to pay less than retail through online stores, but I'll concede that GameStop works in a pinch. It's convenient, the staff is typically knowledgeable, and the selection of games is pretty good for a footprint as small as its stores have.

Unfortunately, that's about as good as it gets for GameStop. The latest gaming craze involves musical simulation games with bulky drum and guitar controllers, and that trend is posing a serious challenge for GameStop.

In an interview with MTV Multiplayer this month, a GameStop executive discussed the challenge the bigger packages pose. They're forcing GameStop to consider larger stores and offer drop-shipping of high-end drum sets that won't be available for sale in the actual stores. The alternative would be reduced inventory, which would make GameStop worse than your local Hollywood Video, because at least the shift from VHS tapes to smaller DVDs helped boost in-store inventory levels.

That's not the only reason I'm lukewarm on GameStop this week:

  • Digital delivery lies at the heart of connectivity in all of the next generation of video-game consoles and handhelds. As software developers reach out directly to the consumer, isn't GameStop the odd chain out?
  • Bulls will argue that GameStop can survive digital delivery because a good chunk of its business comes from selling used games and gear. Patrons trade in tired titles and systems, in exchange for in-store credit. That makes for a higher-margin business than if it sold the new stuff. But let me offer up CarMax (NYSE: KMX  ) as a cautionary tale. The used-car specialist saw its comps slide by a whopping 17% this past quarter. What's my point? CarMax bulls used to believe that the company's resale niche would hold up in a weakening economy. Cars aren't games, but either GameStop will have a glut of used gear, or consumers will take their stuff elsewhere, since they don't have the money to add to a trade-in for something new.
  • GameStop is showing no signs of slowing. Sales and earnings climbed 35% and 162%, respectively, in its latest quarter. That's nothing shabby, but think about the growth spurts that investors have grown used to lately. When the trend turns, things will get ugly.

Add it up, and you have a company with a product-mix conundrum, facing the threat of obsolescence with digital delivery, and promoting a resale service that may not be as recession-resilient as investors think.

Good news
As I have every week, I don't talk down a stock unless I have three alternatives that I believe will outperform the company getting the heave-ho. Let's go over the three fill-ins.

  • Take-Two Interactive (Nasdaq: TTWO  ) : If digital delivery is the future, Take-Two will be at the wheel. The company already scored a $50 million deal with Microsoft (Nasdaq: MSFT  ) to deliver a pair of episode follow-ups to its Grand Theft Auto IV juggernaut. Meanwhile, BioShock is getting the Hollywood theatrical treatment. Take-Two is now just trading at just eight times this year's projected profitability, a pittance compared with its slower-growing rivals.
  • Apple (Nasdaq: AAPL  ) : Digital distribution isn't just limited to consoles, portables, and computers. Some of the top-selling games through the iPhones App Store marketplace include EA's Spore Origins, Vivendi's Crash Bandicoot Nitro Kart, and THQ's (Nasdaq: THQI  ) Star Wars: The Force Unleashed. If consumers are playing games on their smartphones, that means less direct sales for physically distributed titles through GameStop.
  • Best Buy (NYSE: BBY  ) : This is GameStop with the flexible superstore space to expand. Not only does Best Buy have room for all of the Rock Band and Guitar Hero: World Tour gear, but it's even adding a healthy collection of real musical instruments to some of its stores. Best Buy is also the only third-party retailer selling iPhones, and that rubs even more salt into GameStop's open wounds.  

GameStop is clearly on a roll right now. It may take a few quarters for some of these factors to take a toll. I'm also seeing this differently than the Motley Fool Stock Advisor analyst team, and that's a group that knows its stock-picking.

However, I have to play the game as I see it. I have to approach GameStop the stock the same way I do GameStop the store. It looks nice, but I know I can find better deals elsewhere.

Other headlines out of the weekly trash bin:

Do you like Rick's substitutions? Would you rather stick it out with the tossed company? Are there other stocks he should look at in future editions of this column? Let him have it in the comment box below.

Microsoft, CarMax, and Best Buy are Motley Fool Inside Value selections. Take-Two Interactive Software is a Motley Fool Rule Breakers pick. GameStop, Best Buy, and Apple are Motley Fool Stock Advisor picks. The Fool owns shares of Best Buy. Try any of our Foolish newsletter services free for 30 days.

Longtime Fool contributor Rick Munarriz thinks GameStart is a better name than GameStop for a video-game chain. He owns no shares in any of the stocks in this story and is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.


Read/Post Comments (11) | Recommend This Article (5)

Comments from our Foolish Readers

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  • Report this Comment On September 24, 2008, at 4:48 PM, SuperDev wrote:

    This guy wrote almost the exact same article last week (his buddies are probably short GME), so I will submit my exact same comment from his other article...

    Rick "Aristotle" Munarriz has no idea what he is talking about, and needs to quit writing garbage like this. Also he should quit calling himself Aristotle while he is at it, as his blatant ignorance is an insult to the real Aristotle. As a game developer, I can almost guarantee that most of the things he predicts happening are utter fantasy, and he is spinning things around to make his argument. Sphyerion made an excellent post, and I agree with it in its entirety.

    The biggest factor here is the bandwidth it takes to transfer games, and games are just getting bigger (while ISPs are initiating bandwidth caps...). Broadband is pretty much maxed out with transfer speeds, and the only solution to this problem is replacing the entire infrastructure with something like fiber optic. It will be at least ten years before fiber optic or something equivalent will be ran throughout the US.

    What Mr. Aristotle has hit on is that game developers WANT to go all digital, I can't refute that. It is very good for the bottom line. However, in contrast, most gamers do not like digital downloads, and are holding out to adopt. There are a lot of problems with things like DRM currently, and if you do your research, you will realise that gamers much prefer to have a physical medium for the many advantages that come with it (resale, transferability, etc.). Digital downloads do have their place, but they are forming a NEW segment of the industry with smaller, more casual titles, rather than taking marketshare from the big release games (the ones that actaully make $).

    I could keep going, but I would rather refer back to Sphyerion's post, as he hit the nail on the head with his observations. Digital downloading is not going to have much of a negative effect on retail sales by stores such as Gamestop, and for a multitude of reasons like he listed, most notably the bandwidth issue. The technology is just not there for it to happen. Also, Mr. Aristotle forgot to mention a very important thing...Gamestop sells digital downloads! Go do you research a little better next time before you write garbage like this please.

    One final thing I have to say in closing, is look back at previous times of economic hardship, and where consumer spending went. It always goes into entertainment, and considering we are looking at the mother of all economic downturns right now, I would say that Gamestop is in a very good position for the next few years.

  • Report this Comment On September 24, 2008, at 5:27 PM, chali2na wrote:

    Ironic as the GameStop across the street from my house just closed its doors. I think the one in the mall did too.....

  • Report this Comment On September 24, 2008, at 5:57 PM, clarkbarrett wrote:

    I can understand why you would make an argument like this if Gamestop were trading at a hefty premium typical of growth stocks. But as of today GME is down almost 50% from its highs. Forward P/E is almost down to single digits. This from a stock that has repeatedly blown by estimates and raised guidance.

    The game industry is still in a rapid-expansion mode. Hardware sales (especially the Wii) have been very strong in the last 12 months. Even if hardware sales growth slows, people who bought those consoles will be buying software to go with. Software has higher margins than hardware. This growth cycle is far from over and GME will continue to be a major player.

    At these levels, it is foolish (not Foolish) to recommend selling the stock. I expect it to recover once the data reveals that video game sales will continue to grow for the forseeable future.

    Oh, and in response to chali2na, two closed stores is hardly an argument for selling. In its last conference call, management explained that they had opened several hundred new stores and closed a handful. There will always be a few stores closing, and that's a good thing: it means management is paying attention and cutting costs by dropping unsuccessful locations. The point is they are growing at a *net* store increase of something like 500-600 per year.

  • Report this Comment On September 24, 2008, at 5:59 PM, marcuslr wrote:

    When you have an article titled :Throw This Stock Away" I think it only proper to show that stock chart under the title, not some other poorly place company's chart that you say good things about below. It really makes it look like the other company's stock is the one to throw away. I had to read the article twice to make sure they weren't recommending throwing away the THQI stock. Very poorly placed graph for this type of article.

  • Report this Comment On September 24, 2008, at 7:16 PM, SuperDev wrote:

    I came back to read some of the responses of this article, and after re-reading the article, I found so much more irony that I want to respond directly to this article, instead of just responding to the author's other article that was essentially the same sans the stock picks.

    The first stock pick that the author recommends instead of Gamestop is Take Two. EA has been overpaying to buy up studios left and right, but they wouldn't reach a deal with Take Two. I wonder why? Maybe it has something to do with the fact that Take Two has one very profitable IP, a couple of decently profitable IPs, and a ton of IPs that lose money like no other. They have nothing substantial in the works for this holiday season, and it looks like the Take Two cycle is going to continue; release GTA, profit, then lose money until the next GTA comes out. This stock is the fad, not gamestop.

    Next up is Apple, another fad stock. Apple makes very overpriced products in comparison to the competition, yet is able to sell them because of ingenious marketing. They actually have consumers believing that Apple products are better than the competition, but anyone in the know realises that this is far from the case. I like how the author praises the Apple app store. Think about this for a minute though. If a developer wants to make a product for the app store, they have to first be approved, then plunk down a load of cash for the dev kit among other things, and then give Apple 30% of all revenues. Now, let's look at Google Android, which will work on multiple phones (vs. one iPhone). Anyone can download the dev kit for free, release their product at almost no cost to multiple phones, and not have to pay a percentage of their sales to anyone. And best of all, Google is giving developers $10 million as incentive money to come up with innovative software. I wonder where most of the developers and the innovative software are going to wind up...

    Apple is a fad stock, and in a few years once MS gets their marketing act together, Apple is going to get hammered like the days of old.

    The last stock pick is Best Buy. I do not know a great deal about this stock, so I am not going to say it is a bad pick. However, with the reasons the author gives, it would be a terrible pick. Best Buy selling musical instruments? Come on now, I don't think I even need to give an argument why that is not going to make the stock blowup.

    I find it very ironic that GME is supposedly a fad stock, and the author recommends selling it, even though they have an extremely strong balance sheet, not really in debt, just got a credit rating boost (in this crazy liquidity environment), and are posting blazing profits that really have no reason to be slowing up (like I and many others in the know have argued, digital downloads are irrelevant). And this is all while the stock is getting absolutely hammered by the market. I could understand it maybe if the stock was trading at 30x earnings, but it is nowhere near that.

    Come on now...

  • Report this Comment On September 24, 2008, at 7:42 PM, GamePig wrote:

    Wow it must have taken all of 30 seconds for Rick to simply copy all this bad commentary and call it an article. Although there is probably a market for news that appeals to an obvious shorting trend. I have just come to expect more from Motley Fool's editorial, other sites call this reasearch.

    As a counter to this poorly done article here are some facts ...

    The transition from the past generation (PS2, and XBOX) has been a tough one for developers and console manufacturers. System complexity translated into high console price points, and even higher development costs. Games came out looking impressive, but offered little in the form of truely new game experiences. But the development teams have caught up with this new generation of technology and by doing a little research on Metacritic you can see the products being released this year are substantially better than those released in '07.

    One of the best examples is the new Madden title which now runs at double the frame rate and looks fantastic. As a result despite lower sell in number, retailers have reported increases in sales versus last year. Bottom line the games are getting better ..!

    Not only do the games look and play great, but the size of the gaming industry has unexpectedly grown thanks to Nintendo. The new highly accesible Wii has increased the number of people playing games in a way Microsoft and Sony never expected. From this perspective an investment play on the content side makes alot of sense since you wouldn't be tied to a single platform. An investment in GameStop or another retailer covers all the platforms. Even specific publishers got burned on this one like EA who put bigger investments in XBOX 360 and PS3 games than they did in the Wii.

    It is true you can play this from two sides, you can bet on a publisher or you can bet on a retailer. but a retail bet protects you from implementation screw-ups and delayed product launches and helps you capture any un-expected successes. Retail plays also carry some inventory protection since many retailers send back unsold product or negotiate mark-downs through the game publishers. GameStop is particularly appealing since it is a pure video game play and does not carry baggage from under-performing sectors like home audio, dishwashers, and PC.

    Take-Two .. are you kidding? There is a reason the stock dropped to 15 after years of horrible management, and limited product depth. Look at product sales across their line-up, sports reviews are getting pummeled by EA's new games and Bio-Shock was great but it is a single title not an established multi-year franchise.

    Apple .. I like the software play, but they are a long ways from having iPhone software sales contribute in a material fashion to their bottom-line.

    Digital distribution is a short term pipe-dream. Despite current gen consoles having the ability to download content they are not designed to replace disk distribution with digital distribution .. their hard drives are too small, downloads take too long and consumers like to have physical product. It is much faster to drive to the store and buy a product than try and download it even on broadband, and I don't have to worry about losing invisible digital licenses. Digital DRM is causing huge problems for publishers right now ... read the articles about the Spore release. Maybe this will get fixed on the 'next' generation of consoles.

    "Best Buy .. space to expand" is that because the rest of their inventory isn't selling? There is no way the game industry which would love to move to digital distribution if it could is going to start regularly stocking a wide variety of large boxed retail packages. Software distributors want less packaging and less plastic .. not more. Look at what has happened to Toys "R" Us and you will see that large shelf space toys may be a great business for China but not for US distrbutors who carry the inventory risk.

    I can't say whether or not GameStop's aggressive growth potential justifies its' relatively high multiple, but the support for the article was thin and shoddy at best.

  • Report this Comment On September 25, 2008, at 1:48 AM, pthomas1172 wrote:

    Motley Fool just went to the bottom of the investment bookmarks. I'm surprised that fool would publish something like this?

  • Report this Comment On September 25, 2008, at 3:07 AM, CuttingHorse wrote:

    Rick? What does he know about kids interest--he's only thinking of himself and how he can save a buck somewhere else. Kids don't want to go to Best Buy or drug around Walmart or Target! Their toy store is GAMESTOP and they are everywhere. He needs to be positive about them enlarging stores! It's so nice that its a place their Dad can take them one on one--no hassle park in front--be in and out in a few minutes! Hey everybody do you agree? How many young boys did he survey for this article? They are a well run company and certainly a buy right now before holidays! Cutting Horse

  • Report this Comment On September 25, 2008, at 12:24 PM, jlwood830 wrote:

    Give me a break. Shelf space for music games? Please. Back rooms work just fine because customers who want these peripherals ask for them. And while I do occasionally purchase online content any game that costs more than $5 or $10 I want a hard copy of regardless of whether or not I would consider trading or selling it. A game that just exists on my hard drive has no real functionality besides play at my home. Hard copies I can give away, trade, sell, just look at in my game collection or whatever. The bottom line is there is a big difference between purchasing a product through an online store (which is a part of GameStop's business model) and purchasing a download. I think you need to do a bit more research before dishing on another stock in the manner that you dished this one!

  • Report this Comment On September 25, 2008, at 4:16 PM, flyerd wrote:

    Right of the bat you sound like an idiot when you say this: "GameStop is clearly on a roll right now. It may take a few quarters for some of these factors to take a toll."

    --> On a roll?... Seriously?... If a stock at a 52wk low is "on a roll" I'd hate to see what a stock you thought was in the dumps looked like. Actually, maybe that would be a stock at its highs?...

    Short and simple: You always sound like someone with a vested interest in the stocks fall (one way or another and regardless of your disclosure policy)...

    The majority reason that GME, and the mkt as a whole, is down right now is a mkt trading on "FEAR" as opposed to "fundamentals". Digital downloading is a factor but the size and scope of the impact is dramatically overstated by most people. The size of current and upcoming mega-hit games are huge and even at DSL speeds aren't attractive to "mainstream" buyers. Additionally, there are still a great number of people that use dial-up or satellite connections which are even worse than DSL/Cable. Satellite has download limits and weather issues that make unattractive.

    Digital delivery will be "primarily" held to upgrades/add-ons as opposed to the original game purchase. This will be the case for at least the next 5-10 yrs. Buyers want the ability to get an easy exchange if they get a bad game and most still prefer a hard copy they can hold and yes, trade-in.

    In bad times, VG's are used as an escape mechanism and will continue to be used as such. .As the mkt recovers the $ that is sitting "scared" on the sidelines will make its way back to the mkt. GME, especially at these levels, is "far from" a stock to throw away...

  • Report this Comment On September 26, 2008, at 3:59 PM, trgeorge wrote:

    Hey SuperDev, you wrote: "Next up is Apple, another fad stock. Apple makes very overpriced products in comparison to the competition, yet is able to sell them because of ingenious marketing. They actually have consumers believing that Apple products are better than the competition, but anyone in the know realises that this is far from the case."

    1st off, Apple is a 'fad stock'?? Wow, that is SOME fad.

    2nd, look up any review site (consumer reports, cnet, etc) and Apple products are going to be near the top because they are good products. I have used 4 different brands of mp3 players and I can tell you without a doubt the ipod is the best and it's not even close.

    3rd, it's realize, not realise.

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