10 Reasons to Disown GameStop

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Shares of GameStop (NYSE: GME  ) hit a fresh 52-week high yesterday, after Janney analyst Tony Wible issued a bullish note singling out the 10 reasons to own the video game retailer.

I don't see it that way. GameStop's stock is still trading 60% off its 2007 high, and there is little reason to believe that the company will be as relevant in the digital distribution model that the industry is moving toward as GameStop was in the bricks-and-mortar realm.

Let's go over the flaws in Wible's bullish arguments.

1. Loyalty
Wible points out that GameStop has signed up more than 8 million users to the largely free PowerUp Rewards customer loyalty program it launched last year. So? Didn't Blockbuster have contact information for tens of millions of couch potatoes before filing for bankruptcy?

2. Digital investments
GameStop is trying to slip its dinosaur bones into a new body with recent digital gaming acquisitions. It is the right approach, but financial journalists playing this up as a shot for GameStop to be the Netflix (Nasdaq: NFLX  ) of gaming are either naive or missing the bigger picture. Are they not aware that Valve's Steam and hungrier upstarts are already out there?

This isn't Hollywood, where fragmented movie studios and home theater appliance makers didn't come together until Netflix figured it out for them. Companies have their own ecosystems. Apple (Nasdaq: AAPL  ) doesn't need anybody else to man the App Store it uses to feed more than 100 million iOS-powered gadgets. Why should Microsoft (Nasdaq: MSFT  ) share the wealth of its successful Xbox Live marketplace with a middleman? Activision Blizzard's (Nasdaq: ATVI  ) revamped this past summer, so that it would be its own gatekeeper.

3. Hardware trojan horse
GameStop's plan to sell refurbished tablets -- or possibly introduce a dedicated gaming tablet -- isn't going to change the fact that the companies behind the operating systems are the ones that control the digital distribution.

4. New product cycle
Every few years, the big three hardware players refresh their product lines. We saw it in the handheld space with last month's 3DS debut. Microsoft and Sony (NYSE: SNE  ) also rolled out motion-based controllers to breathe new life into their console platforms late last year.

This may all be true, but GameStop's leanest margins come from hardware, which accounted for a mere 7% of last year's gross profit. The thicker markups come in software and used games and gear.

Have you seen the 3DS? There are some flagship games, but its neater features are the ability to download 3-D movie trailers or stream Netflix. GameStop will be less relevant there. Besides -- after seeing used video game products account for 26% of the revenue mix but 46% of the gross profit -- why are GameStop bulls not worried that you can't resell digital downloads?

5. Cash flow and buyback
GameStop generated cash flow in excess of $590 million last year, and it's been aggressive with buybacks. There's nothing to knock on either front, but it's important to note that healthy cash flow is the byproduct of a store model that is unlikely to last. Blockbuster stores were once cash cows. Really.

6. LBO potential
GameStop's juicy cash flows and cheap valuation make it an attractive private equity buyout target, but don't these firms also buy companies that they feel they can flip for even more later?

GameStop doesn't fit the bill. Private equity has seen the error of buying CD stores, video rental chains, and now bookstores as traditional media caves to the digital revolution. Video games are next.

7. Riggio overhang and management responsiveness
Wible argues that chain founder and Barnes & Noble (NYSE: BKS  ) chairman Leonard Riggio has cashed out of most of his GameStop position. Wible also feels that new management is more responsive to investors.

This would be great if GameStop has growth catalysts cooking, but digital sales accounted for just 3% of revenue last year, so these won't be moving the needle anytime soon.

8. Short ratio
Longs love shorts, and with 26% of GameStop's shares sold short it does open the door to a short squeeze. Once again, what's the driver to trigger that kind of rally? If a bullish Janney note or overbidding everyone else for digital acquisitions are enough to send the shares to a new 52-week high, gravity can also cut the other way just as easily.

9. Holder concentration
With GameStop's 15 largest holders owning 72% of the company, the thin float can move shares higher in a hurry. But investors who have seen their investment cut in half over the past few years know that this is a two-way street.

10. Technical break-out
Janney's chartist sees the potential for a technical breakout. These technical swings may be lucrative in the short run, but fundamentals rule the long run. Even some of GameStop's most ardent bulls are unsure of where the company will be a in a few years.

Would you be a buyer or a seller of GameStop here? Share your thoughts in the comment box below.

Microsoft is a Motley Fool Inside Value recommendation. Apple, Activision Blizzard, and Netflix are Motley Fool Stock Advisor picks. The Fool has written puts on Apple. Motley Fool Alpha LLC has bought puts on Netflix. Motley Fool Options has recommended a bull call spread position on Apple. Motley Fool Options has recommended a synthetic long position on Activision Blizzard. Motley Fool Options has recommended writing covered calls on GameStop. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Activision Blizzard, Apple, GameStop, and Microsoft. Motley Fool Alpha LLC owns shares of Activision Blizzard and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Longtime Fool contributor Rick Munarriz will admit to still playing video games, though finding time is the rub. He does not own shares in any of the companies in this story. He 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 (4) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 14, 2011, at 2:59 PM, Earthhouse2 wrote:

    Your not kidding. Bought it and Nvda last december because my kids were getting their gift cards from everyone. Fortunately, dumped both my shares and jan 2012 25 calls at a nice profit thanks to the article. I will keep my nvda for now and am happy with the profit on the calls that were only a 1.23 back then. Of course, I saw them drop to .88 before they ever returned. I am sitting on the sidelines with this one. Now, whoever recommended CPE thanks for nothing:)

  • Report this Comment On April 16, 2011, at 11:49 PM, EquityBull wrote:

    I think you are overly bearish. Digital is growing fast at GME and the can always just acquire the valves of the world. They still get strong roi from each new store.

    Even if all your arguments hold some water the stock is priced for bankruptcy in just a few years. That just won't happen. I'd like to see a dividend of 5% here just to knock out the shorts. It worked for seagate that has no bright future with tablets and ssd's so it would work for gme

  • Report this Comment On April 19, 2011, at 7:07 PM, EthanF wrote:

    I don't think Gamestop is in that much trouble. They have time and opportunity to change their fortunes right now. I see this whole industry changing and the developers like Activision ( being a big part of it.

  • Report this Comment On April 21, 2011, at 4:48 PM, SpeleoFool wrote:

    Interesting question. I'm mainly a console gamer rather than a PC gamer, and this generation of consoles is still based on physical media. I think that one fact is protecting GameStop's short-term value, but if digital distribution takes off for the next generation of consoles then they're in real trouble.

    Let's look at the XBox: Internet connectivity has enabled Microsoft to offer downloadable versions of (some) games, but right now the value proposition is very one-sided. The biggest problem, as the article astutely observes, is that you cannot resell digital downloads. Add to that the monopolistic delivery system (MSFT exclusively controls distribution & pricing of downloads). Then consider that the XBox physical storage is proprietary and ridiculously overpriced. As a consumer, the choice to buy used game media from GameStop instead of downloads from Microsoft is a no-brainer. Why spend inflated fixed prices on a download I can't resell that eats up expensive storage space on my console when I can get the exact same content for less money, no storage hit and with the bonus opportunity to get some pennies back when I trade in that game toward my next used game purchase?

    BUT, the console manufacturers like MSFT control the whole sandbox, so what if the next generation of consoles attempt to do away with physical media altogether? Personally, I think the move would hurt the gaming industry (I know I'd be playing far fewer titles), but that would outright kill GameStop. Moreover, I could believe big publishers supporting the idea since they don't see any money from used game sales anyway. Their short-sighted big-business thinking will have them believe they'll be getting a bigger slice of the pie, when in reality I think the lack of competition in game distribution will stifle console gaming. Is a bigger slice of a smaller pie a win? :)

    In any case, the fact that GameStop has no control whatsoever over the forced death of physical media would have me worried about a long-term position in their stock. I think they're safe for a few more years, but keep an eye out for spec announcements for the next-generation Playstation & XBox....

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