The house rules are simple in this weekly column.
- I bash a stock that I think is heading lower.
- I offset the sting by recommending three stocks as portfolio replacements.
Who gets tossed out this week? Come on down, GameStop (NYSE: GME ) .
The bearish case for the country's leading small-box video-game retailer are fairly well known. Digital distribution -- the same beast that has boarded up your local CD shop, bookstore, and DVD rental joint -- is going to gnaw on the physical distribution of video games in the coming years.
GameStop's response has been to beef up its customer-loyalty programs and invest in Web-sprung diversions. The bulls have been winning this battle lately, with the retailer's stock hitting a two-year high back in May.
Unfortunately, it's just not that easy for GameStop, and a spot-on rebuke by Pacific Crest analyst Evan Wilson yesterday nails my worrywart sentiment exactly. Wilson downgraded the retailer to "Underperform" for a variety of reasons. In a nutshell:
- Sales are softening, and share buybacks are accounting for the bottom-line gains on a per-share basis. In other words, GameStop isn't as cheap as its low earnings multiple seems to suggest.
- Its digital acquisitions have been ho-hum players. He believes that Kongregate, with its small bases of users on Facebook, has peaked and has a small base. Jolt Online has "done nothing" since being snapped up.
- GameStop's highest-margin business -- reselling used games and gear -- has dismissed challengers in the past, but Wilson believes that Best Buy's (NYSE: BBY ) revamped effort that streamlines the trade-in process will make a dent.
We're not talking about a cyclical lull here that flies in the face of a buoyant share price. GameStop's model may be irreparably damaged. As soon as digital downloads begin taking over, there won't be a reason to head over to your neighborhood GameStop store aside from hardware purchases. Downloads will also naturally eat into the resale business. Wilson warns that GameStop suffered its first year-over-year dip in gross profits in that key business during the holiday quarter. Gross profits there were essentially flat during this year's first quarter.
Investors continue to buy in, impressed by near-term results and low multiples, without considering where GameStop will be in a few years.
Wilson's right, and shareholders may as well punch out while they're still on top.
As I do 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 replacements.
- Electronic Arts (Nasdaq: ERTS ) : I haven't been a fan of EA in recent years. My two favorite plays among a tattered gaming sector are Activision Blizzard (Nasdaq: ATVI ) as the market leader and Take-Two Interactive (Nasdaq: TTWO ) as a takeover candidate. However, I love EA's move to buy PopCap Games this week. The company behind Plants vs. Zombies and Bejeweled will give EA even more leverage in growth areas outside the console box, even if it didn't come cheap. Zynga's outrageously priced IPO will either boost valuations in this sector or prove that a changing of the guards is taking place. EA is positioning itself to come out ahead in either scenario.
- Apple (Nasdaq: AAPL ) : Three months ago, GameStop floated the possibility of rolling out a tablet for diehard gamers. It was laughable then, and it's just as funny now. Apple makes the only tablet that folks are materially buying, and that's unlikely to change. Apple also has played the biggest part in the waning popularity of video games in general and GameStop in particular. Its App Store disrupted the value proposition of games, leveling the playing field for developers in the process. The seemingly infinite supply of free and $0.99 games may not seem to pose a threat to the layered masterpieces commanding $50 or $60 at GameStop, but it's all about the allocation of time here. Apple clearly has the consumer's attention.
- NetEase.com (Nasdaq: NTES ) : If games in physical form in this country are endangered, let's kill two angry birds with one rolling stone and turn to China's leader in online gaming. NetEase is the fast-growing company behind some of China's most popular multiplayer experiences, and it's also Activision Blizzard's licensed partner in the world's most populous nation. NetEase is trading for just 12 times next year's projected profitability. GameStop may seem cheaper at just 8 times next year's bottom-line target, but only one of these two is likely to be more relevant in three to five years than it is now.
I'm sorry, GameStop. I just don't have the heart to hit the "continue" button.