Throw This Stock Away

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  ) .

Game over  
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.

Good news
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.

The Motley Fool owns shares of Take-Two Interactive Software, Activision Blizzard, GameStop, Apple, and Best Buy. Motley Fool newsletter services have recommended buying shares of Apple, Best Buy, Take-Two Interactive Software, NetEase.com, and Activision Blizzard, creating a synthetic long position in Activision Blizzard and a bull call spread position in Apple, and writing covered calls in GameStop. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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 doesn't mind taking out the garbage every so often. He owns no 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 (26) | Recommend This Article (8)

Comments from our Foolish Readers

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  • Report this Comment On July 13, 2011, at 6:30 PM, Varchild2008 wrote:

    I did a search for the word "Impulse" and came up empty. Zero matches. I then decided not to even bother reading your article.

    Yet another example of how the *bears* seem to avoid Impulse so much it is as if they are petrified of it.

    Come on. Stop being scared of Impulse and start actually taking a look at it.

    www.impulse-driven.com

    Dnload software today so your next article can address how the Impulse team is doing.

  • Report this Comment On July 13, 2011, at 7:22 PM, Varchild2008 wrote:

    Gross profits were essentially flat 1st quarter 2011?

    1st Quarter 2010 Used Video Game Gross Profits

    274.4

    1st Quarter 2011

    300

    Could you please clarify how that is "Flat" in your opinion?

    How much GROWTH did you want to see to say it was GROWTH?

  • Report this Comment On July 13, 2011, at 7:25 PM, Varchild2008 wrote:

    RICH Munarriz thinks 8.5% year over year growth in Gross Profits for Used Video Games is FLAT!

    8.5% growth = FLAT????

  • Report this Comment On July 13, 2011, at 7:31 PM, Varchild2008 wrote:

    "•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."

    Can you believe this garbage?

    Same Store Sales Q4 2010 around 3%.

    Same Store Sales Q1 2011 roughly above 9%

    That's right.... Q1 2011 saw same store sales rise 9% year over year.

    Nearly a DOUBLE DIGIT gain in same store sales qualifies for "Sales Softening."

    Investors should punch out!!! Investors are doomed!!!!

    Quick... everyone flock into (AAPL) <----- while you stil can!!!! The only stock in entire stock market worth investing in is AAPL!!!!!!

    Rich then avoids "IMPULSE" so as not to mention then 53% growth in Digital Sales.

    That's right... 53% Growth in Digital.... 9% growth in Physical.

    And Gamestop REFURBISHES the Apple IPAD by the way.

  • Report this Comment On July 13, 2011, at 7:33 PM, Varchild2008 wrote:

    "Total sales for the first quarter of 2011 increased 9.5% to $2.28 billion, in comparison to $2.08 billion in the prior year quarter. Total company comparable store sales were 5.3%, driven primarily by strong HD console sales, the Nintendo 3DS launch and a 9.5% growth of pre-owned products. Digital sales increased 53% over last year as each digital segment experienced strong growth."

    My bad.... It's 9.5% TOTAL Sales growth.

    5.3% Same Store Sales growth... That's a bigger same store sales gain than Q4 2010.

    Digital up 53%.

  • Report this Comment On July 13, 2011, at 10:56 PM, gordongek wrote:

    varchild I do not know where you get your information but the writing is on the wall with this company. Digital distribution is the single biggest factor. The tablet idea they had is a joke, the "increase in digital" you site is compounding an infentesimal number. Kongregeate is a huge repository of shovelware and is in no way a player in the market. They are floundering and artificialy infalting their share price with buy backs essentialy paying the shareholders with their own money and calling it profit. Their loyalty program is terribly executed with mandatory quotas beign thrust upon the poor people unfortunate enough to work in their "upscale pawn shops" to begin with. The quotas are only serving to create fictitious member accounts, which is artificially inflating their "success". IT is also exactly what you'd expect when you threaten peoples jobs with unrealistic qoutas...but this is only par for the coarse at gamestop. If you do not want to take my word for it or want more just google the words "gamestop" and "labor dispute". Happy reading.

  • Report this Comment On July 13, 2011, at 10:59 PM, gordongek wrote:

    Varchild you seem like you have more than a small stake in this game? Is it possible you are trying to bring "power to the players" on this site with your misinformation? Coughh :shill: cough cough.

  • Report this Comment On July 13, 2011, at 11:00 PM, gordongek wrote:

    Gamestop will have gone the way of BLockbuster, and the dodo before the end of the next presidential administration not matter how shrill the knashing of teeth is by all those unfortunate investory too short sited to see the big picture.

  • Report this Comment On July 13, 2011, at 11:09 PM, gordongek wrote:

    And to respond to your APPL comments, no I think there's at least one other stock worth investing in...Best Buy. Unless of coarse they too try to sell a "tablet".

  • Report this Comment On July 14, 2011, at 11:12 AM, Rehydrogenated wrote:

    Woah, things gettin' a little vicious on the boards. I gotta love Varchild's math vs gordongek's theories since that is what makes the GME case so interesting.

    Digital distribution is just beyond the horizon. RUN AWAY!!!!

    vs

    Every fundamental of value investing ever.

    Personally I see GME as the only barrier between the customer and the end of "used games".

    Also, if everyone is so certain that GME is pursuing a failing strategy, why do I keep reading that Best Buy will succeed? Best buy sells warranties on appliances, otherwise their profit would be negative. You can't sell warranties on video games.

  • Report this Comment On July 14, 2011, at 11:51 AM, gordongek wrote:

    Every fundamental of value investing? Are you mad? Such a fatuous statement makes me wonder if you base it on anything besides a need to be clever.

    You can't buy warranties on video games?? Really? Ask Varchild since I have no doubt he works for gamestop, and he will tell you that gamestop has bilked the customers out of MILLIONS selling "Game Protection Plans" or GPGs.

    Best Buy can undercut them on cost since they have other facets to their business. It is also not neccesary to charge 55 dollars for a used game that orginaly cost 60. Just lowering the price they can charge would seriously undercut gamestop and take a huge chunk out of their bottom line.

    THE end of used games?!?!?! Are you serious???

    SO people can't buy used games on Ebay, AMazon, Craigslist, yard sales, flea markets, other pawn shops, toys r us, FYE, Play and Trade, Wallmart...ETC ETC ETC

    Truly sir you are a fount of business sense.

  • Report this Comment On July 14, 2011, at 11:56 AM, gordongek wrote:

    NOT to mention people could wise up and just trade straight across with friends. But that would mean people had gained common sense and is therefore unlikely.

    By all means keep investing in GAmestop. I am sure those 18 million dollar CEO appreciate you funding their short-selling activitites.

    HOw many time do they have to pull the same trick??

    THe company's stock is over 24% held in short sale stock. Anything over 14% should send alarm bells ringing. ESPECIALLY when corporates big idea is to dirve the price artificaly with the shareholders money.

  • Report this Comment On July 14, 2011, at 12:07 PM, gordongek wrote:

    Look at the records the CEOs divested themselves in late winter last year... At the same time they cut the employees benefits and bonus programs.

    They are a short-sighted, flash in the pan company whose middle management is comprised of mostly inept thugs who were fired form more reputable retailers. Just google "Gamestop DM" and look at the parade of replicants that pop up. Their resumes read like a study in failure.

    Speaking of their DMs, they see fit to pay these over compensated bullies upwards of 90K a year for doing the exclusive "job" of harrasing a bunch of retail clerks on a daily basis.

    They waste millions on sales that fall flat ( see last XMAS)

    The bottom line is that any thinking person does not enjoy shopping in a place where to get from the register to your car one must first endure a avalance of sales pitches on useless add ons and promotions form a person whose livlihood( such as it is) is threatened if he doesnt push their nonsense. It is an excersise in frustration loaded with awkward rejections and pushy desperate pleading.

    they are not pushing value either. they are pushing the following...

  • Report this Comment On July 14, 2011, at 12:13 PM, gordongek wrote:

    The privilage of giving them 5 dollars to "reserve a game" that they will then pressure the employees to sell out of the day it is released and instruct them toi send all complaints to the DM so it "doesn't go to corporate". (it is only by playing the law of averages that they are not totaly inundated with complaints.) Once peopel start doing business with a retailer that honors reservations they will be out of luck.

    The "magazine" they sell for with their 15 dollar power up card is anything but a value: leaving aside for the fact that the magazine is nothing more that a pile of misleading paid for game reviews and a pile of ads, the 15 dollars you spend to get 10 percent off is a farse.

    One would have to spend TWO HUNDRED dollars to save a whopping FIVE with this "deal". This is their line one item, the "power up program" thye have invested over 18 million in. If it wasn't for scared retail clerks they wouldn't even have the inflated most likely false numbers they do with this program.

  • Report this Comment On July 14, 2011, at 12:17 PM, gordongek wrote:

    ALso the quality of their used games is infamous in the gaming industry. They look like someone trawled cement with them most of the time. They use the customers as free labor under the guise of a 7 day return policy and let the poor people drive back and forth with the defective garbage, wasting gas, instead of refurbishing them there and then. If they did that they might have to pay someone, heaven forbid.

  • Report this Comment On July 14, 2011, at 12:23 PM, gordongek wrote:

    If you really want to see how great they are doing walk in to any gamestop at about 2:30 on a weekday. Unless you are in a major city you will find one clerk ALONE and he will most likely remain alone until 4 in the afternoon due to "cutbacks" Ask your self why a billion dollar company can't afford to place at least two people during, their busiest time, in the store. The answer is it is far easier to remind the poor sod that he is lucky to have a job in this economy ad get the aformentioned DM/thug to harrass him into working unpaid overtime. I do not know about you but I don't want to support a company that uses people like chattel. The sooner they are put in their place the better. Fortunatley based on how Best Buy ate their lunch last xmas that is coming soon.

  • Report this Comment On July 14, 2011, at 12:31 PM, gordongek wrote:

    For those not informed of last xmas's debacle let me educate you.

    With the goal of "beating 2008" ,because 2009 was too snowed in to be an acurate yard stick, they concocted a series of completely inefective sales promotions. I say ineffective because with every single one, without exception, Best Buy, Target, Wallmart, and even Toys R US did the same items for half price and had inventory. Gamestop ran trade promotions and gave modest discounts on games no one wanted, they even ran buy two get on free deals on used games. NO effect. The avg store I spoke to was down 30 % on black friday. They were not simply outclassed on xmas they were decimated. They disp[layed a complete lack of flexibilty to adapt to a changing market place and, as a result, had an underperforming holiday season,

    Now imagine what a fully equipped Best Byu could have done with a seperate game store within their store in the same vein as "World of Nintendo" in toysrus from the 1980's. I don't need to remind most of you that World of Nintendo comprised over 50 percent of toysrus's profit throughout the mid ninties and that was with competition from funcoland, babages, and electronics boutique.

    If Best Buy does this right they will take a HUGE bite out of gmaestop's downtrodden, abused, weary clientelle.

    Hopefully, they attract a few employees away too.

  • Report this Comment On July 14, 2011, at 2:06 PM, Rehydrogenated wrote:

    Wow jeez, you had me at Game Protection Plans. That's a great reason to invest in Best Buy. You win, ill just take my 30% gain in the past 3 months and walk away...

  • Report this Comment On July 14, 2011, at 2:19 PM, gordongek wrote:

    For your sake I hope your not being sarcastic...or do you honestly believe this stock has somewhere to go besides down.

  • Report this Comment On July 14, 2011, at 2:20 PM, gordongek wrote:

    I lost a bundle when everyone was predicting it would stay at 37 and that was with neglidgible competition 2 years ago. Lesson learned.

  • Report this Comment On July 14, 2011, at 6:02 PM, Riskysam wrote:

    its one thing to trash a company, but to say their used games are defective is just ridiculous.

  • Report this Comment On July 15, 2011, at 12:43 AM, crca99 wrote:

    And thx for the NTES update. I always appreciate it.

  • Report this Comment On July 15, 2011, at 4:39 PM, gordongek wrote:

    I never saud they were all defective, I just said that the vast majority are sub par, especialy for what they are charging. Also, I commented on how they use the guise of a leanient return policy to essentialy transform the customer in to free labor to test their games.

  • Report this Comment On July 15, 2011, at 4:40 PM, gordongek wrote:

    Also when we started this "discussion" the stock was flirting with 27dollars......last 4 days have gone in just one direction.

  • Report this Comment On August 04, 2011, at 7:33 PM, invest101 wrote:

    Gordongek, I am glad we share the same opinion on GME - we are together in victory or defeat! This Varchild2008 guy does seem to have quite a bit in the game (no pun intended) as he went ballistic on my negative opinion. I seriously do wonder if he is an executive with the Company.

  • Report this Comment On August 04, 2011, at 7:37 PM, invest101 wrote:

    By the way, people keep pointing to those digital sales are very impressive when Steam is growing sales at about 100% still (and they are estimated to have over $800M in annual revenue). That 53% growth figure is NOT going to win all the share they say need to achieve to reach their growth goals.

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