Shorting Gamestop -

GameStop (GME:NYSE) - Sell Recommendation

GameStop: Blockbuster 2.0

Tim Brooks, a GameStop retail manager in Northern Philadelphia, claims to know 98 to 100 percent of the customers that visit his store^[1].  A high volume of repeat customers is typically a sign of a financially sound company. After all, customer loyalty leads to stable and predictable cash flows, a feature investors pay great premiums for.  But what if this was 2003, and I told you Tim was a manager of a local Blockbuster chain. All of a sudden, the staunch customer base no longer seems so loyal. Much like Blockbuster in 2003, GameStop faces an unfavourable industry shift that dwarfs any of the benefits associated with the unjustifiably high intangible assets they “own”.

Recent sales disappointment exposes GameStop’s faltering business model

On Friday, January 13, 2017, GameStop reported that global sales for the holiday period fell 16.5% to $2.5 billion.  Additionally, total comparable store sales declined 18.7% and new hardware sales decreased 30.3%. Management hastily pointed that sales were “impacted by weak Call of Duty: Infinite Warfare and Titanfall 2 sales", coupled with "aggressive promotions on Thanksgiving Day and Black Friday”.

A blatantly simple fact about the industry is that Brick-and Mortar video game stores are no longer necessary as consoles are shifting away from physical disks to downloadable content. Furthermore, streaming services (think Netflix for gaming) like PlayStation Now, Xbox Live and Steam are gaining market share and tightening industry margins. “PlayStation Now”, for example, offers access to over 450 games for a monthly subscription fee of $19.99. As physical games become obsolete, this will not only lead to lower sales for GME's new gaming business, but also deteriorate its pre-owned gaming business. The pre-owned segment accounts for a much higher profit margin than its new segment (46.4% vs. 24.3% for pre-owned and new software, respectively).

Still overvalued after the 8% drop that coupled the poor holiday sales report

The threat of obsolescence is simply not captured by EPS, EV/EBITDA, P/E and other ratios the market value is typically derived from. Value investors might look at GameStop, apply historic averages and estimates, and then naively conclude the stock is now undervalued (thanks to the 8% drop from Holiday’s sales report). This attitude, despite its pervasiveness, is erroneous.  John Hempton from Bronte Capital put it best:

“There is another iconic way that value investors lose money - and that is technical obsolescence. Kodak was made obsolescent and was a value stock all the way down to bankruptcy. The circumstances on which you might be wrong (digital photography going to 95 percent of the market) could have been stated pretty clearly in 1999. You might think it was worth owning Kodak as a "cigar butt stock" - plenty of cash flow and deal with the future later. There was a reasonable buy case for Kodak the whole way down”.^[2]