At first blush, video-game retailer
looks like a great
. The company has been buying back huge amounts of stock, its
trade for less than 10 times trailing
, and the company's $3 billion in tangible
is not far below the its entire $3.5 billion
So it's curious to discover GameStop is a favorite of short
sellers. They hold 38 million shares in their short accounts, which
is 28% of the trading
and the equivalent of 10 days of trading
. Short sellers typically target richly-valued stocks. Why are they
going after this seemingly attractively-priced stock? Likely
because they see potential for a long-term erosion in the
that eventually sends GameStop to the same fate of other retailers
such as Blockbuster and Circuit City -- bankruptcy court.
A wrenching transition to digital
GameStop has been expanding its retail foot print for the past
decade. The company now has more than 6,600 stores in 17 countries.
Sales are likely to reach almost $10 billion in the
that ends this coming January.
Yet as you examine the company's
, some red flags start to appear. For example, same store sales
fell 9% in the quarter ended July, which management attributes to a
light schedule for new software releases compared with the prior
year's quarter. Might sales also be slumping because consumers are
starting to seek other forms of entertainment at the expense of
console-based video games?
Management tacitly concedes as much by working aggressively to
boost GameStop's presence in the digital-download
. Digital-download revenue rose an impressive 69% in the fiscal
second quarter (though the company declined to report an actual
revenue figure. A review of the company's
also shed no light on the revenue breakdown, although management
will have to break out digital sales figures when they comprise 10%
of sales). Digital-focused initiatives include the development of a
download app for tablet computers, the sale of iPads in its stores,
and investments in up-and-coming digital players such as
There-in lies the rub. As consumers increasingly embrace downloads,
GameStop's massive store are starting to suffer from negative
de-leveraging. Retail stores have a high amount of
such as rent, utilities and labor, and the real profits accrue only
when incremental revenue exceeds the fixed costs. Yet a drop in
traffic starts to render these stores practically useless as
drags. Of the company's 6,600 stores, how many can handle a 10-20%
drop in foot traffic and remain profitable? Put another way, at
what point does management start closing the weakest stores to
preserve profit margins?
This can lead to a death spiral that firms like video rental chain
Blockbuster went through. Blockbuster started closing the
weakest stores only to find that it had reduced buying power and
scale economies when it came time to service the remaining open
stores. What started as a slow trickle of store closures eventually
became a tsunami.
Will GameStop suffer a similar fate? Not this year. Not next year
either. But short sellers are watching for signs that a process of
retrenchment has begun.
What size slice of the pie?
GameStop is just beginning to compete with firms like Zynga that
are gaining traction in the mobile game space. The firm also has to
share the traditional video game market with new players. Earlier
began to offer video-game rentals along with its Redbox DVD-rental
has given mixed signals on an effort to start offering video-game
rentals by mail, but it would present a formidable threat to
GameStop, due to aggressive pricing and the convenience of the
games-by-mail business (or video-game streaming, as the case may
Gaming is unlikely to go away as a consumer hobby, but GameStop's
gate-keeper role in the industry has clearly begun to erode.
Risks to Consider:
Short sellers are betting that GameStop's quarterly results
will steadily deteriorate as time passes, so if the retailer
delivers better-than-expected results, then shares could get a
. It's best to short this stock with a long-term perspective,
acknowledging that shares could actually spike before heading into
a long-term decline.
Action to Take-->
Broken retail business models don't collapse overnight. But the
mere sense that a long-term decline is enough to start hammering
shares. Same-store sales declines are the key metric to watch. They
fell sharply in the July quarter, probably stayed even in the
quarter that ends this week (October), and at that point, investors
will give close scrutiny to the all-important holiday selling
How do short sellers place a target price on a stock like this?
They don't. The bet against the stock is that it could head lower
and lower as time passes, but there is no specific set of metrics
that point to an appropriate valuation such as $20, $15 or $10.
-- David Sterman
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.
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