GameStop (GME) – A buggy whip manufacturer

GameStop is a leading bricks and mortar retailer of video games. This business is in a slow decline due to online competition.  The short thesis is simple… and quite subjective.  Online delivery of video games offers more value than physical delivery of games.  It’s cheaper, more convenient, and the copy of the game can’t get damaged or lost.  In my opinion, it’s inevitable that most video games will be distributed over the Internet.  GameStop’s revenues and profits will be a fraction of what they are today.

Unfortunately, predicting GameStop’s future revenues will be incredibly difficult as there isn’t a historical precedent to base predictions on.  Inflection points are hard to predict precisely.  However, GameStop’s high valuation provides some margin of safety.  If GameStop makes $400M after-tax annually (this is a little generous) and has a market cap of $6B, then its P/E ratio is 15.  That P/E ratio is too high if GameStop’s revenues were to shrink to a fraction of what they are today.

The coming inflection point

There are three ways of distributing video games:

  1. Over the Internet: Steam, Electronic Arts’ Origin, Microsoft’s Xbox marketplace, Sony’s Playstation store, etc.
  2. As a physical disc in the mail (e.g. Amazon, GameStop’s online store, etc.).
  3. As a physical disc in bricks and mortar stores.

For gamers with a high-speed Internet connection, option #1 is often the most convenient.  Most games require downloadable updates anyways.  It’s silly to buy a game on a DVD and then have to wait for updates and patches to download!!!  Gamers might as well download the entire game in the first place.  The status quo is silly and doesn’t make a lot of sense.  It’s also silly that gamers are buying online games (e.g. World of Warcraft) on a disc since those games require an Internet connection.

For people without high-speed Internet, physical discs can still be more convenient.  The convenience between #2 and #3 is a toss up.  Some people don’t like waiting for mail while others do not enjoy traveling to a store.  Over time, I would expect the penetration of high-speed Internet to increase and for Internet connections to become exponentially faster.  There is a small niche of gamers who prefer the goodies and artwork that come with retail boxes of games.  Historically, the industry has been moving towards putting less and less extras in retail boxes.  When the video game industry first started, retail boxes used to be much bigger and took up more shelf space.  The advantages of physical distribution only cater to small niches in the overall gaming market.

From the developer’s/publisher’s perspective, digital delivery (#1) is the cheapest followed by mail delivery (#2).  Currently, there is an artificial market in video games as games are often priced the same between the three modes of delivery.  If the true cost of distribution were passed onto consumers, it’s obvious that consumers will rapidly shift towards the most convenient and cheapest form of distribution (digital downloads).

Many video game studios are also moving towards microtransactions, where users can buy add-ons and downloadable content (DLC) digitally.  These transactions bypass retail markups.  Another trend is the growing niche of free “pay to win” games.  Users can download the base game for free while they can purchase in-game advantages for money.  While I consider these games to perverse, many people will put money into free games (I know I have).  To be fair, I think that these games will remain a niche because not everybody is interested in paying to win.  Nonetheless, GameStop’s core business has little part in the trend towards in-game digital transactions.  Currently, GameStop will try to upsell customers on DLCs.  But it’s obvious that Gamestop is a middleman that generates no value.

Eventually, bricks and mortar stores will play a very small role in distributing video games.  The question is how long this transition will take.  Unfortunately, I don’t have a good answer.  I admit that this is the weakest part of the short thesis.  However, many industries are clearly in the middle of a trend towards online shopping and/or digital distribution.  Book retailers like Borders have gone out of business facing competition with Amazon’s online store and e-readers.  Movie rentals have shifted away from Blockbuster’s retail stores(now bankrupt), away from Netflix’s mail delivery, and towards Netflix’ digital distribution.  What’s unique about games is that digital distribution is more compelling than for books or rental movies.  With books, many people don’t own an e-reader or don’t like them.  There are no such barriers for games.  With rental movies, the video quality of streaming is slightly inferior to a physical disc.  With games, quality is identical.

Past sales figures

The NPD Group analyzes the game market and tracks the sale of games.  Their figures aren’t perfect as they have to guess some of the numbers for games sold as digital downloads.  Penny Arcade Report has an excellent analysis of NPD’s flaws.  The industry magazine Gamasutra also explains why it is skipping NPD reports.  Nonetheless, the trend has been that digital downloads have been taking market share away from physical stores.  NPD data also show that PC gaming is in a massive decline.  This is likely due to flaws in its methodology.  The PC gaming market has largely shifted towards digital distribution (mainly Steam), which NPD has trouble tracking.  The console market has been slower in shifting to digital distribution as many blockbuster games cannot be purchased digitally.  Part of the reason is because the physical disc for consoles deters piracy.

Gamestop reports its comparable store sales and revenues for its segments.  Its latest quarter has been terrible as same store sales and revenues fell 10.7% (see press release).  2013 was the first year that GameStop has seen its revenues fall, from $9,551M to $8,887M (-7%).  GuruFocus.com is a good way to easily look at GameStop’s historical financial data.  The drop in revenues suggests that the inflection point has arrived.

The alternative explanation for the drop in revenues is that gamers are buying less in anticipation of new console releases from Sony and Microsoft.  However, one has to conveniently forget the launch of the Wii U in November 2012.  (To be fair, the Wii U had very poor sales.)

Will GameStop’s decline be slow?

GameStop’s management is very, very smart.  They see the future and are trying to be a part of it.  They bought Impulse (now rebranded as GameStop App), a digital distribution platform that competes directly with Steam.  GameStop also sells vouchers for Steam (!).  GameStop can profit from these physical gift cards because many people will lose them (retailers love gift cards for this reason).  The bigger picture is that management sees what’s coming and is trying to do their best.  They have been letting their physical store count shrink and have paid off all long-term debt.

Operationally, management has done a fantastic job at operating GameStop.  They have grown revenues at around 21% / year over the past 10 years.  Its share price in the last decade has roughly roughly 20% / year.  Excellent management makes GameStop less compelling as a short.  Normally, excellent management leads to earnings growth.  However, I don’t see how GameStop will grow when it is shrinking its store count and it is not doing well against its digital distribution competitors.  Management says that its digital initiatives are growing rapidly.  However, this is mostly because it has been selling gift cards for competing services (or upselling DLCs).  This is not a good position to be in.  Upselling DLCs is not a sustainable business in the long term.  Selling gift cards/vouchers may be profitable, but that business will never be big enough to support GameStop’s market cap.  So far, GameStop has been losing the digital battle.

I don’t think that GameStop’s digital distribution business (GameStop App) will compete effectively against Steam.  Because there is a social networking aspect to Steam (e.g. you can see when your friends are online so you can invite them to play with you), Steam enjoys network effects that its competitors do not have.  Steam’s software also has more features than its competitors at the moment (e.g. DRM, saved game data is stored in the cloud so you can move between computers, etc.).  GameStop App seems to have very little market share and GameStop does not break out its digital distribution business in its segment information under Other.

The bottom line

GameStop is a buggy whip manufacturer with excellent management.  But even the best buggy whip manufacturer will see its core business die.  Unfortunately, the short sellers have to get the timing right.

Be careful with shorting the common because short interest is around 25% (see Yahoo Finance).  There are put options available on GameStop, though I would prefer it if the implied volatility on the options was lower.

Links

VIC writeup #3 (short)

VIC writeup #2 (long) – There are a lot of comments that are interesting and worth reading.

VIC writeup #1 (long)

Jim Chanos’ presentation slides on GME and other stocks

Valve, Steam, and the threat to your GameStop Investment – Seeking Alpha article by a gamer.

*Disclosure: Short GME through the common stock and puts.  I love Steam and don’t see any reason why I would want to shop at any store owned by GameStop.

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2 thoughts on “GameStop (GME) – A buggy whip manufacturer

  1. While I agree with your thesis long-term, I disagree with your timing for a few reasons.

    Many gamers, especially console gamers, don’t have ample disposable income and use the trade-ins at GameStop as financing. While I find the trade in value of games inadequate, people can find significant value there with a little mental accounting. You no longer have this option if you don’t own the games.

    Moreover, console gamers are very attached to discs. When Microsoft announced the Xbox One would do away with “ownership” of games there was a very vocal backlash. Sony maintaining the status quo with the PS4 won them adulation and resulted in Microsoft walking back their stance on physical discs. The upcoming generation of consoles retaining physical discs as their primary vector of distribution buys Gamestop at least 5 years to get their act together and derisks their business near term.

    You have noted that GameStop’s management is quite capable and isn’t asleep at the wheel. Their trade in business generates significant cash flow and gives management significant optionality. While this is not enough to make me long the stock, it makes it much too early to be short.

    The largest risk for GameStop near term isn’t digital distribution in consoles, it is mobile gaming (and the digital distribution of games in that market). Many casual gamers are eschewing consoles (shows in poor Wii U sales). It is yet to be seen if PS4 and Xbox One sales are effected.

    • The technology has always been there to buy games digitally on the old Xbox (and Playstation). The real battle is between the game publishers+studios and the retail game stores. There will be a day when the majority of games are cheaper digitally (and through online mail order) than in bricks and mortar stores.

      If you want to buy indie games, bricks and mortar stores aren’t even an option.

      2- As far as discs go, we can look at games that are available on Steam and on consoles. If the price is the same, there are a lot of people who will buy the game on Steam. The lack of a disc is a positive for them (I am in that camp). Other people like having a disc.

      3- You can buy a lot of remastered arcade classics on consoles as downloads. Most gamers I know are ok with not having a disc. And they are ok with not being able to resell their games. Many of them have a problem with Steam sales. Steam sales are like crack and people go crazy over them.

      Steam has done a very good job at driving volume for game studios, especially for indies. The only reason why boxed games are priced at parity with downloads is because the studios/publishers need the retail stores to drive volume. If the console stores figure out how to copy Steam, then a lot of gamers will find out about new games from the console stores. The value proposition of retail stores will go down.

      The digital distribution guys have an incentive to grow the indie market (which hurts GameStop) since the indies are entirely dependent on them. This article might be relevant:
      http://www.edge-online.com/news/cthulhu-dev-its-no-wonder-xbox-indie-games-sell-poorly/

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