Is GameStop Dead? These Hedge Funds Still Believe

Meena is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In 2012 thus far, few stocks have been as controversial as GameStop (NYSE: GME). On one side of the fence, the bulls have been adamant that the company, which holds close to four-fifths of the used video game market, can make the transition to digital distribution while still holding relevance in the brick and mortar arena. It’s these supporters that believe even though GameStop has lost customers – same store sales are expected to fall 5% by the end of the year – to non-traditional gaming devices like tablets and smartphones, there is still a place for the store amongst the hardcore gamers that play Halo and Call of Duty religiously.

In the hedge fund industry, aggregate interest has pretty much remained steady throughout the course of the year; 19 funds held long positions in GameStop at the beginning of the year, compared to 18 at the halfway point of 2012. Moreover, some of the biggest bulls actually upped their positions in the company at the end of June, including Chuck Royce (+14%), Joel Greenblatt (+26%), David Harding (+81%), and Israel Englander (+66%). Here’s a full look at the hedge funds currently invested in GameStop, but the main question we have to ask is: what’s the reasoning behind this optimistic buying behavior?

Anytime we see names like Greenblatt and Englander invested in a particular company, it’s very likely that it is a value-play, and with GameStop, these assumptions are correct.

Down a little over 3% on the year, shares of the retailer currently trade at a trailing earnings multiple of 9.9X, with a forward P/E of 6.8X. These metrics are far below the specialty retail industry’s average (32.1X), and competitors like Amazon.com (NASDAQ: AMZN) at 130.4X, eBay (NASDAQ: EBAY) at 17.7X, and Wal-Mart  (NYSE: WMT) at 13.6X. Only troubled electronics retailer Best Buy (NYSE: BBY) at 5.8X, has a cheaper forward P/E.

From a growth standpoint, sell-side analysts still expect GameStop to generate solid EPS growth of 8.9% a year over the next half-decade. This is below Amazon (35.4%), eBay (14.0%), Wal-Mart (9.4%), but above Best Buy (-0.6%) by a significant margin. Now, when we use the PEG ratio to estimate how the markets are valuing this expected growth, we can also see that GameStop is borderline undervalued with a PEG of 1.12. In fact, it’s cheaper than the likes of Amazon (93.65), eBay (1.18), and Wal-Mart (1.64). 

On the other side of the coin, however, there are reasons to believe that GameStop is a value trap. For starters, an industry wide shift toward digital distribution may be the biggest risk facing the company at the moment. It is estimated that in 2012, digital delivery of games via console generates close to $19 billion in revenues for the video game industry. By 2017, this total is predicted to eclipse $35 billion, a 16.8% annual growth over the next half-decade.

In the console market, individual developers have their own digital distribution systems, with companies like Electronic Arts (EA) promising to go 100% digital in the future. In fact, EA Sports VP Andrew Wilson called GameStop out directly when he told reporters last year “there will come a day where I think that people will stop going into [retailers like] Game and GameStop,” saying that “It's important for retailers and us [EA] to understand what the consumer wants in the future.” EA’s Origin distribution system has caught on quickly, garnering over 10 million users in its first year.

Console makers Sony Corporation (SNE) and Microsoft Corporation (MSFT) already have stores built directly into their platforms, and we haven’t even mentioned PC digital distributor Steam, owned by the privately held Valve.

Now, the bulls will claim that GameStop’s acquisition of PC digital distributor Impulse allows it to make headway in this realm, but the service only holds 5%-15% of the market, compared to Steam’s 70% share. Additionally, Impulse does not give GameStop a foothold in the console digital distribution market, which at least equally as important at this point in time.

Looking forward, it is heavily rumored that Sony’s PlayStation Orbis and Microsoft’s Xbox 720 will be out within the next 12-24 months, and will have an even bigger focus on digital distribution. While it remains to be seen if some titles will be offered digital-only, the possibility likely keeps GameStop execs awake at night. If that were the case, there would be no reason for gamers to visit used game retailers like GameStop, and it may even render the concept of a “used game” obsolete.

In short, it is clear that the video gaming industry is heading toward a strategic inflection point that, once past, can render GameStop a mere shadow of its former self. The company’s entry into the PC digital distribution market is obviously important, but ardent bulls should look toward the future to see if any console digital distribution is in GameStop’s plans, either from partnerships with game developers and console makers, or via an acquisition. Continue reading here for an interesting take on if Amazon should consider buying GameStop


This article is written by Jake Mann and edited by Meena Krishnamsetty. Meena has a long position in MSFT. The Motley Fool owns shares of Amazon.com, Best Buy, and GameStop. Motley Fool newsletter services recommend Amazon.com, Best Buy, eBay, and GameStop. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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