Top 10 Most Shorted Stocks – Gamestop

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

A recent survey of the top 10 most shorted stocks in the S&P 500 found Gamestop (NYSE: GME) coming in at #1. The company currently has about 31.73% of its outstanding shares sold short. My contrarian nature makes me think there might be opportunity where others see problems. Let's look at Gamestop a little more carefully and see what's going on.

Gamestop

Current Price: $22.99
P/E based on '12 earnings: 8.01
Growth expected: 8.1%
PEG: 0.99
Yield: 2.61% 

On the surface the stock looks fairly valued. In addition, Gamestop's new dividend gives it a yield of 2.61%, which is big news. Generally speaking, people short stocks that don't pay a dividend. Gamestop's recent introduction of the dividend is a shot right at the shorts, as well as a deserved reward for shareholders.

In a heavily shorted stock one question is, could the shorts start to close out their positions because they have made enough? In the last six months Gamestop has been as low as $20 and as high as $26. This doesn't bode well for current shorts because there appears to be technical support at just under $23, which is where the stock trades right now. In addition, in the last year the stock has fallen 19.78% from its 52-week high. This means to short the stock you have to believe that a 20% haircut isn't nearly enough.

Assuming you are going to short the stock, you have to believe the company is going to miss earnings expectations. In Gamestop's case they have actually beaten earnings in two of the last four quarters, and they met projections in the other two quarters. This isn't screaming "Short this stock!" to me.

One factor that shorts might be looking at is the company's slowing growth rate. Gamestop shows a previous growth rate of about 12.85%, and forward growth expected of 8.1%. This implies a deceleration of nearly 37% from prior growth. That is significant. To believe in shorting the stock you have to think that an even larger drop in growth is likely to happen.

If I were shorting a stock, I would look for negative cash flow. After all, a company with negative cash flow is going to have to borrow money or issue stock to pay its bills. This is another area where I'm not sure what the shorts are looking at. Prior to their dividend, Gamestop had average positive free cash flow of about $176 million in the last four quarters. Even with the new dividend, which should use about $80 million of this, the company would still have nearly $100 million in positive free cash flow per quarter.

If the company is repurchasing shares, that is a sure sign of trouble for a short. After all, if the company is buying back its shares, the outstanding shares shrink. This will cause EPS to rise even with flat earnings. Give Gamestop another point, as the company has repurchased shares in all four quarters this last year.

Let's check Gamestop's balance sheet. If the company has too much debt this can spell problems even if the company is cash flow positive. That is just not the case here either. Gamestop reports no long-term debt, and has cash of about $442 million.

The only other reasons to short this stock would be crushing competition, or that the company is being left behind by new technology. One of Gamestop's closest competitors is Best Buy (NYSE: BBY). Best Buy sells for $25.19, which gives the company a forward P/E of about 7.45. The company is expected to grow at about 8.53%. Best Buy is cash flow positive, and has a net cash position on its balance sheet. While Best Buy is certainly a competitor, they have nowhere near the used games selection that Gamestop does. In addition, Best Buy stores are much larger and sell all types of electronics, computers, appliances, etc., whereas Gamestop is in the niche of games and game systems.

As far as Gamestop being left behind by new technology, this just isn't the case. High-end games such as Call of Duty, Battlefield, and others contain far too much data to ever be streamed over the Internet as some would predict. While casual games have grown in popularity, this appears to be adding gamers to society instead of stealing gamers from more traditional systems. Gamestop also sells its wares through multiple websites, and operates a few digital gaming sites as well.

Bottom line, shorts I think it's time to close out your positions. With a new dividend, share repurchases, positive cash flow, and a net cash balance sheet, this company isn't going anywhere anytime soon. The stock is already down nearly 20% from its 52-week high, and has support right around the current price based on the last six months of stock movement. The fact that the company has beaten earnings expectations just adds more fuel to the potential fire of a short squeeze. I'm placing a green thumbs-up CAPScall on GME to back up my thoughts. Let me know what you think in the comments section below.


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