Can This Physical Retailer Go Digital?
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Sometimes investors have a hard time looking past a company's current structure to try and envision what they could look like in the future. One such company, which is also a popular short candidate, is GameStop (NYSE: GME).
Short sellers have been betting against the company for a while, and the reasons for shorting the stock are pretty straightforward. The company operates thousands of physical locations in an industry where digital sales are taking over. GameStop also is reliant on the ability of the gaming industry to produce hit software titles and new consoles to generate interest. While this “short story” has been ingrained in investors' minds, GameStop is attempting to change their business into something the shorts might not see coming.
To understand why GameStop could potentially stop short sellers in their tracks, you have to understand the gaming industry. The industry used to be measured by console and physical game sales because that was all that existed. Over the last several years, the industry has changed, with companies increasingly selling their wares online.
Companies like Zynga cater to casual gamers with virtual worlds and goods. Two of the larger game producers, Activision-Blizzard (NASDAQ: ATVI) and Electronic Arts (NASDAQ: EA), are tasked with coming up with hit games multiple times a year. In the middle of all of this, you have one of the most well known retailers for gamers, Best Buy (NYSE: BBY), struggling to stay relevant. With such a complicated landscape, why would investors consider GameStop?
If you look at GameStop's last earnings report, there doesn't appear to be a lot to like about this retailer. The company saw sales decrease 8.9%, and same-store sales were down 8.3%. In the company's business segments, there are two somewhat bright lights that investors should pay attention to. The company essentially sells new video game hardware and software, used games, and digital and mobile products. In the new hardware and software space, GameStop is struggling, but through little fault of its own.
GameStop saw new game hardware sales drop over 33%, but as most people know, there hasn't been a new console on the market in the last few years. The Wii U is a new introduction, but that didn't come until near the end of the year. With Sony and Microsoft both looking at new consoles either this year or next, GameStop will struggle to show good growth in this area. The good news is these sales dropped from over 14% of revenues to just over 10%. When it comes to new software, sales were down 12.43%, but this was due to the fact that one of the biggest launches of the year, Call of Duty: Black Ops II, didn't come out until near the end of the year.
Given the release schedule of games this last year, the fact that GameStop only saw a drop of 12.43% in new software sales is actually a good sign. Popular titles like Diablo III, Skylander's Spyro's Adventure, and others were released during the year, but this was a difficult comparison to the huge releases of other franchise games in 2011.
Since Activision and EA have now established several franchises, this should give some predictability to the game upgrade cycle. Activision seems to update its most popular titles once a year, and with the Call of Duty series, World of Warcraft, Diablo, and Skylanders franchises all well established, updates should be predictable and generate more consistent interest from gamers.
EA has the core franchises of Battlefield, Madden, and the NCAA series of games, but EA needs to do more with both the Madden and NCAA games to generate consistent interest. In the last few years, the company's updates have largely left reviewers unimpressed. New innovative features that make gamers want to upgrade might bring a sales windfall to both EA and the physical retailers like GameStop and Best Buy. However, physical game sales aren't all there is to GameStop, and investors who don't realize this might be in for a surprise in a year or so.
GameStop and Best Buy both somewhat rely on new game hardware and software to get gamers into stores. However, GameStop is doing something that Best Buy is not, and that is moving fast into the digital arena. The company's “Other” sales were up 31.07% year-over-year, and have risen from 12.6% of revenue to 18.2% of revenue. The company is pushing toward digital distribution and pre-owned mobile sales. These growing categories can diversify GameStop's revenue stream. While this “Other” category is still a small piece of the pie, as these sales increase the GameStop story changes.
Today GameStop's stock is primarily a turnaround and income play. With shares yielding close to 4% and growth expected at just 3% in the next few years, it doesn't sound like there is a lot to like about GameStop. Relative to Best Buy's higher yield, but negative expected growth, GameStop's “Other” category is the difference maker.
When Sony and Microsoft introduce their new systems, this is likely to drive interest back to traditional console gaming. I would argue that GameStop's knowledge of the gaming industry, digital distribution plans, and loyal customers are reasons to favor the company over Best Buy. GameStop's gross margin of 31.44% is better than Best Buy at 24.05%, and they are generating positive free cash flow as well. Patient investors who understand the coming transformation of this company could be well rewarded.
MHenage has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard. The Motley Fool owns shares of Activision Blizzard 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!