GameStop Will be the Stock to Watch Thursday

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Video game retailer GameStop (NYSE: GME) is set to report earnings Thursday. Given the stock’s high short interest and the rocky state of its industry, it has the potential to be one of the biggest movers in Thursday’s session.

GameStop is heavily shorted

Short interest isn’t available in real-time, but as of the last report, more than one-third of GameStop’s shares have been bet against.

GameStop bears likely view the company’s problems as fundamental. In many ways, GameStop today is facing the same issues Tower Records (a now defunct seller of music CDs) struggled with a decade ago.

GameStop is stuck in a business model that is increasingly becoming obsolete. More and more, game makers are shifting to digital distribution rather than physical disc copies of their games; soon, GameStop could have no product to sell.

The video game industry has been under fire in recent months

To make matters worse, the game companies GameStop depends on have not fared well in recent months.

The CEO of Electronic Arts (NASDAQ: EA) stepped down earlier this month, taking responsibility for the company’s recent disappointments. Along with his resignation, the company announced that its sales would come in lower than expected this quarter.

EA’s SimCity debacle stands out as the most prominent recent failure. To fight piracy, EA required players to remain online and connected to its servers while playing. Unfortunately, EA’s servers ran into technical issues, and early adopters were unable to play. The company later offered free copies of some of its top games to compensate players.

EA’s recent struggles highlight two problems with GameStop. The first is that traditional video game companies are struggling to sell games in the current environment, and it's not just EA. Square-Enix, a Japanese video game developer, announced Tuesday that its CEO was resigning. Square-Enix said that it would post a significant loss for its current quarter.

The second is the growing digital trend. Although a player can buy a physical copy of SimCity, they must be connected to the company’s Origin digital service to play it. Origin also allows players to buy games straight from the service, and download them right to their computer.

Can refurbished electronics save the company?

To combat the company’s problems, GameStop has started buying used electronics like tablets and iPods, refurbishing them, and reselling them. On GameStop’s last earnings call, management said that in the stores that had begun to focus on refurbished electronics, sales had risen 7%. The company intends to expand this business to more of its stores in the coming year.

Interestingly enough, it’s not the only troubled company banking on this strategy. Coinstar (NASDAQ: OUTR), itself being pressured by a shift in media from physical to digital, has begun testing several different concepts for future vending machines.

One of these concepts, called Orango, intends to do exactly what GameStop is banking on: selling refurbished electronics.

Of course, the idea that a company can be sustained by selling refurbished electronics seems a bit suspect to begin with. Tablet prices drop dramatically each and every year as companies continue to innovate (Apple updated its iPad twice in 2012!). How much margin is really there for a seller to exploit?

To be clear, Coinstar's Orango machine isn't a done deal, but one of many new concept vending machines the company is considering rolling out. Coinstar remains heavily reliant on Redbox for the majority of its revenue and growth, but as consumers increasing opt for digital streaming over disc rentals, Redbox's future seems uncertain. Investors that want to bet on the sale of refurbished electronics probably shouldn't jump into Coinstar stock just yet (instead, the company intends to focus on its new coffee vending machines in 2013). 

But if the potential is there for a healthy market, Coinstar could undercut GameStop relatively easily. Like its Redbox kiosks to Blockbuster's brick and mortar stores, Orango machines wouldn’t carry the overhead or staffing costs of a GameStop store.

New games could help

Ultimately, GameStop’s guidance could be key. This year looks to be the year of new consoles: Sony’s Playstation 4 will hit stores this fall, while Microsoft’s next Xbox is expected sometime this year as well. Nintendo released its Wii U last year, but the console has had few must-have games released for it. That could change this year.

Likewise, the current trend for game developers could turn around. In a note released Tuesday, analysts at Piper Jaffray upgraded EA from Neutral to Overweight. In their note, analysts cited hope for the company's upcoming games, including Battlefield 4 and 2014 FIFA World Cup. Piper Jaffray's new $23 price target would mean that EA shares have over 20% upside from current levels, but to buy into that logic, investors should be confident that EA's upcoming game launches will be more successful than recent ones.

The combined effect of all those new consoles and games could juice GameStop’s sales this fall. Investors should pay close attention to what the company says in its expectations for the holiday shopping season.

Trading GameStop ahead of earnings

So what should investors do with the stock ahead of earnings? The company’s problems seem both obvious and severe. Yet, the high short interest could cause shares to experience a rapid rally if the company can manage to beat expectations.

At this point, the risk/reward profile for GameStop seems to be to the upside. That said, many of GameStop’s suppliers -- the video game makers -- are expecting poor sales this quarter; how can GameStop escape that?

At any rate, GameStop looks like it will be a big mover on Thursday. The big surprise will be if the stock trades flat.


Joe Kurtz has no position in any stocks mentioned. The Motley Fool owns shares of 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!

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