The Bulls Are Right So Far on Gamestop, but Will the Party Continue?

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When I wrote about Gamestop (NYSE: GME) last October, the stock was trading at $20 per share and I said it was worth $55 in a best-case scenario. The stock has since risen to above $40 per share -- a sweet 100% return for owners of the stock over this period.

My optimism about Gamestop's future has increased since then, but not because of the large rise in share price. As Benjamin Graham famously warned investors who take their cues from the market, "you are neither right nor wrong because the crowd [agrees] with you. You are right because your data and reasoning are right."

Instead of the market price, I was focused on whether or not my analysis of Microsoft (NASDAQ: MSFT) and Sony's (NYSE: SNE) incentives to continue including functionality for used games on the next generation of consoles was right. Here's what I said in the October article:

...the used game market isn't going anywhere anytime soon. If Sony removes backward compatibility from the Playstation, Microsoft can increase customer satisfaction (and market share) by including support for old games. It is important to remember that consumer behavior ultimately determines production. As long as consumers demand backward compatibility, console-developers will have to give it to them. Thus, I don't see this being an issue as long as physical disks are used to distribute games

Since Gamestop is increasingly reliant on the used game market for its revenues, it was crucially important for this statement to be correct in order to support a higher valuation. As it turns out, the bulls who believed this statement were right to do so.

Microsoft initially announced that its next generation Xbox console, the Xbox One, would not support used games and would instead rely on digital distribution of games. Sensing an opportunity, Sony launched an aggressive campaign to market the Playstation 4's ability to play used games. As pressure mounted for Microsoft to allow the same, it finally relented and backed off of exclusively relying on digital downloads.

This was a major win for Gamestop bulls -- and for consumers. It shows that consumer preferences still carry a heavy weight, even in markets dominated by just a few large companies. However, as technology changes, consumers may start to prefer a method of game acquisition that bypasses Gamestop altogether.

Inevitable demise

The most popular argument among Gamestop bears is that digital distribution is the way of the future. Although I think a full-out move to a digital distribution model is still a couple console cycles away, it will inevitably take hold.

But the transition will not take place when Microsoft and Sony wish for it to take place; instead, consumers will dictate when the digital transition takes place. Although console-makers are ready for the transition, many end-users lack the necessary Internet connectivity and speed to download games in a timely fashion; it would be faster to go to Gamestop to buy the game instead of waiting for it to download.

Still, Sony and Microsoft's incentives are aligned with game publishers Electronic Arts and Activision Blizzard to destroy the used game market -- or at least Gamestop's share of it. In fact, Microsoft's digital download plan included the ability for publishers to re-sell used games directly to consumers -- taking Gamestop out of the equation.

Ultimately, Microsoft wants to create a new and used game market that it controls. Xbox One enables users to trade in games for credits that can then be used towards purchasing other games. Game publishers will get a cut of each sale, but there is no need for Gamestop. Instead, Gamestop's $9 billion in sales would be split up between game publishers and console makers.

There are other factors keeping customers from embracing the switch to digital -- including large stashes of used games, the pastime of browsing games at an actual store, and similar factors -- but most users will likely embrace change once the technology takes another leap forward. When console Internet connectivity is ubiquitous and download times are measured in minutes rather than hours, customers will no longer have a reason to shop at Gamestop.

Still at war

Although their incentives are aligned with one another as far as used games are concerned, Sony and Microsoft continue to fight for control of the console market. Sony's PlayStation 3 edged out Microsoft's Xbox 360 with 78.4 million units sold worldwide, just over 1 million more than Xbox 360 sales.

Meanwhile, sales of Sony's PlayStation Portable boosts its presence in a market in which Microsoft does not compete. Still, Sony's product is outsold by two Nintendo products -- Ninendo DS and Game Boy Advance. The PlayStation Portable is unlikely to gain top share in this market, especially if Microsoft decides to enter the market.

Sony's decision to enable backward compatibility is just another blow in the battle between console-makers. But, eventually, cooler heads will prevail and a focus on profitability will ensue.

Bottom line

So, while Gamestop may have been a great bargain when it was trading for just four or five years' worth of free cash flow, investors who pay today's rate of about a decade's-worth of free cash flow may be cutting it close on a company that is sure to be in a secular decline in ten-year's time. I would recommend waiting for the price to fall quite a bit before making another go at Gamestop.

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Ted Cooper has no position in any stocks mentioned. The Motley Fool owns shares of GameStop and Microsoft. 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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