Analysis: GameStop sees solid future despite video game shift to digital

Tue Apr 3, 2012 2:30pm EDT

People enter a GameStop store during ''Black Friday'' sales in Carle Place, New York November 25, 2011. REUTERS/Shannon Stapleton

People enter a GameStop store during ''Black Friday'' sales in Carle Place, New York November 25, 2011.

Credit: Reuters/Shannon Stapleton

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(Reuters) - GameStop executives are tired of hearing about investors who bet against the stock of the video game retailer that they have given them a nickname: shallow divers.

The knock against shareholders with a negative short-term view of the stock is meant to prove a point: take a more thorough view of GameStop to understand it will not end with the same fate as movie rental chain Blockbuster, which filed for bankruptcy protection in 2010.

"Are we paralyzed in fear that our business model isn't working? Not at all ... Investors are a trailing indicator," GameStop Chief Executive Paul Raines said in an interview.

Raines and his team have their work cut out for them, as a growing number of their investors are getting pessimistic. Hedge fund manager James Chanos of Kynikos Associates singled out GameStop at a conference last fall for following in the footsteps of Blockbuster and struggling UK entertainment retail chain HMV Group in slides he presented entitled "digital distribution destruction."

"Packaged games are pressured by growth in casual, mobile and social network games," and game publishers, such as Electronic Arts "are increasingly direct competitors," Chanos said in a slide show reviewed by Reuters.

About 41 percent of GameStop's shares are now held by short sellers who are betting that its stock price will fall instead of rise over the long-term. That is up from 30 percent in January and more than double the amount of retailer Best Buy, which has short interest of 17 percent and has been posting weak quarterly sales.

Raines and GameStop's other top executives have become well-versed in explaining to investors why it will not become the next Blockbuster. They note that GameStop currently has no debt on its balance sheet, which is rare for a retailer -- and unlike Blockbuster -- it has short-term, flexible leases on its 6,200 global stores and much smaller square footage.

Raines has been driving change at GameStop since being recruited to lead the company from Home Depot in 2008. Raines has challenged executives to find a way to sell digital game downloads in stores, something that had not been done before. Raines also set aside $100 million for acquisitions related to online gaming and helped devise a customer loyalty program to ensure that gamers keep coming back to stores.

"We were on a mission and you can't accuse us of not driving a heck of a lot of change," Raines said.

The company says that the plan Raines and his team devised has worked. GameStop, which is based in Grapevine, Texas just outside of Dallas, invented technology that lets gamers buy access codes for games in stores and then download the content at home, a major driver of its $453 million in digital sales last year.

The loyalty program Raines devised now has 17 million members and is growing rapidly. The program helps GameStop gain share in its most profitable business of buying and selling used games.

GameStop has gone from having about $1.2 billion in debt after it bought Electronics Boutique in 2005 to generating an estimated $500 million in free cash. Of the 19 analysts who follow GameStop, none of them have a "sell" rating on the stock while 11 analysts have a "buy" or "strong buy" rating, according to Thomson Reuters data. Eight analysts have a "hold" or "underperform" rating.

But GameStop's share price, trading around $22, has fallen about 10 percent this year, while the S&P's retail index has gained 18 percent. Revenue has flattened year over year after growth as high as 24 percent in 2009, which could explain why it catches the eye of the shorts.

"They're trying to do the right things but they're fighting a losing battle of selling physical games in a digital world," said Jeff Matthews, an investment manager who has invested in long and short positions in GameStop in the past but is no longer a shareholder.

Short interest in GameStop began rising steadily in 2007 and increased when video stores started struggling, said Dan DeMatteo, who was GameStop's CEO from 2008 and 2010 and is now the executive chairman of the board.

CHANGE AND CHALLENGES

There is no doubt that the video game industry has changed since GameStop was spun off from Barnes and Noble in an initial public offering in 2002. Total retail sales of video game products were down 20 percent in February compared to a year ago, according to research firm NPD.

In March, Game Group, the British video game retailer which competes with GameStop in Europe, filed for court protection from creditors and had to cut more than 2,100 jobs.

But Zynga, one of the hottest video game companies, sees most of its sales from games played on Facebook.

To combat the secular changes and boost its digital efforts, GameStop spent some of the $100 million Raines earmarked for acquisitions to buy two digital gaming companies last year, Spawn Labs and Impulse.

The company has also sought out more tech-focused board members, such as Shane Kim, who joined GameStop's board last summer after a 15-year stint in Microsoft's games unit.

"The digital transition — evolving the company so that digital becomes a bigger part of the customer story and proposition — is a tough challenge. It is not part of their historical DNA," Kim said.

But Kim said GameStop is well-positioned. It is trying to figure out how to create a new digital delivery service for both customers and video game publishers, he said. DeMatteo, the founder and former CEO, added the company is also studying how to distribute mobile games.

iPAD HEDGE

The slogan "We buy iPods, iPads and iPhones!" is now emblazoned on top of GameStop receipts, a sign that the company isn't sitting idle while Apple's slice of the gaming market keeps growing. It expanded a program this year where customers can trade in Apple devices and other used electronics in more than 1,000 stores for cash or store credit.

"While our stores are very full today, there may become a time when they won't be as full and this is a hedge," said DeMatteo, who named "GameStop" after the book store "Bookstop" that was acquired by Barnes & Noble in 1989.

GameStop expects used gadget sales of up to $200 million by 2012 and $600 million by 2014, which executives said would give it a leading position in the $1 billion market for used electronics. The company will face competition from Apple, which also pays customers for their used devices, as well as big-box retailers such as Target and Best Buy.

But GameStop has an edge because its customers are already comfortable trading in their used products in stores, said Wedbush Securities analyst Michael Pachter. On a recent Sunday at a GameStop store in Farmingdale, New York, for instance, employees said that customers who trade in their old Apple products are usually members of GameStop's reward program.

The Apple program is a new revenue stream that complements GameStop's core business. And while GameStop does not envision games on discs disappearing anytime soon, DeMatteo said the company has reinvented itself several times and can do it again if necessary.

"We saw this coming and we've prepared for it. Every quarter we refine the plan but at least we have a good foundation," DeMatteo said.

(Reporting By Liana B. Baker; Editing by Peter Lauria and Bernard Orr)

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Comments (4)
govtmule wrote:
Another example of how the market is disconnected from real life. The stock is being shorted and is down but Gamestop is a really stong company with a completely unique business model with no direct competitors in their specialty of buying back and reselling games. I have some younger friends who are there all the time buying and selling games and they are always pre-ordering the new games through Gamestop because they can get them earlier and go wait outside the stop the night of the release. They are a unique part of the gaming culture. I was impressed by these facts and that’s why I bought it.

Apr 03, 2012 4:50pm EDT  --  Report as abuse
stroft wrote:
Once a small league of corporations gain control of a market, such as in the gaming industry, its not long before they constrict all life out of it. With this kind of greed and consumate profiteering driving the sector, there is no room for anyone else but independant agents willing to perform as desperate lackies, content to feed on crumbs. This is what we see here.

Apr 04, 2012 5:27pm EDT  --  Report as abuse
stroft wrote:
govtmule, As leaders in the gaming industry continue to move towards total market domination, used games will soon be nothing more than a fond memory for both consumer and former small business owners.

Apr 04, 2012 5:35pm EDT  --  Report as abuse
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