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Is GameStop a Good Long Term Bet or is the Tide Against it Too Strong Now?

Can Gamestop Remain Viable in this Mobile World?

One has to wonder after the latest numbers out of NPD if there really is a future for GameStop (NYSE: GME) or not.  NPD said game software sales slid by 42% in April compared to a year prior.   Hardware sales were also down to the tune of 32%.  This is not the type of trend you would see in a growth industry. Worse yet, Gamestop, pre-announced a same store sales drop of 12.5% citing light demand for AAA games.  I ask the question as to why buyers have dried up for AAA games?  These types of steep declines were not seen before the tidal shift to mobile and social gaming platforms that have enjoyed explosive growth in recent years.

I was long GameStop shares for several years believing in the cheap valuation but also that a decline in physical sales would be a very slow burn over more then a decade. Looking at today’s data, I realized the deterioration is happening much faster then I had calculated when I first bought the stock.

The Reasons Why Console Games are Shrinking

The reasons for this acceleration away from physical console games are the explosion in social gaming on FaceBook as well as the growth out of the Apple (NASDAQ: AAPL) gaming platform.  Users are turning increasingly to cheap or even free games on iPad, iPod Touch and iPhone’s.  Not to count Android out, that platform is also siphoning off users spare time and dollars in the gaming industry. According to Newzoo research, the US alone has grown from 75 million to 101 million mobile gamers of which 69% plays on smartphones and 21% on tablets.  If you think about this, we went from zero in the pre-app world from just a few years ago to these huge numbers.  This is not a macro trend that favors GameStop.

People only have limited time to spend on leisure activities such as video games.  Increasingly, this time is being spent on all these various mobile devices.  We are witnessing the rapid acceleration in usage here and the continual decline in gaming consoles and physical game sales.  The hard data is right in front of us.  It’s time to accept this fact and stop living in denial.

GameStop’s used game business is likely to continue to decline as trading velocity inevitably decreases.  Fewer hit console games means fewer games traded in each fiscal year.  The whole business model is breaking down and doing so faster then I calculated (but still probably slower then shorts were counting on).  Mobile gamers playing free and 99 cent games instead of $60 console games is now the norm these days, not the exception.

But Hey, The Stock is Still Cheap!

The stock is dirt cheap and GameStop will keep fighting the good fight.  They now take trade-in’s for Apple iDevices and also bought Kongregate which is an interesting online gaming website.  Kongregate is growing but seems unlikely to fill the hole being created by this mass change in consumer behaviour.  We are witnessing an acceleration in the disruption to the console game industry, like it or not.

In what seems ironic to me, it wasn’t what bears have been predicting that would hurt Gamestop.  They thought game makers would change from physical media on consoles over to downloadable console games thus bypassing GameStop’s physical distribution model.  Indeed this is happening to some degree but not nearly enough to even move the needle.  It turns out that the “next” gaming platform, Apple, Android & Facebook, are the ones obliterating their physical distribution business model. Companies like Zynga and OMGPOP are already doing huge numbers online.  Established companies like EA are transitioning to digital as fast as they can.

The Time Comes to Face the Music and Sell

So, after many years I sold my entire position in GameStop.  I don’t know if we’ll see a pop from a short squeeze at some point which would have given me a better exit price but I can’t count on that.  GameStop carries a 50% plus short position and at some point all those shorts will have to cover.  Usually this happens with a blowout earnings surpise, a buyout or some catalyst.  I’m not sure GameStop has another one of these in it.  I don’t know if anybody would acquire it or take it private either.  There are better companies with more potential, large moats and fair valuations out there for me to re-deploy the cash from this sale.

Warren Buffett’s Two Rules of Investing

This was one I got wrong but fortunately the lesson didn’t cost me much.  I sold for about breakeven if you include the call options I wrote against the stock over the years.  The lesson here is that this is the beauty of investing with a large margin of safety as Warren Buffett and Ben Graham recommend.  I knew GameStop was crazy dirt cheap when I bought it and would, at the very least, allow me the greatest chance of satisfying Buffett’s two rules of investing:

  1. Rule No. 1: Never Lose Money.
  2. Rule No. 2: Never Forget Rule No. 1

The reason for this is that it is hard to get your capital back.  An example is if a stock drops 50% you then need a 100% gain in it to break even.  This is not easy.  When I bought GameStop I had this rule in mind.  I felt I had a fair opportunity for some good upside and very little downside if I was wrong.  Thanks to Buffett’s rules I didn’t have to lose money.  Think of this tenet the next tinme you buy a stock.  How much can I lose at this valuation and how much upside do I have?  How likely is it at the current price that I lose money on this investment?  If you follow these simple rules your portfolio will thank you.

For more of my insights and opinions check out my personal blog: www.oracleofjersey.com

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