Where I Went Wrong With GameStop


Research, research, research... When I put my hard-earned money into stocks, I do massive amounts of research to decide which companies will earn the greatest returns. I'll admit I don't do the same amount of research for all of my Motley Fool CAPS picks. Which leads me to why I will no longer be shorting GameStop . It's a perfect example and constant reminder of why going on a whim with stocks, even in CAPS, is a horrible idea.

I came across GameStop and quickly wrote it off as a bricks-and-mortar store that will fade into obsolescence as digital downloads take over the gaming world. Giving it an underperform CAPScall would be a no-brainer, right?

Wrong... Confirmed by my -66% CAPScall.

Had I taken even 20 minutes to do some research before I quickly red-thumbed it in CAPS and moved on, I would have unearthed two important factors. The first: GameStop's strategy toward its future battle in the digital download arena. In April 2011, it acquired a streaming tech company named Spawn Labs. Shortly after that purchase, it acquired a digital distribution platform called Impulse. This means it can offer access to high-definition video games that will rival digital front-runner Steam. With this multichannel strategy, it has the right cards in hand to dominate physical game stores as well as digital downloads.

The second factor, which I did consider but didn't bother to research all aspects of, was the substantial effect of new gaming consoles on GameStop's revenues. What new consoles mean for GameStop is a bump in store activity, consumer excitement, and marketing campaigns. As GameStop notes in its most recent 10-Q report, growth in the video game industry is mainly driven by new technology. A 9.1% decline in this quarter's net sales, from $1.94 billion in the prior-year quarter to $1.77 billion, is blamed on current consoles' increasing age. You can expect this trend to abruptly reverse when new consoles hit the stores.

Here are some console events to watch and how they will affect GameStop.

Up to bat
First up is Nintendo with the Wii U. By late Sept. 2012, pre-orders of the Wii U, which was released Nov. 18, had sold out at big-name retailers including Best Buy, Toys R Us, Target, and even GameStop. Nintendo announced that pre-orders were very strong and GameStop said that "demand for Wii U has been off the charts." Not to be pessimistic here, but I must point out as a former marketer that this is all a part of the game. Create more demand than supply and generate buzz and urgency through "pre-order sell-outs." Well played, Nintendo, well played. Either way, it's good news for Nintendo, GameStop, and long investors alike.

Nothing official has been released yet, but it's expected that Sony and Microsoft will both release new console systems around the 2013 holiday season. Looking at history, we should remember that GameStop traded at its high of $62 roughly one to two years after the release of the last generation of gaming consoles.

Top-line sales up; what about margins?
As I noted above, consoles are what drive top-line sales growth. What will these releases do to GameStop's margins? To get an idea, we need to back up for a second. Used-game sales represent 27% of fiscal-year 2012 sales. That's a sizable chunk of business. That chunk also represents significantly higher gross margins than the rest of the company. Gaming consoles and hardware represent 7% gross margin while new software/games represent 21%. Used-game products come in at a whopping 47%. So as we see top-line sales growth driven by consoles, we must expect a decline in margins as a result. Don't be alarmed: It's cyclical, and margins will return one to two years after the new consoles are released.

Bottom line
There is reason to be skeptical for the long-term future of GameStop. Its return on equity, return on asset, and net margins have all steadily declined since 2008. Competition to be top dog in digital download and streaming content will continue to increase as bricks-and-mortar game stores die out.

Short-term is a different story, as GameStop is spending significant money, through acquisitions, to get its foot in the door of the digital market. With new consoles on the horizon providing a catalyst for top-line sales, I think shorting this stock is a bad idea.

The lesson I learned here reminds me of what a basketball coach once told me: Always take game-speed shots during warm-ups. Our thought process should be no different when investing, even when making picks on CAPS. Don't take investing lightly, and make thorough researching a habit even when you're not investing real dollars.

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The article Where I Went Wrong With GameStop originally appeared on Fool.com.

Fool contributor Daniel Miller has no positions in the stocks mentioned above. You can follow Daniel on Twitter @StreetSmartFool. The Motley Fool owns shares of GameStop and Microsoft and is short Sony (ADR) and has the following options: long JAN 2013 $22.00 calls on Sony (ADR). Motley Fool newsletter services recommend 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.

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