Last Thursday GME issued a better than expected Q1, and saw its stock gain more than 4% on the day but has since filled in a bit of the gap. We laid out a bearish trade in early January in GME that worked out well, with an initial catalyst of the weak holiday sales environment for video games:
Moreover, the weak holiday sales results from HGG yesterday, which also hit BBY stock, could be another indication that electronics demand for the crucial 4th quarter might miss estimates. Now, it’s worth noting that GME has likely benefitted quite a bit from the strength in Sony PS4 demand, which looks to have done better than the Xbox One. And short interest in GME is still at 20% of the float. But the technical and fundamental situation are concerning for the bulls here.
My hunch is that the actual sales season was not necessarily bad. My real concern is about the future console sales after the initial excitement from the hardcore gamers.
The weakness in the holiday season was a significant hit to GME, as the stock hit 6 month lows following the poor data at the start of 2014:
GME’s bounce last week after a strong first quarter number is a drop in the bucket compared to the decline in the stock from December (above $50) to early February (below $35). The holiday season comprises more than 60% of the annual earnings power for GME, which is the reason for the huge fall on the weak January earnings report.
But there were signs of optimism in the Q1 report and conference call. First Adopter laid out the bull case in a Seeking Alpha post today, which included an interesting explanation of why GameStop is actually gaining market share and physical video games remain in demand over digital:
The whole crux of the bear argument is GameStop is the Tower Records and Blockbuster of gaming and will lose market-share as time goes on. In reality these facts that the bears now can’t deny show the opposite is happening. GameStop is gaining more dominant market-share this cycle.
I believe the main bear thesis for GameStop was thrown out the window when Microsoft gave up on digital DRM for the Xbox One. Microsoft did try to disintermediate GameStop with a no physical used games policy, but gamers revolted. When Sony decided to go with the old used games model and used it as a key differentiating marketing point, Microsoft was forced to reverse their decision. Games aren’t like CD music or DVDs. Gamers don’t want to give up the significant value they receive from being able to trade-in their used physical discs. Console digital downloads today have no trade-in value and are sold at the same price as physical discs. It’s all about the incentives.
Part of our skepticism on GME was exactly the transformation of the gaming industry to the digital space. But the new console cycle could indeed be a confirmation of at least one more cycle where physical games dominate digital games. At the moment, many market participants still seem to view GME as a dying brand, as short interest sits at around 27% of the float, though that’s actually down quite a bit from 2011:[caption id="attachment_41029" align="aligncenter" width="600"] GME short interest, Courtesy of Bloomberg[/caption]
GME is a 12 P/E stock with earnings growth of 10-25% over the next few years. Clearly, investors are quite skeptical about those earnings targets. However, if last week’s earnings report and management’s optimism is to be believed, GameStop could be much better positioned for growth than the market thinks. With a low valuation and low bar, we like the odds of further upside in GME over the next 6 months.
Implied volatility has come in pretty hard post the results, nearing 52 week lows, but we would likely look at long premium strategies in the stock were to once again test and hold technical support at $35 and corresponded with a continued decline of 30 day at the money IV matching the Jan lows:[caption id="attachment_41030" align="aligncenter" width="600"] GME 1yr chart of 30 year at the money IV from Bloomberg[/caption]
For now we will keep on our radar and continue to track the technical and vol set up.