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Guitar Hero and Rock Band 2 video game bundles are seen on display at a GameStop store in Redwood City, Calif., Wednesday, Dec. 17, 2008. (Paul Sakuma/AP)

Guitar Hero and Rock Band 2 video game bundles are seen on display at a GameStop store in Redwood City, Calif., Wednesday, Dec. 17, 2008.

(Paul Sakuma/AP)

Strategy Lab

Video-game retailer's stock faces enormous risks Add to ...

Chris Umiastowski is the growth investor for Globe Investor’s Strategy Lab. Follow his contributions here and view his model portfolio here.

As an investor I spend a fair bit of my time looking into high-growth industries where technology is disrupting old markets. Sometimes I invest in companies that make clever use of disruptive technologies while other times I see an opportunity to profit from betting against a company on the losing end of an industry transition. This week I’ll touch on one such example in the video-game market: GameStop Corp.

I think the video-game market will play out much like the video rental market. Looking back, some investors who were smart enough to see Netflix disrupting the video rental market profited handsomely by short-selling Blockbuster well ahead of its bankruptcy filing in late 2010. Is it sad to see industries vanish? Sure. I have fond memories of family trips to our local video store when I was a kid. But today the notion of a retail store to rent video is essentially obsolete.

The video-game industry has now started its own transition to digital delivery. It started with the launch of the iPhone app store in 2008. The games were certainly not competitive with modern consoles, but they were cheap, super fun and available at the press of a button. Today’s mobile games are quite impressive. Game developers have dedicated a lot more effort to mobile platforms because of the iPhone, iPad and Android.

Fast forward to 2014 and we are starting to see a consolidation of mobile, streaming media and gaming. Low-cost set-top boxes run essentially the same operating systems as our phones and tablets. The latest example is FireTV, a $99 (U.S.) box that Amazon recently launched in the U.S. market. In some ways it’s nothing special. It plays TV shows, movies and music just like the similarly priced boxes from Apple or privately held video-streaming company Roku. But Amazon has invested a lot of effort into bringing games to FireTV. They’ve set up Amazon Game Studios internally, and they’ve partnered with lots of great developers by releasing tool kits to publish games in Amazon’s game store. Because the FireTV runs a version of Android, developers can adapt existing mobile games to the platform quite easily.

I would be shocked if 2014 ends without Apple launching a similar plan powered by a new Apple TV box. Google is also working on Android TV products. I expect all upcoming products to pack more technology horsepower so these set-top video boxes can also double as very good gaming devices. All of the games will be downloaded from a digital store.

Hard-core gaming enthusiasts love to point out that today’s mobile games, which are migrating to low-cost set-top boxes, can’t compete with the latest consoles from Microsoft and Sony. That’s true, but it doesn’t matter in the long run. All of the big game-console vendors now support digital game delivery. And more importantly, the next crop of kids who grow up playing their first video games are likely to be buying them from a digital store where great-quality games cost only a few bucks. The era of physical game disks is dying, and I think it will be dead within five years.

One stock that is negatively exposed to this trend is GameStop Corp. Customers love their stores, which heavily focus on selling new and used video games throughout their installed base of 6,600 stores. If I’m right about physical game disks going away in the next five years this business will be forced to reinvent itself – a rather difficult task to achieve.

Today GameStop is very profitable. The stock trades at just over $40 (U.S.), giving it a market capitalization in the $5-billion range. Analysts expect earnings per share to rise 20 per cent next year to $4.42, for a price-earnings ratio of about 10. Analysts think short-term growth will happen because of the recent refresh in gaming consoles from Microsoft, Sony and Nintendo. But the P/E ratio tells me Wall Street is nervous about what comes next, and I think the market is being too kind. I suspect the next five years could be much worse than Wall Street assumes. Remember, the professional investing industry tends to focus on very short-term (i.e. one year) results. Analysts are not dumb, but they are not paid to look years into the future. They see risk in GameStop, but the investing industry is all about gaming the top of the stock. If sales are still rising some see no need to panic, right?

I have no idea where the stock will go in the next few quarters. But I do think GameStop’s current business faces enormous risks. When it becomes clear to Wall Street that physical game disks are dead there may be little value left in the stock. I can understand why some investors who feel the traditional video-game distribution business is under threat have concluded that GameStop is a good short-sale candidate.

Disclosure: The author currently own shares of Apple, Google, Amazon and Netflix in his Strategy Lab and personal portfolios.

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