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GME: Got No Game

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Jill: GameStop (GME) is scheduled to report quarterly earnings on August 22. The stock is up 197% year over year, has $2 per share in cash and no debt which covers the dividend with plenty of cushion. There is also a big short interest position on GME, and just look how well the shorts have performed in this 2013 market. HORRIBLE! Selling has been met with buying as soon as performance chasers see an opportunity to get in at relatively attractive levels.

Sounds like it's a no-brainer to own GME for the long term and ride the momentum? Not in my mind. Besides the pristine balance sheet and over crowded shorts, it blows my mind how this business model can be sustainable. (plus, it always scares me when stocks are bid up huge into the print like GME is) Let me explain it to you in four words: Borders, Blockbuster, Circuit City. You can buy everything in the world online, and of all spaces to be in, GME is in the heart of the online experience.

GME relies on used games to make its business work. Let's be honest: If tomorrow there were only new games, GameStop would cease to be, as more and more buyers simply download games. Last quarter, GME earned $347 million in revenue off used items in its last reported quarter, representing 31% of total revenue. I read an excellent article in Forbes that goes into extensive detail on the used game market. Take the time to read it and understand more why I don't think GME is the best long-term play.

If used games disappear, things are going to get ugly at GME. To keep itself relevant, the company needs to do one of two things; Either it can figure out how to keep the used-game model the same as it is now for years or diversify itself into a better business. Let's turn to Skip for more on the dividend and our options strategy.

Skip: If you buy video games for: 1) the kids 2) the grandkids or 3) you, the kid then you should know of GME. Video gaming is part of the culture, an expense accepted as such since the late 1990s. This retail powerhouse for video gaming is at a critical inflection point for its business as I see things. Game makers such as EA Sports (EA), Activision (ATVI), etc. have reached the point in their development as corporations where the cloud offers them far less cost to deliver their games to the market than using the current method of selling games through retail chains like GME. Thus, like the buggy whip of 100+ years ago, GME has to either adapt or be bypassed as things have changed for its business model. Being bypassed is not good for the survivability of GME.

Other problems surrounding the business plans of GME are that (AMZN) has bit into its lucrative game re-sale moneymaker as well as Wal-Mart (WMT) matching prices with GME in sales of both games and game hardware/consoles. Going up against AMZN and WMT is not the match any company wants to tackle.

GME has many doubters willing to short the stock evidenced by the continued total short interest remaining for many months now at 20% or higher (25% currently). Most times in a major bull cycle I like going against the shorts. However it is a tell for me, a bearish one, when the shorts stay their course in spite of being squeezed!

Next week, GME will report quarterly results. GME analysts have the company barely profitable over the last quarter. Its average earnings estimate is a paltry $0.04 per share. GME should trade ex-dividend before the end of this month, a $0.275 share payout if it retains this payment amount. That is not an easy trick to pull off when only earning $0.04 per share.

The trade tactic we prefer is the bearish put spread. The 50 strike lays only a few cents above GME's closing price of $49.47 yesterday. And Friday being August's options expiration, we have built into this trade's execution target price some upside price room for GME to gain.

Trades: Buy to open 3 GME October 47 puts for $2.80 and sell to open 3 GME October 42 puts at $1.30.

The total risk for the spread is $1.50 per trade.

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At the time of publication, Jill Malandrino and Skip Raschke held no positions in the stocks or issues mentioned.

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