Turkey of the week: video-games retailer set to slide

This video-games retailer has invested in physical outlets, leaving it exposed to risk from increasing popularity of online purchasing.

Shares in this video-games retailer may have jumped following the launch of new games consoles such as the Nintendo Wii, PS3 and Nintendo DS Lite, but the company has just made a serious strategic error. Paul Hill reveals why despite a strong trading statement, this stock is still worth letting go of.

Game Group (GMG), tipped as a BUY by Oriel Securities

Last week, shares in Game Group, the UK's largest video-games retailer, leapt more than 7% to 193p after an upbeat trading statement reported that turnover had jumped following the launch of new games consoles. Like-for-like revenues rose 45.6% in the 22 weeks to the end of June, ahead of City hopes, driven by sales of these consoles, such as the Nintendo Wii, PlayStation 3 and Nintendo DS Lite. In fact, "the Wii sold out almost immediately with consumer demand remaining strong for all formats", said CEO Lisa Morgan.

In May the group also laid a substantial wager on the importance of owning physical outlets as a means of selling video games. By purchasing the Gamestation chain from Blockbuster for £74m, it has added another 217 stores in the UK. Game Group now operates 1,065 outlets, with 629 (or 59%) located in the UK and the rest abroad. The transaction is presently being reviewed by the Office of Fair Trading. For the time being, the board intends to retain both names, the logic being that Game Group is aimed at families and customers of all ages, while Gamestation targets the hardcore gamer typically male teenagers and young adults.

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However, I believe buying Gamestation is a strategic error as it adds to Game's exposure to physical stores at a time when customers are increasingly shopping on the internet. Given that CDs, DVDs, books and even software are more frequently bought online, why should video games be any different? Downloading games isn't currently as popular as downloading music because file sizes are much larger. But as broadband speeds improve and compression software is used, this inconvenience will be eliminated. If I'm right, then Game will be left with a large fixed-cost base generating steadily lower revenues a sure-fire recipe for disaster.

On top of this, the trading environment remains very competitive. Not only are traditional retailers, such as Virgin, Argos and Woolworth, selling video games, but there is growing activity from the likes of Amazon and Play.com. Then there are the major supermarkets, such as Tesco and Asda, and the resale market serviced by auction sites such as Ebay. As a result, Game's profits are already being squeezed, with gross margins predicted to fall this year by 2.5% to a skinny 24.7%.

Finally, the recent releases of the Wii and PlayStation 3 have artificially lifted revenues, so present rates of growth are unlikely to be maintained. In terms of numbers, the City is forecasting sales and underlying earnings per share of £1.2bn and 9.2p for this year, rising to £1.3bn and 12.6p next year. Hence the stock trades on a punchy 20 times earnings, which looks too rich in light of the challenges ahead. I suspect that as the internet becomes an ever-more important distribution channel, Game Group could suffer a similar fate to HMV and Fopp.

With the share price having more than doubled in the past year, it's time to sell.

Recommendation: SELL at 193.75p

Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments

Paul gained a degree in electrical engineering and went on to qualify as a chartered management accountant. He has extensive corporate finance and investment experience and is a member of the Securities Institute.

Over the past 16 years Paul has held top-level financial management and M&A roles for blue-chip companies such as O2, GKN and Unilever. He is now director of his own capital investment and consultancy firm, PMH Capital Limited.

Paul is an expert at analysing companies in new, fast-growing markets, and is an extremely shrewd stock-picker.