Game over

Digital revolution

I’ve been looking forward to Game’s annual report ever since its share price halved at the turn of the year, qualifying the company for my table of bargains. The shares had already halved since their highs in 2008.

Larger companies, Game’s reduced market capitalisation is still £300m, are infrequent visitors and, with the exception of deeply distressed Mallett and French Connection, retailers have also been rarities in the realm of the very cheap recently.

You can just walk into shops, talk to staff and customers, visit ecommerce websites, and read customer reviews to get a feel for a retail business, but despite their amenity to the scuttlebut approach, I have a patchy record investing in them. I’ve done best when the chief executives are female: Kate Swann at Smiths News and Belinda Earle, who ran Debenhams for a while.

HMV was a disappointing investment though, so perhaps it’s a bad omen that this retailer also sells video games, and that Chris Bell has just replaced Lisa Morgan as interim chief executive.

Buying shares when the economy is gloomy can be a winning strategy if it means they are cheap, and the company is conservatively financed. Game’s fortunes are also linked to another cycle, though, the release of new consoles. When Sony introduces a new PlayStation, or Microsoft a new Xbox, sales rise as gamers upgrade and buy new games and accessories to exploit their capabilities. The Nintendo Wii seems to have brought an entirely new set of armchair athletes to Game (GMG) which contributed to a  remarkable uplift in profit (blue chart), profitability (light green chart), and financial strength (dark green chart) in recent years.

But retailing is also changing permanently as customers spend more online. Games, like music, films, and books are most vulnerable because gamers can try them, download them, or play them without ever going near a store.

The shares are certainly cheap enough for the Thrifty 30, costing just nine times average earnings. If the collapse in Game’s share price is a reaction to the temporary effects of recession and a lull in the release schedules of new consoles, they look like a bargain. But I suspect investors doubt Game will ever experience a games market as profitable as it has been, and they may be right.

Game puts up its defence in the first pages of its annual report where it says the depth of its product range, and the knowledge of its staff gives it an advantage (as well as its loyalty card, and discounts). The trouble is, I’ve seen this defence before at HMV where it rolled the two virtues into one concept ‘range authority’, but has been unable to stem the flow of customers buying blockbuster books, movies, music and games from supermarkets.

They could buy the full range at Amazon too. On the Internet the range is limitless, and customers turn to each other for expertise, rating, reviewing and troubleshooting products.

The company, which operates stores in ten countries, earns nearly £100m in revenues online. It sounds impressive, but it’s just over 5% of total revenue and looks somewhat less significant to scale:

Digital sales (downloads and online gaming) account for less than 1% of sales.

At least Game isn’t in denial. It includes a market report in the annual report that predicts a digital distribution revolution, which means less games in boxes on shelves and perhaps the end of handheld games consoles like the PSP as the smart phones become games platforms.

In response, Game has embraced the revolution by building websites, selling downloads, and online gaming time, and building up a social networking site for gamers (currently in beta testing). But this is speculative territory, nobody knows how profitable the digital revolution will be and which companies or methods of selling games will be the big winners but changes in the music and print markets suggest incumbents are often big losers.

Valuing the company by its average earnings is a very good way of ironing out the peaks and troughs caused by economic and console cycles if the rhythm of those cycles is likely to govern future profitability. It’s a lousy measure if its stores are likely to be less profitable in the future.

With some pundits predicting the current generation of consoles will be the last, or last but one, and online gaming services like OnLive threatening to cut out the console and distributor and promising wide ranges of titles on rudimentary hardware wrapped up in a social experience, it’s very difficult to say with confidence the shares are cheap.

It pains me to go with the crowd, despite what the statistics tell us, but I not adding Game to the Thrifty 30.

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Thrifty 30 updates

The current Thrifty 30 portfolio

Art and antiques dealer Mallett reports quiet trading in the first four months of 2010, lower than the same period last year and worse than management expected.

Auto engineer Ricardo also reports weak trading, although order intake was higher than last year.