GameStop’s (GME) shares dropped 6% on Tuesday as the video game retailer announced that its holiday season sales were below expected levels.  This was a big disappointment as the majority of the company’s sales are during the holiday season. During the nine weeks ending December 29th, used game sales dropped by 16% over the prior year while new software sales fell 5%. There are however some signs of optimism in the digital division which observed a 40% increase in sales, reflecting a paradigm shift of sorts. We expect a recovery in sales in the next two years as Microsoft (MSFT) and Sony release their next generation consoles.
Nintendo Wii U A Failure?
Nintendo’s recently launched next generation console, Wii U, sold more than 320,000 units during the holiday season but GameStop still reported a 3% decline in hardware sales during the period. This is not really a cause for alarm as Nintendo Wii accounts for just one-sixth of hardware sales in the U.S., where GameStop primarily operates.  Electronic Arts (EA), one of the biggest game developers in the country, reported $1.1 billion in revenues from X-Box 360 consoles and Playstation 3 consoles each in 2011 while its revenues from Nintendo Wii were just $200 million.
The X-Box 360 and the Playstation 3 are currently in 7th year of their product cycles and sales have declined as most gamers who wanted the consoles have already bought them. We expect hardware sales to increase in the next two years as the product cycles refresh.
Developers Playing A Waiting Game?
Video game developers are reluctant to release new titles for consoles that are in the waning phase of their product cycles. EA launched 36 titles in fiscal 2011, 22 in 2012 and plans to release just 14 titles in 2013. The company plans to launch new video games specifically designed for the X-Box 720 and the Playstation 4 once the new consoles are released. An increase in the number of video games developed will lead to an increase in new video game sales in the coming years.
Drop In Inventory
A decline in new video games also leads to a decline in inventory of used video games. This was the primary reason for the drop in second-hand game sales during the holiday season. As new games are released for next-generation consoles, the used game inventory will improve leading to an increase in sales. We expect a lag between the increase in new game sales and used game sales.
Digital The New Way
The 40% increase in digital sales was not unexpected. The video game landscape has been evolving over the last few years. The digitally distributed video game market has grown by over 200% since 2010.  Electronic Arts recently stated its intention to shift its operations to the digital domain. 
It remains to be seen whether GameStop will be able to capitalize on this paradigm shift. The company has established itself as a brick and mortar retailer but will face increased competition in the digital domain, especially from developers who can themselves distribute the games online. Electronic Arts uses its online portals, Origin and Play4Free, to earn digital revenues. Also, digital sales might have a cannibalization effect on physical sales. We maintain an optimistic outlook for GameStop’s competitiveness in the market and currently forecast a steady increase in digital revenues through the next few years. You can modify the interactive chart below to gauge the effect a decline in sales might have on our price estimate.
- GameStop slashes same-store sales forecast; shares skid, Reuters, 8th January, 2013
- Market Shares of Digital Distribution Platforms in 2010-2011, Deals4downloads
- EA exec: We’ll be ’100 percent digital’ eventually, CNET, 3rd July
Disclosure: No positions