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It is no secret that the traditional video game industry has hit a rough patch in recent years. In a previous article, I wrote about the adverse effects the abnormally long current console generation was having on the video game industry as a whole. In short, my conclusion was the longer Microsoft Corporation (MSFT) and Sony Corporation (SNE) take to release their respective new consoles, the longer current video game hardware sales, and by extension software sales, would remain in overall decline.

Fast forward three months after my article was published and sales have continued to slump. Hardware sales, even with Nintendo Co.'s (OTCPK:NTDOY) recently released WiiU console, are at extremely depressed levels and are coming off of their worst holiday season since 2006. On a year over year basis, hardware sales have declined every month since 2010. Not surprisingly, hardware sales for the first three months of 2013 are much worse than comparable 2012 levels. Weak hardware sales correlate to weak software sales: VGChartz.com shows total software sales in 2012 have declined by 28%, led by a 15% decline in Xbox 360 game sales and 22% decline in PlayStation 3 game sales.

The industry has been notoriously difficult for investors to navigate as of late, with casual mobile/social developer threats like Zynga Inc. (ZNGA) and Glu Mobile Inc. (GLUU) encroaching from all sides and the seemingly constant negative headline risk proclaiming video games as detrimental to children of all ages, the industry's hardware manufacturers, publishers and retailers have all struggled. However, it is my belief that possible foundational shifts in console platforms pose a much more serious threat to game retailers like GameStop Corp. (GME) going forward.

About The Company:

Through its GameStop, EB Games and Micromania brand stores, the company's retail network of over 6,000 locations in 15 countries has made GameStop "the largest multichannel retailer of video games" in the world. The company services video game enthusiasts in just about every product category, from consoles to personal computers to digital and mobile gaming. With recurring exclusive pre-order game content, a subscriber-based rewards program and an extensive trade-in platform GameStop has positioned itself with a large portion of the video game retail market.

Throughout recent console generations, GameStop has managed to flourish in an industry where many brick and mortar retailers have struggled just to survive. The company's ability to engage consumers' needs to save money by selling used video games and console-related equipment has allowed GameStop to stay relevant despite constant pressure from hardware creators like Microsoft and Sony and third-party game publishers like Electronic Arts Inc. (EA), Activision Blizzard Inc. (ATVI) and Take-Two Interactive Software Inc. (TTWO).

The Risks:

Despite the doom and gloom over the last few years with regard to declines in hardware/software sales, the dawn of the next console generation is fast approaching and I believe the video game industry is due for its long awaited turnaround. In February, Sony announced its plans to release the PlayStation 4 for the 2013 holiday season. With powerful technical specifications, impressive social integration and an exhaustive lineup of planned first and third party launch games, Sony created quite a buzz around its upcoming console. This excitement, which should be at least matched by Microsoft's upcoming announcement for the next Xbox system (codenamed Durango), bodes well for the entire video game industry, specifically third party publishers like Electronic Arts, Activision Blizzard and Take-Two Interactive, which stand to benefit from a wider consumer base and increased enthusiasm and media attention.

However, recently there has been suggestive evidence on a worrying rumor that has been circulating around the industry for a while, that Microsoft will not allow used-games to be played on the next Xbox system. Information found in the latest Durango Xbox Development Kit, originally reported by VGLeaks.com, states that "play from optical disk will not be supported." The development kit wording also makes reference to a hard drive big enough to hold "a large number of games" and that "all games will be installed on the hard drive." This indicates that when consumers purchase a new game for Microsoft's next Xbox, it will have to be installed on the video game console itself in order to play, a large hard drive suggests that consumers will be able to store all of their games digitally. The worry amongst consumers is that once installed on an Xbox system the purchased disc will not be allowed to be installed onto additional systems, and therefore is relatively useless on the used-game market, which would completely cut out aftermarket retailers like GameStop.

While nothing has been officially confirmed or denied by Microsoft itself, this is news that investors in GameStop have to consider a serious threat to the company's used games business. Analyzing the company's latest earnings report (for the 13 weeks ended 10/27/12), $496.3 million in sales came from the 'used video game products' business category, which is approximately 28% of the company's net sales of $1.77 billion in the most recently reported third quarter. Although used game products sales and net sales were both down year over year over the same 13-week time period, the portion of GameStop sales generated from the 'used video game products' remained a constant 28%, as a percentage of net sales.

Although the company's balance sheet does not break down how much of 'used video game products' revenue was generated from each console specifically, I have estimated that at least 25% of GameStop's used game revenue was generated from Xbox 360, as Microsoft's console accounted for approximately 29.28% of total video game sales in The United States in 2012 and approximately 28.42% of global video games sales in 2012 (numbers from VGChartz.com). In both global and domestic terms, the Xbox market is large for all retailers, GameStop included, and any restriction on the next Xbox's secondhand market will negatively impact GameStop's revenue.

Additionally, the used games category accounts for over half of the company's profits despite it being only approximately 28% of net sales. Gross margins on the sale of used games is significantly higher than that of new games, 47% versus 21% according to Forbes, and as such used games represents GameStop's most important business category. Also important is the fact that the company's 'used video game products' category has weathered the industry's general sales decline better than the company's 'new video game hardware' and 'new video game software categories,' down only 8.85% during the third quarter versus 33.42% and 12.43% for new hardware and software respectively. A threat to used games is a serious threat to GameStop's revenue and would be a possibly crippling blow to the company's profits.

If Microsoft's next console does restrict used games, the impact on GameStop cannot be fully known, as there are variables that will change. Since Sony has already largely debunked the notion that it will restrict used games on the upcoming PlayStation 4, with the "license repurchase" element that President of Sony's Worldwide Studios Shuhei Yoshida references still remaining somewhat of a mystery, it is probable that some consumers will switch from Microsoft to Sony for their console gaming needs. My belief is that Microsoft will lose a lot of gaming consumers to Sony should the company restrict used games and this could help cushion the blow for GameStop. However, with the exact nature of PlayStation 4's compatibility with used games still not completely known, there is still significant risk for GameStop investors in the event of a restriction on the secondhand video game market.

It is important to note that many of the same worries, along with much rumor and speculation, with regard to used games circulated around the PlayStation 4 system and were proven at Sony's official console unveiling to be largely inaccurate. This can easily turn out to be the case with Microsoft's Xbox successor but investors will not be able to know for sure until Microsoft breaks its silence surrounding its upcoming system.

My advice to investors would be to monitor Microsoft's unveiling of its new Xbox system, reportedly taking place in June at the E3 entertainment show in Los Angeles, very closely. If the rumors of a next-generation Xbox ban on used games are true, it could cause irreparable damage during the next console generation and GameStop shares might have to be traded in for cash.

Source: GameStop: Time To Trade-In Shares?