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GameStop’s (GME) stock has gained 25% since the company reported better-than-expected results for the fourth fiscal quarter of 2012 on March 28. The video game retailer beat its own estimate of a 4-7% decline in sales for the quarter by reporting sales and gross profit figures in line with the prior year’s figures. The company has maintained a market share of over 30% in software sales in the U.S. and beat the industry trend for the year. [1] While the U.S. video game market saw a 25% decline in hardware sales and a 21% decline in software sales through 2012, GameStop reported a 7% decline in sales for the fiscal year with a 17% decline in hardware sales and a 12% decline in new software sales.

We believe that decline in the video game industry is primarily due to console fatigue from the prolonged product cycles of the seventh-generation consoles. The industry is set for a turnaround later this year with giants Sony and Microsoft (MSFT) expected to launch their eighth-generation video game consoles during the holiday season. (Sony Announces PlayStation 4 Videogame Console – WSJ.com, Feb 20, 2013) GameStop’s market price is now in line with our $33 price estimate for the company’s stock

How Will The X-Box And Playstation Do any Better Than Nintendo Wii U?

Nintendo Wii U sales in the U.S. have been disappointing. The first of the eighth-generation of video game consoles has sold just 3.45 million units since its launch last year. [2] Although Nintendo’s (OTCPK:NTDOF) management has blamed a lag between the launch of the console and the launch of software titles playable on the Nintendo Wii U for the under-performance, we believe that Nintendo has also lost some of the market share to other sources of casual gaming like mobile and tablets. Nintendo’s best selling games have been Mario Kart and Super Mario 3D Land both of which have mobile counterparts. [3]

On the other hand, the X-Box and Playstation consoles are geared towards more “hardcore” gamers. The X-Box 360 has been the top selling console for more than two years in the U.S. [4] The top developers for these consoles, Electronic Arts (EA) and Activision Blizzard (ATVI) depend on video game franchises like FIFA and Call of Duty, the game-play and graphics for which cannot be fully replicated on tablets and mobile devices. Both of these companies are regulars on the charts for top selling games in the U.S. and reported strong sales of their flagship franchises despite the industry decline. EA earns around 30% of its revenues from X-Box and Playstation each and less than 2% from Nintendo consoles. Activision earns around 20% of its revenues from Microsoft and Sony (SNE) consoles each while the contribution from Nintendo is just 6%.

With franchises like FIFA, Call of Duty, Skylanders and Battlefield performing better than ever, [3] it can be assumed that the so called hardcore gamer is not ready to switch to mobile gaming just yet. These gamers form the target demographic for GameStop. The company has developed as a swap shop where customers can trade in their games and use this money to buy other games and also earn store reward points. There are more than 30 million members enrolled in GameStop’s PowerUp, Megacard, EB World and GameStop Plus programs in the United States, Europe and Australia.

GameStop already has over 900,000 members in its PlayStation 4 First to Know List and expects strong sales of the console. We expect the launch of the new consoles to breathe new life into software sales across the U.S., with GameStop in pole position to capitalize on it.

Digital Revenues To Help

Video game developers are no longer dependent on just software sales for revenue. Increased efficiency through pricing and downloadable content seems to be the new trend for companies like EA. The company released 60 titles in 2009 and 54 in 2010, (DLC) primarily stand alone titles with little or no online support. The revenue earned per title was just around $60 million. Since then, EA has added time-based subscription services and game related content that needs to be downloaded, increasing the revenue earned per title. The number of titles released by EA in 2010 was 36, on which the company earned $107 million per game. EA took this strategy a step further in releasing just 22 titles, but earning $180 million per game. In 2013, the company plans to launch just 14 titles.

This increase was primarily due to increased digital revenues from downloadable content to support games, sales through platforms and through in game advertisements. Digital revenues in the 2012 calendar year were 48% higher than digital revenues in 2011. EA earns more than 15% of its revenues from GameStop. The retailer has so far successfully leveraged its direct sales for EA and implemented its swap-shop business model to benefit from this digital revolution. GameStop provides DLC both in-store and online offering its customers PowerUp points for transactions that can later be traded in for more games, accessories or DLC.

The company’s digital sales have grown at a CAGR of 48% over the last two years, surpassing $630 million in 2012. Mobile sales have also been strong, reaching $184 million for the year. We expect the company to continue to benefit from this trend in the coming year, albeit with a slight cannibalization effect on physical software sales.

Notes:
  1. GameStop Management Discusses Q4 2012 Results – Earnings Call Transcript
  2. Nintendo’s earnings disappoint as Wii U falls short, April 24, 2013
  3. VGChartz
  4. Xbox 360 U.S. sales hit 302,000 in February

Disclosure: No positions

Source: GameStop Is Worth $33 But Eighth-Generation Consoles Could Fuel Upside