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Quick Take

  • Microsoft unveiled its eighth generation console, the Xbox One, and said that it will charge pre-owned fees for used games installed on the new console.
  • In comparison, Sony has allowed used games to run on its eighth generation console.
  • GameStop earns more than 40% of its gross profits from used game sales.
  • Although new consoles are expected to increase inventory and grow used game sales, Microsoft’s console could cut into almost a quarter of the potential sales of the retailer.

GameStop’s (NYSE:GME) stock dropped 5% after Microsoft (NASDAQ:MSFT) unveiled its eighth generation console, the Xbox One. [1] Although the highly anticipated console will help revive hardware and software sales, Microsoft’s decision to charge “pre-owned” fees for used games that are installed on the new Xbox One will cut into GameStop’s main cash cow: used video game products. (Xbox One Makes It Difficult to Borrow Video Games With ‘Pre-owned Fee’) The retailer earns almost 30% of its revenues through the sale of used video games. Higher margins on this revenue stream make it the biggest contributor to its profits, with over 40% of GameStop’s gross profits coming from used video games.

GameStop’s stock has gained more than 60% since the turn of the year and is now in line with our $33 price estimate for the company’s stock. GameStop is scheduled to report earnings for the first fiscal quarter of 2013 on Thursday, May 23.

Why Are Used Games So Important?

The company’s gross profit margin on used video games is more than 45% compared to 20% on new video games. Apart from this, used video games are an intrinsic part of the company’s business model. GameStop has developed into a swap shop for video games where customers sell their games for cash or reward points at GameStop’s stores and use these points to purchase other used or new games. 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. A decline in used games sales could also have a detrimental effect on new game sales at GameStop’s store.

Quantifying The Effect Of Declining Sales

Sony (NYSE:SNE) announced its eighth generation console, PlayStation 4, earlier this year. The company stated that the console will allow used games to run, so GameStop’s sales are safe in that respect. The retailer does not provide a breakdown of revenues from PlayStation or Xbox though.

According to our estimates, the Xbox has a market share of 24% in the global console market and has been the top selling console for more than two years in the U.S. [2] Looking at developers, Electronic Arts (NASDAQ:EA) earns around 30% of its revenues from Xbox and PlayStation each while Activision Blizzard (NASDAQ:ATVI) earns around 20% from each.

There are four major platforms for which GameStop sells games (PlayStation, Xbox, Wii and PC). Now taking into account the developers’ revenue contribution and the consoles’ market shares, we can safely estimate that around a quarter of GameStop’s used game sales are from the Microsoft platform.

The prolonged product cycle of the seventh generation consoles has led to console fatigue, causing an 11% decline in new video game software revenue in 2012. This decline also led to a fall in the used game inventory, leading to a 7% year-on-year decline in used game revenues. We expect the launch of the new generation of consoles to spark an increase in new game sales, subsequently leading to an increase in used game sales.

However, if customers are discouraged from reselling games due to Microsoft’s pre-owned fees, GameStop’s sales could decline by up to 25% from our forecast (considering the estimated contribution from Xbox). There is 10% downside to our price estimate in this scenario. You can modify the interactive chart below to gauge the effect a change in our forecast might have on the Trefis price estimate.

Notes:

  1. Introducing the all-in-one entertainment system.
  2. Xbox 360 US sales hit 302,000 in February

Disclosure: No Positions

Source: Why The Xbox One Launch Led To A Drop In GameStop's Stock