This evening, Microsoft (MSFT) issued a statement on Xbox One labeled "Details on Connectivity, Licensing and Privacy Features" after confusion reigned supreme among investors, gamers, and the media following the initial unveiling. MSFT clarified its stance on digital games on the Xbox One, and while it isn't directly imposing a used game block or fees for used games, it is giving its gaming partners (i.e. publishers) the ability to do so, which will have materially negative consequences on GameStop's (GME) business for both new and used games. While the initial knee-jerk reaction may be to rally GME stock tomorrow as used games will "survive" the next gen cycle, the smart money will be selling/shorting GME as the used game model has cracked. Video games are set to follow in the footsteps of movies and music into the digital era. As these ramifications are understood, GME should quickly move to my $20 ($18-23 midpoint), representing 40%+ downside over the coming 12 months. See my GME full note for details.
Following the Xbox One unveiling, there were more questions than answers as the event was used mostly to hype the "all-in-one" entertainment features rather than the game playing aspect. One principal area of concern investors had was whether an always-on connection was the prelude to a crackdown on used games and the onset of the eventual digital age of console games. Conflicting comments in Q&A sessions and offline after the presentation had people thinking Xbox One was going to block used games. The statement tonight was likely issued the week before the huge E3 industry conference to quiet the gamers up in arms about a possible end to used games. Used games will survive this generation, GME investors exhale. However, reading the fine print would suggest a slow death for used games or at the very least a sharp contraction in GME's used game profit pool.
The Two Key Details Signaling the Slow Death of Used Games
(1) The first key detail:
"Buy the way you want-disc or digital-on the same day: You'll be able to buy disc-based games at traditional retailers or online through Xbox Live, on day of release."
By allowing a same day digital download of all games, digital downloads are going to follow the migration curve of PC game downloads. Today, over 70% of all PC games are downloaded digitally vs. <1% for consoles. The digital move was made possible by the market leader Steam providing a quality medium, broad selection, and ease of use. Microsoft is now copying Steam's playbook and making it easy for the consumer to download all games digitally. Previously, console games were not downloaded digitally because frontline games were not available and the connection speeds made it too arduous. Now all games will be made available digitally the same day as disc and the technology has arrived for a relatively speedy download.
Why wouldn't game console downloads follow that same migration path in a shortened timeframe? An Xbox One requires a minimum 1.5 Mbps connection and uses two antennas to improve the speed. Note the average Internet connection speed according to Akamai is 2.9 Mbps. Utilizing the "always ready" Xbox One connection that is "running in a low powered connected state" games will be partially downloaded allowing a gamer the sensation of downloading the game instantaneously even though it was only partially downloaded with the remainder being performed in the background. (See my GME note for details). Why would a gamer go wait in line at a GameStop at midnight to buy the latest Call of Duty 'Ghosts' disc when he can simply download it on his Xbox One and play the game at 12:01 AM while his friend is still waiting in line. In addition, a gamer will be able to access his entire game library in the cloud without any discs. Digital copies of discs will be stored on your console and in the cloud. Sounds very similar to iTunes and the end of the CD. My rough estimate is that every 5% of downloaded games will destroy 10-15% of GMEs value due to the multiplier effect.
The movie industry has long utilized a window or a lag to keep their cash cow DVD business alive. Within the last few years, studios decided to narrow the window from the traditional 4 week delay between DVD to Video on Demand (aka VOD) to 1 week or less even though VOD was less profitable. The death of DVDs has been well publicized and in addition to the emergence of Netflix was hastened by the shortening of this window and the convenience of digital. Microsoft sees the inevitability of digital downloads thus moved to same day release to help speed up the transition. The movie industry understood the power of a special window, video game disc unfortunately has no such window.
One corollary business that MSFT did not address was the digital used game store that Phil Harrison talked about following the original Xbox One event. Harrison -
"We will have a solution - we're not talking about it today - for you to be able to trade your previously-played games online," Harrison said.
Microsoft will give gamers a credit for their digital copy that they trade in. So for GME bulls who argue that digital will not take off like PC downloads because there is no trade in value are sorely mistaken. My sense is MSFT didn't address it as part of this release because they were trying not to further anger their retail partner GameStop and they have more details to iron out. MSFT wants to make the choice between disc and digital one of convenience for the consumer not an economic one.
(2) The second important detail from the statement:
"We designed Xbox One so game publishers can enable you to trade in your games at participating retailers. Microsoft does not charge a platform fee to retailers, publishers, or consumers for enabling transfer of these games...Third party publishers may opt in or out of supporting game resale and may set up business terms or transfer fees with retailers. "
MSFT confirmed that they are putting in place a system to control the sale of used games. MSFT will not charge a fee to retailers, but it confirmed that publishers will be able to charge fees or potentially block the sale of used games. Also, it looks likely that MSFT will use this action in the sale of its first party titles (Halo, Gears of War). This still has the big potential of changing the economics of the used game business.
Publishers for years have privately complained ad nauseum about the used video game market cannibalizing their new software sales. Some publishers such as EA tried to get around blocking used games through their 'Online Pass'. The 'Online Pass' gave the gamer additional online content and when the game was bought used the gamer would need to purchase an 'Online Pass'. EA discontinued the Online Pass a few weeks ago, many thought because there was a better way around used games coming directly from the hardware manufacturers. Now publishers have the power of 'enablement' to decide whether or not their game could be traded in. Finally the publisher has some leverage against GameStop. The tradeoff is simple, Ubisoft and EA (EA) will enable Assassins Creed and/or Need for Speed to be traded in if I can get say 40% of GME's used game profits on their game(s). If not then they will decide not to enable those games for trade-in's. It's also telling that games were not automatically enabled for trade-in. Clearly Microsoft is siding with its strategic publishing partners in giving them some leverage to finally participate in the used game market.
In One Quick Move, Apple Crushes GME Mobility Dreams
Late in the day yesterday, Apple (AAPL) issued a headline that it will soon start accepting iPhone trade-in's at its retail stores. In partnership with Ingram Micro's (IM) Brightstar, Apple will allow trade-ins of old iPhones for credit toward new iPhone purchases. When Apple made this announcement, it was brushed aside as a fairly meaningless move for Apple itself, but for GME it poured cold water on its emerging business. This group labeled "Mobile" for GME, thrown in the "Other" segment on the P&L, represents trade-in's of used electronics namely old iPhones, iPads and other smartphones/tablets. The segment grossed $50 million in revenue last quarter, only 3% of revenue, but grew an astounding 300% y/y and carries with it an above corporate gross margin of roughly 34%. GME hopes that this segment may soon represent another burgeoning opportunity similar to used video games years ago. Trading in used electronics would provide a use for many of the retail storefronts that become increasingly unnecessary in a digital world. Unfortunately, Apple getting in the business of tacking trade-in's itself takes away massive supply from it as Apple products represent the majority of trade-ins. Apple now joins carriers like AT&T and Verizon who accept trade-ins of used smartphones. Will Samsung with the help of Best Buy at its store within a stores follow suit?
Bottom line, digital will eat into new software games sold. Whether digital starts at 5%, 10%, 20%, etc., it will only build momentum as users become familiar with the technology. The result will be less new software games sold at GameStop. Note in FY'13 new software games represented 40% of revenue and 30% of total gross profit. The used game business while not going away is clearly under pressure and will be affected by less disc sales but also by giving a cut away to the publishers. Used game revenue will likely flat line as overall industry growth offsets declining units. Used game margins will be under pressure as GME needs to split economics with its publishers. Note used games represented 26% of revenue but 42% of gross profit. Ultimately, the digital evolution represented here is materially negative for GME. This is confirmation that the game is changing for GME, and with its stock 10% off historic highs, GME makes for a top short. Fair value for a secular declining business is roughly 8x p/e or $24 vs. upside to $40 (i.e. 3:1 risk/reward) which is an extremely full 12-13x for a secular declining company whose biggest profit contributor is unlikely to exist in a few years.