After assessing consumer response at the Electronic Entertainment Expo (E3) last week, Microsoft (NASDAQ:MSFT) is backtracking on its stance on used video games. The company had earlier hinted that it would allow game publishers like Electronic Arts (NASDAQ:EA) and Activision Blizzard (NASDAQ:ATVI) decide whether they would charge fees for reactivation of a used game on an Xbox One console. However, following Sony’s (NYSE:SNE) announcement last week that the Playstation 4 would allow used games, Microsoft has stated that the Xbox One will also allow the same.
According to the company’s official consumer interaction portal, Xbox Wire:
An internet connection will not be required to play offline Xbox One games – After a one-time system set-up with a new Xbox One, you can play any disc based game without ever connecting online again. There is no 24 hour connection requirement and you can take your Xbox One anywhere you want to play your games, just like on Xbox 360.
Trade-in, lend, resell, gift and rent disc based games just like you do today – There will be no limitations to using and sharing games, it will work just as it does today on Xbox 360.
In addition to buying a disc from a retailer, you can also download games from Xbox Live on the day of release. If you choose to download your games, you will be able to play them offline just like you can presently do. Xbox One games will be playable on any Xbox One console — there will be no regional restrictions. “
This announcement comes as good news for GameStop (NYSE:GME), which has emerged as a swap shop for video games, allowing customers to sell their video games for cash or reward points, and use these points to purchase other used or new games. The retailer earns 27% of its revenues and 40% of its gross profits from used game sales.
GameStop’s stock has gained more than 50% since the turn of the year and is now in line with our $36 price estimate for the company’s stock
Microsoft Is The Key In the U.S.
Although GameStop has international operations in Canada, Australia and Europe, its main market is the U.S., which accounts for around 70% of the company’s sales. The Xbox 360 is the most popular console in the U.S. market, outselling its counterparts in the country for the last 24 months. Seven of the top ten best selling console games of last month were on the Xbox 360 platform.  According to our analysis, nearly half of the video game sales (in terms of units sold, including PC, PS3 and Wii) in the U.S. last year were on the Xbox 360 platform.  Clearly, the Xbox platform is critical for GameStop’s business.
Used game trades are GameStop’s most important business accounting for 38% of our price estimate for the company’s stock. The retailer’s gross profit margin on used game sales is more than 45% as opposed to just 20% for new game sales. Microsoft’s decision to allow used games to run on the Xbox One will allow GameStop’s trading model to continue through the next console cycle. Console fatigue due to prolonged product cycles for Xbox 360 and Playstation 3 caused an 11% decline in new video game software revenue in 2012. This decline also led to a downfall in 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 a recovery in new game sales, subsequently leading to an increase in used game sales.
International Acceptance And Opportunity
The Xbox 360 was region locked, which meant that gamers could not take their games across continents. As a result, the Xbox 360 was not able to maintain its popularity worldwide and lost out some market share in the international markets. Only 36% of the international game sales last year were on the Xbox platform. However, Microsoft’s decision to remove regional restrictions from the Xbox One also opens up possibilities of international trade and expansion for GameStop.
The company has 336 stores in Canada, 416 in Australia and around 1,500 in Europe. The revenue contribution from these geographies in 2012 was 5%, 7% and 18% respectively. The company has announced plans to shut stores in 2013, but with the new console cycle and the lack of regional restrictions on the Xbox One, GameStop has the potential to expand game trades internationally. We will keep a close eye on developments and update our model accordingly. You can modify the interactive charts in this article and on our main page for GameStop to gauge the effect a change in forecast would have on our price estimate for the company.
Disclosure: No positions