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GameStop (NYSE:GME) had much to celebrate over the Thanksgiving weekend as video game hardware sales in the U.S. surged 21% over the prior year on Black Friday.[1] Research group InfoScout reports that Xbox One accounted for 31% of hardware sales in the country while Xbox 360 accounted for 30%. Sony's Playstation 4 and Playstation 3 accounted for a combined 30% of hardware sales. [2]

Although hardware sales are not a big business for GameStop, accounting for just 4% of the company's gross profits, strong initial sales of the eighth generation consoles portends a revival in video game software sales as well as the retailer's trading business. Around 30% of GameStop's gross profits come from new software sales, but used video games are its most important income stream, accounting for 45% of gross profits. The company recently reported a 19% year-on-year increase in total global sales for the third quarter of 2013, but will be focused on the holiday season as the console product cycle refreshes for the first time in eight years. More than 40% of GameStop's revenues are earned during the last three months of the year.

Our price estimate for the company's stock is $54, implying a premium of 10% to the current market price. We expect the new consoles to revive GameStop's trading business.

A Good Start

The new consoles have been in the market for just two weeks but have been well received so far. Both Microsoft (MSFT) and Sony (SNE) reported that console sales crossed the 1 million units mark within the first 24 hours of release. GameStop sold through all of its reservations and additional allocations for the Playstation 4 during the first week and still had over 2.3 million customers on the first-to-know list. The gross profit margin for hardware sales is just around 7%, but the company recognizes the importance of strong hardware sales for future software sales. GameStop is actively promoting the new consoles, allowing customers to trade in their old consoles for store credits which can be used to purchase new consoles. More than 40% of new consoles were entirely paid off before launch, with over 20% of the reservation payments funded with trade credits. [3] This is higher than the 14% average trade credit funding for a new product sold through GameStop.

Higher Margins For Software

New software sales are important for GameStop, with a gross margin of more than 20%. New software accounts for 40% of the company's net sales. Electronic Arts (EA) has suggested that each Playstation 4 console sold is currently accompanied by at least three game titles. [4] This is good news for GameStop as it not only boosts short-term game sales but also allows the company to replenish its inventory, thus reviving its trading business. Video game sales were already given a shot in the arm by Rockstar Games' Grand Theft Auto V, which drove a 43% increase in new software sales for the third quarter. We expect strong sales through the holiday season as the new consoles gain traction.

The Main Attraction

High margins of 40% on used game sales make it the most important business for GameStop. Pre-owned game sales have consistently been around 65% of new software sales for the last four years. Although sales fell 2% through the last quarter, the correlation with new software sales means that a resurgence is likely around the corner. We expect an increase in sales from 2014 onwards, but there is a 20% downside to our price estimate for the company's stock should sales remain flat through the next four years. You can modify the interactive chart below to gauge the effect a change in the forecast would have on our price estimate.

Disclosure: No positions.

Source: GameStop Hopeful On Strong Sales Of New Consoles