GameStop’s (NYSE:GME) stock has been on a roller-coaster ride over the last week as investors have been unsure about whether the company can capitalize on the next generation consoles while adapting to the digital revolution that has changed the gaming landscape. Holiday season sales for the company were disappointing, with new software sales down 22.5% year-on-year for the nine-week holiday period ended January 4, 2014. In addition, rumors that Microsoft (NASDAQ:MSFT) might be preparing a diskless console have also spread through the market, further adding to the pessimism surrounding the video game retailer.
GameStop’s software decline is not isolated but an industry wide trend; research group NPD’s figures indicated a 17% decline in software sales through the crucial holiday period (NPD’s figures do not include digital sales). This might be because gamers were spending their money on the next generation consoles, as hardware sales across the U.S. increased 28% through the period. GameStop also reported a 99.8% increase in new video game console sales. Strong sales of the next generation consoles indicate that a software revival is just around the corner. We believe that GameStop’s business model will allow it to gain from this trend.
Our price estimate for the company’s stock is $54, implying a premium of 40% to the current market price.
With Digital Sales Increasing, Why Would Anyone Go To GameStop?
Gaming companies like Electronic Arts (NASDAQ:EA) and Activision Blizzard (NASDAQ:ATVI) are focusing on efficiency through the digital domain. EA released 60 titles in fiscal year 2009 and 54 in 2010, earning $60 million per title. In fiscal 2013, the company launched 35 titles (13 on consoles and PCs and 22 on mobile and internet platforms) but the revenue per game increased to $108 million. This has been mostly due to the revolutions in the digital domain; a third of EA’s December quarter revenues came from digital streams.
The fact that publishers are now focusing on digital streams tends to suggest that brick and mortar retailers like GameStop will soon become obsolete. This suggestion is strengthened by Sony’s (NYSE:SNE) launch of the cloud based gaming service, Playstation Now, which leverages Gaikai’s streaming technology to allow gamers to play popular Playstation 3 games on PS3 and PS4 platforms without having to purchase physical CDs. However, one must consider the limits of the service in terms of availability of high-speed internet required to seamlessly play games and the range of games available on the cloud before jumping to conclusions.
Video game publishers are more focused on in-game extra downloadable content than full game downloads; 40% of EA’s digital revenues for the December quarter came from DLC and only 20% came from full game downloads, mostly on the PC platform. GameStop has been able to adapt to this trend by pre-selling digital downloadable content (DLC) and selling it on the day of launch. The retailer has over 31 million PowerUp Reward members, to whom it offers exclusive digital and physical content at the launch of each major title. The company has also built up longstanding relationships with publishers which allow it to maximize its offerings. During the launch of Disney (NYSE:DIS) Infinity, GameStop offered customers the opportunity to pre-order over $400 worth of characters playable in the game. GameStop was also the only U.S. retailer to offer the exclusive $150 collector’s edition of Grand Theft Auto V. During the holiday season, the company reported a 15% increase in digital revenues, accounting for 7% of total sales. GameStop also acquired Spawn Labs’ game-streaming services in 2011. The platform enables gamers to transmit HD-quality (720p) content over the Internet via a peer-to-peer connection. GameStop’s R&D department is developing the service further and could provide an alternative to Sony’s service.
Although there is a possibility that GameStop will lose out to the digital trend in the long-term, we believe that it is currently well-positioned to capitalize on the digital revolution. GameStop is the biggest video game retailer in the U.S., with more than half of the Xbox 360 and PS3 titles sold in the U.S. during the September quarter sold through the company’s stores. As the console cycle progresses, the company should see an increase in new software sales.
Trading Still Strong
Pre-owned games are the real cash cow for GameStop, with a high margin of close to 50%. Used game sales account for 30% of the company’s sales and half of its gross profit. Sales are highly correlated with new game sales as the latter replenishes GameStop’s inventory; pre-owned game sales have consistently been around 65% of new software sales for the last four years. The company reported a 7% increase in used game sales during the holiday season, driven by strong demand for previous generation used games. Both Microsoft and Sony will allow used games to run on their eighth generation consoles, which will allow GameStop’s sales to grow further.
GameStop is also looking to expand this trading business to consumer electronics, offering discounts on new and pre-owned video games, tablets and smartphones. For example, the company has announced an $80 discount on new Amazon Kindle Fire HD or Kindle Fire HDX tablets, in exchange for two PlayStation 4 or Microsoft Xbox One video games. We expect double-digit growth in used game sales through 2015 and will keep a close eye on the electronics division.