- The tide of the video game industry is turning against used games which form a large part of GameStop's profit.
- GameStop's new initiatives follow in the footsteps of established companies that will offer fierce competition.
- Video game publishers will probably embrace digital distribution as an indirect way to block used games without angering consumers too much and GameStop has no leverage to prevent this.
GameStop Corp. (NYSE:GME) has seen its best days behind it. There is a small chance that the company might reinvent itself, but that would be the victory. For many companies, especially one that was GameStop's size, continued existence and growth is a given. I do not believe that to be the case for GameStop. I would not put money on a bet saying that GameStop goes bust or gets bought out, but I see very little to cheer about. Even the new initiatives that are supposed to reinvent the companies seem stopgap solutions at best and probably too little, too late.
Having followed GameStop after its earnings report and seeing a lot of the chatter on twitter from analysts with ratings on the stock. I would characterize the chatter as positive, but not completely. A bunch of them lowered their price targets for the year based on the earnings report, but are still in the $50s. I saw one that increased its target to $52.
I would not call these projections ridiculous, considering how the market has done overall. It might very well be the fair value for the company based upon its current condition. However, I would argue that GameStop should be put in the basket labeled anti-growth stocks. Growth stocks receive a higher valuation due to the potential for the future. What I have labeled anti-growth stocks deserve a lesser valuation for the same reason.
I just want to lay out the risks that GameStop faces in the long-term, because I think that short-term thinking is driving a lot of the analysis. That is acceptable, but for people who do not sell when the stock is up 10% it can be a problem. I want to talk about the short-term drivers that might bring in some money to GameStop, and contrast that with the long-term obstacles that fall under the umbrella of obsolescence. I want to approach the company from the perspective of the video game industry and not the retail industry. Also, I want to add my 2.5 cents as a gamer.
The Post-Physical World
Sterne Agee said that despite the most recent earnings report the solid sales of next-gen consoles bodes well for GameStop. I strongly disagree. Despite the actions and rhetoric of the console makers used games are on their way out. The lesson of the Xbox One launch as that you cannot force the death of used games by blocking them. That is a fine line, because it does mean that you can kill used games indirectly. In this case it would be through the death of physical media. All the games can be bought and downloaded digitally. Snail mailed DVDs helped kill Blockbuster, RedBox nailed the casket, and streaming was the cremation.
PC gaming has almost completely made the shift to digital only. Steam is the blue whale of the group, but there are many more digital stores. The more conceptually important ones are Electronic Arts' (NASDAQ:EA) Origin store, Activision's (NASDAQ:ATVI) store, Ubisoft's Uplay, etc. These are all the online stores of publishers, which is also interesting because these games are all on Valve's Steam. The point is that publishers like digital distribution. PC gamers have come to terms with no used games, and consoles are going in that direction. To drive home the point, other online digital game sellers include Amazon (NASDAQ:AMZN), Xbox store for Windows, GOG, GamersGate, etc.
The discount nature of used games can be replicated on digital platforms. Steam sales bring in major amounts of money and unlike used games the publishers do see a return. The publisher can even do the sale themselves. On these online stores the publishers can cut the price a few weeks after the game is released. Even $10 off the retail price less is a great situation when used games return nothing. It means that value hunters can buy a game after a few weeks at that price but do not have to wait for used game inventory. If you stick a time limit on the sale like Steam does you can really drive and time purchases.
The publishers can also directly market the sales once players go into the store. The Steam homepage does the same thing. All-in-all the digital platform model offers publishers a massive amount of benefits while still giving value hunters what they want. They would be foolish to not push for the transition.
Keep in mind that Sony (NYSE:SNE), Microsoft (NASDAQ:MSFT), and Nintendo (OTCPK:NTDOF) are all video game publishers and developers. As console makers they might try to sound amicable with used games, but they want to make money like anyone else. Microsoft wants its money from Halo. Hardware makes the most money initially, and that is only if the console does not cost more than the selling price. Game sales make consoles worth creating.
Then there is GameFly which is Netflix (NASDAQ:NFLX) for console video games. For a monthly fee you can rent games for the major consoles, with the option to keep the game if you like it by paying the used price. There are many reasons that Gamefly has not become the institution that Netflix has. One is the way people play games over time and usually multiple games depending on one's mood, replayability due to multiplayer, and having to buy any DLC. Owning games is not going to disappear, but they are going post-physical.
I do not see the hard drive limitations as a factor, as you can always re-download games later. People are not playing 12 games simultaneously, and you can erase old games you do not play. Your saves can be intact and you can pick up where you left off later.
The current generation kept the physical media capability, but either the next generation and definitely the one after will remove physical media all together. It was even considered for this generation, but was deemed not consumer-friendly. It is just like how laptops still had CD/DVD drives even as USB drive use increased, but now many laptops do not include them. People say good riddance because the machines are thinner. Tastes and expectations change.
Don't be fooled the holiday sales, because during the holidays gamers get games as gifts from non-gamers. Also, sales were driven stronger by the shift to a new generation. Non-gamers go to stores to buy games. They ask the salesperson what is a good gift. It is parents and grandparents that do this. How many people do you think were mall shopping for Christmas gifts, saw a GameStop, and went in knowing that little Timmy spends a lot of time on his Xbox?
Gamers themselves will use a mix of physical stores and digital downloads. In the past it was because for console games you needed physical media. You could get it now at GameStop or in a bit from the Internet. Now, you can get it now from the comfort of your home. Teenage and older gamers will probably embrace digital downloads first, and they spend the big bucks.
So Sterne Agee feeling good about GameStop due to the new consoles is extremely misguided. In the short-term you might see a boost in revenue from bargain buyers grabbing used games on the last generation. That game that slipped through the cracks during your busy schedule is at a cut rate price, but it is high margin for GameStop. The lack of backward compatibility means there might be some sales to be made in used consoles, but not much.
Gamers will keep the old games they like and they need to keep their old consoles to play their old favorites. Over time people might even repurchase older games released digitally on the new consoles just to get the old consoles off their entertainment shelves. So a boost in used game inventory is going to be followed by people buying up games, but that used inventory will not keep turning over.
The sheer habit of buying games could buoy sales for a bit, but I expect it to be an eroding number. Even Steam had to work for its current status. GameStop is a house built on used games. Those lines you see of people looking to pick up their game on release day bring in some revenue, but the fat margins that made GameStop an S&P component is due to used games.
It is fairly surprising that GameStop still gets so many preorders and in-store sales considering that you can do the same online, but gamers are an instant gratification culture in large part. Even Amazon Prime shipping is too slow for the game you must have. That is why I think digital sales of console games is the arrow to the heart of GameStop. Different preorder bonus DLC based on your retailer might drive some people to GameStop, but I don't think this will be significant enough. Besides those DLCs are usually not compelling being a weapon or a skin, and can usually bought later if you really feel like you missed out.
I firmly believe that digital download is the way of the future. Game publishers want it, and the consoles have that functionality. It makes business sense for publishers to embrace and push for digital, because they get nothing from used games. GameStop could change that and kick something to publishers on every game sold, but that would erode margins. Even in that case, publishers would prefer to sell a game digitally at the full retail price, than take a small chunk of a used game sale. GameStop is a purveyor of video games, but the publishing companies dictate the course of the industry.
Following in the Footsteps of Giants
I do not want to delve too deeply into the different things GameStop is going to try in order to survive and continue growing. They might work to keep the company afloat for a while, but I think growth will be tough to come by. Maybe it will turn into a consistent cash machine without much growth but a solid and reliable dividend.
The demise of the company will not be something that can be extrapolated from existing data. Plotting the decay of revenue growth, the rise of expenses, and all the other things that is done to determine where a company is going. The pivotal point will be one no one will see coming. Then it will become a debate between people who thinks the company can survive, and those that think it's over. The demise of the video store was not appreciated until it was too late to stem the demise. It is a comparison that is brought out of the closet all the time, but it is very apt.
Blockbuster tried to follow the Netflix model, and then the RedBox model. It tried a hybrid approach. It closed stores and tried to regroup. In the end it did not really work. Now Blockbuster is a distant memory. It might exist in some form, but it's a far cry from its heyday. I want to emphasize that I am not saying GameStop will be scoured from the Earth. Right now it is an S&P 500 component so there is a long way to fall even if it does hang on in some form, and it could be before or after a bankruptcy.
Nothing about GameStop's fresh initiatives strikes me as that different from what Blockbuster tried to do. GameStop owns a digital distribution platform like Steam as well. It bought Stardock years ago. Stardock was no Steam, and I was only aware of it in the edges of my mind. Stardock has converted to a game developer and publisher. Its games are available on Steam, and some are quite good.
They are currently working on Galactic Civilizations III, which will definitely get buys from the Master of Orion crowd and other strategy lovers. The company also published Sins of a Solar Empire with Ironclad Games developing it. These are two solid games, but they do not make an immensely profitable S&P 500 company. They occupy that middle area between indie and triple A, which is rapidly shrinking. Indie games can be made by one person or a handful of people. These middle games are far more traditionally built. One could argue that the company has to start somewhere, but jumping into triple A gaming is a huge risk.
Stores that sell other electronics is the hot new idea. I saw headlines about how GameStop is closing 2% of its stores it is opening more stores that don't sell games. The company wants to sell phones, computing devices, fitness gear, and many other electronic devices and thinks it will work because it has access to gamers. Gamers are not sub-humans from the mall parking garage in Invader Zim. They go to other stores that meet their needs.
There are plenty of other stores out there that sell those items, and some of them even sell all those items. I am not going to the GameStop store to look and buy iPhones, when there is an Apple (NASDAQ:AAPL) store in the same mall. It would take some convincing evidence to make me believe in the potential of this endeavor.
GameStop seeks to leverage its customer loyalty program for its access to the habits of its customers. It would not be the first company to leverage big data to help it make smart business decisions that make its growth explode. It also would not be the first company to fail.
Big data had lofty goals and huge promises that have not materialized for the most part. It becomes a problem of filtering out the noise. There is an inherent uncertainty of using present data to project the future. Throw in subjective things like fashion and electronics, and I bet big data will fail more often.
GameStop does not even set the trend so it cannot leverage a self-fulfilling prophecy by deciding what next season's fad is going to be like fashion designers. The benefits of this customer loyalty program are a red herring in my book until I see the results. It does have a lot of people in its program, but I just do not know if this will matter. Physical retailers are struggling as it is with the Internet, and they have loyalty programs too. Though these are either smaller or less focused than GameStop's.
I cannot say much about Kongregate, which is a game hosting service where people can upload games and can reach GameStop customers. I had not heard of it until I read the most recent earnings transcript. Interesting idea, but I do not really see a solid endgame. Greenlight and early access on Steam are fantastic.
I have a hard time seeing Kongregate becoming an important driver of revenue. It sounds like one of those new things a company tries to see if it can strike gold. The concept is not particularly unique. There are plenty of other players. Lauding the social gaming aspect made me think of Zynga (NASDAQ:ZNGA), and how when it started and was going public it was supposed to change the face of gaming. I think it has been 2 Grand Theft Auto games since then, and a couple of more Call of Duty games.
Free-to-play has ended up being more of a change in the industry than social gaming. The major publishers are jumping into free-to-play with high quality products, and the vast majority of free-to-play games are flashes in the pan with their success. This is especially true in the mobile market, where GameStop also wants to push into.
There is no need to outline every new avenue and refute it. A pattern emerges. GameStop is trying to do things that have already been done. It will face stiff competition from veterans in those fields. The pieces of the company might make acquisition targets for those competitors. It might see a benefit from its new store plans, but I do not think it will continue to be the destination that it is for gamers. The industry is turning against it. Creators of video games want to go in another direction.
Count the number of times that a total reinvention has worked. Blockbuster did not manage to do it. K-mart declared bankruptcy sold off stores, bought Sears, and is now facing down the barrel of another gun with Sears. AOL is not what it once was. Kodak managed to come back from bankruptcy but is no longer a household name. Blackberry is still knocking about but finding it hard to bring up the rear in smart phones.
There are companies that reinvented themselves, but I feel that is the rarer outcome. Even Apple had years of poor stock performance before it started on its current path. The same goes for Ford (NYSE:F). Alcatel-Lucent might be in the midst of this. GameStop would be quite unique to reinvent itself on top.
As long as used games are available and commonplace, GameStop will continue to do well. The company thinks that segment can continue growing albeit slowly. They are expanding into other areas in order to continue to pick up the slack.
It sees closing stores as removing the drag from profits. GameStop has pretty good geographic coverage and not all the stores do amazing business. I have seen stores that are within 15 minutes of each other. It can afford to close those to boost its overall profit.
I do not think that the company can continue on without used games. I think if used games start vanishing as people switch to digital purchasing GameStop will feel serious hurt. None of the other things it does rises to the profitability of used games. It is for that reason that I think publishers want to move to digital media. Also, the console makers try to walk the fine path of publisher-friendly and consumer-friendly. I think retailer-friendly comes third with the other two being tied. Digital downloads are definitely friendly to publishers and consumers.
Investors in the stock need to realize that there are many headwinds. These are powerful enough to force the company into the ground and not just to tamp down growth. I am not big a proponent of straight shorting. If I think that a stock is headed down in a certain time period I use puts.
I got some puts before earnings expecting a miss, and I got it. The stock declined substantially, but not enough to make me sell off my puts. On Friday the stock closed above the high prior to earnings, and I understand why the stock has done so well.
My position could only be considered a pittance, because it was a low cost play on a substantial move downward. I thought an earnings miss could send the stock to $33 or lower. For people who are long the stock for the long haul, I think the information out there is incomplete.
There is discussion about the new course for GameStop and the future of the used game industry, but fail to mention that this is based on hope. By extrapolating numbers they might believe their conclusions, but a simple qualitative look at the state and course of the industry paints another picture.
I think a long position in GameStop relies on the hope that management can help reinvent the company to not rely on used games, while at the same time hoping used gaming continues to grow or at least maintain its current level. PC gaming provides a real example of where console gaming could go and the disappearance of used games. There is no example as on point for stores that do not sell games, converting to a game publisher and developer, or anything that GameStop is trying to accomplish. At least the company is not being crushed under debt or a lack of liquidity.
Hope is not wrong. In the last two years I had written positively about Alcatel-Lucent (NYSE:ALU), and that was based on hope that its solid technology and new management would turn things around. It worked out well. You need to appreciate what you are basing your investment thesis on. These professional analysts make things sound so concrete. Do not confuse their confidence, which is a sales technique, for certainty or accuracy. Get to know the negative path of your investment as well as the positive, then decide which one you believe.