GameStop - The Turnaround Is Just Around The Corner

| About: GameStop Corp. (GME)

Summary

GameStop's second quarter was dismal.

However, its diversification strategy is working.

Tech Brands continue to grow but will slow down.

Collectibles are likely to compensate for future software sales losses.

In the long term, GameStop will have to find a strategy to balance its brick-and-mortar business with online or they will fail.

GameStop (NYSE:GME) has just published their second quarter results and they don’t make happy reading at least as far as their core business – video games – are concerned. This is how annualized revenue numbers look like:

Source: SEC filings

Whilst their new hardware numbers have flattened out, the same cannot be said about their new software performance which continues to show declines. This is in contrast with the overall market place worldwide which is strong and growing at an 8% clip. This is how the picture looks for the U.S. as per NPD:

Source: NPD

GameStop’s second quarter was buoyed by their new hardware sales but the problem with this is that you really do not make much money there. Typically, trade margins for new hardware are around 10%, new software around 20% and used games about 50%. Comparing second quarter 2017 with second quarter 2016 shows that new hardware sales increased by 14.7%, new software sales went down by 3.4% and used products went down by 9.2%.

Whilst the company claims to have gained market share in software – presumably worldwide even though they have not specified the geography – feedback from my national buyer contacts at 27 major retailers in 17 countries including the U.S., China, Japan etc – indicates otherwise and suggests a continued erosion of GameStop’s market position at brick-and-mortar retail. If you include the direct sales to consumers made by the publishers then the situation is even worse.

The problem with eroding software sales is two-fold. One is that it affects your direct profitability. The second is that its longer term throttles your used video game sales. The less new software you sell, the less used games you will get back and be able to resell at 50% margins.

All my retailer contacts, and this includes GameStop’s, are agreed on one thing. The trend where software sales migrate away from brick-and-mortar to direct consumer sales by the publishers is just going to accelerate. Yes, brick-and-mortar will continue to have a role to play as far as new hardware and accessories are concerned but this is about it. If it was just a matter of video games, GameStop would be toast in a couple of years.

However, GameStop has made a very concerted effort to diversify their business into two additional categories – Technology Brands and Collectibles.

This diversification effort has shown to work pretty well to the extent that the combination of Technology and Collectibles is expected to reach 20% of GameStop’s total revenue by end of this year.

This is how sales developed in comparison to the Company’s total:

Source: SEC filings

Let us first look at Technology. The Technology business is mainly driven by GameStop’s 1500 Spring Mobile stores who are exclusive resellers of AT&T mobile devices, mainly phones, plans and accessories. Also, the company offers under the Cricket Wireless brand AT&T phone service activation, phone upgrades, and bill payment facilities in all their video game stores. In addition, GameStop also runs about 50 Simply Mac stores, resellers of Apple products. Gross profitability of the sector is excellent at 74%.

They seem to be on to a good thing since AT&T is growing much more rapidly than its major competitor, Verizon. Also, it appears to be only a matter of time when AT&T will replace Verizon as the market leader

Source: Strategy Analytics.

However, all indications are that the growth of the mobile phone market in the U.S. is slowing down as market saturation rears its ugly head. Mobile phone sales in the U.S. are projected to decline this year by 1%, the third decline in so many years. This negative trend is already demonstrated in GameStop’s Technology numbers and will likely put a cap on the extent to which this sector is going to grow for the company.

As for the other sector – Collectibles – the outlook is very promising. The company has 86 free-standing stores, 24 under the Think Geek name in the U.S. and another 62 Zing Pop Culture stores in Australia and Europe. In addition, GameStop has allocated 50% of its video game store space to the endeavor. Gross profitability at 35% is good and approximately in line with the percentage applicable to the combined video game business it replaces, at least in terms of retail space.

The outlook is excellent. First, the Collectibles market is huge – estimated at $10 billion in the U.S. alone and about $30 billion in the rest of the world. Its largest component is toys which represent an estimated 35% of the total, followed by apparel with about 16%. Secondly, it is growing at an incredible pace – about 25% in 2017 overall and more than 30% for toys in isolation. The major toy companies in the field are Funko with its POP range and Hasbro with its traditional action figure offering.

The table below shows GameStop’s top twenty products and its competitive pricing:

GameStop Sales Ranking

Brand

Provider

GameStop

ToysRUs

Wal-Mart

Target

Amazon

1

Star Wars The Black Series The last Jedi Snoke

Hasbro

$39.99

n/a

n/a

n/a

n/a

2

Star Wars The Black Series Guard Action Figure 4 pack

Hasbro

$89.00

n/a

n/a

n/a

n/a

3

Pop Star Wars The last Jedi D.J.

Funko

$11.99

n/a

n/a

n/a

n/a

4

Star Wars The Black Series 40th Anniversary Legacy Pack

Hasbro

$39.97

$39.99

$39.73

$31.99

$28.87

5

Star Wars The Black Series 40th Anniversary Princess Leia

Hasbro

$22.99

$19.99

$18.95

$19.99

$16.89

6

Fingerlings Interactive Baby Monkey Mia

Wowee

$14.99

$14.99

$14.84

$14.99

$14.99

7

Fingerlings Interactive Baby Monkey Zoe

Wowee

$14.99

$14.99

$14.84

$14.99

$14.99

8

Boris

Wowee

$14.99

$14.99

n/a

n/a

n/a

9

Bella

Wowee

$14.99

$14.99

n/a

n/a

n/a

10

Finn

Wowee

$14.99

$14.99

n/a

n/a

n/a

11

BB 8 App Enabled Droid

Sphero

$119.97

n/a

$116.24

n/a

$114.95

12

POP! Games – Destiny Caydee

Funko

$11.99

n/a

$11.98

n/a

$9.99

13

POP! Games – Destiny Caydee

Funko

$11.99

n/a

$11.98

n/a

$9.99

14

POP! Games – Destiny Caydee

Funko

$11.99

n/a

$11.98

n/a

$9.99

15

POP! Games – Destiny Caydee

Funko

$11.99

n/a

$11.98

n/a

$9.99

16

POP! Games – Destiny Caydee

Funko

$11.99

n/a

$11.98

n/a

$9.99

17

Star Wars The last Jedi Porg

Hasbro

$11.99

$8.75

n/a

n/a

10.99

18

Star Wars The Black Series – The last Jedi Snoke

Hasbro

$39.99

n/a

n/a

n/a

n/a

19

Star Wars The Black Series – Guard Action Figure 4 Pack

Hasbro

$39.99

n/a

n/a

n/a

n/a

20

Destiny Lord Saladin Wirth Iron Wolf Pack

Think Geek

$19.99

n/a

n/a

n/a

n/a

Average of comparable top 4- 7

$23.23

$22.49

$22.09

$20.49

$18.93

Compare Game Stop with Amazon

$25.89

$22.87

Source: Klosters Retailer Panel

This table demonstrates both the strength and the weakness of GameStop’s offering. Its strength is in the company’s skill in getting exclusives which now represent six of its top twenty best selling products. The weakness is in the fact that its pricing is vulnerable to Amazon in that GameStop is 13% more expensive.

Considering the future, there are two main considerations. One is that Amazon is clearly gaining market share in the Collectibles category and this predominantly with Funko. Funko is Amazon’s top action figure brand in the U.S., Mexico, U.K., France, Spain and Italy plus #4 in Canada and #3 in China. This tells us that Amazon is extremely important to Funko, much more than GameStop and if it comes down to competitive choices, Funko will go with Amazon rather than with GameStop. The second consideration is that the international market offers an incredible promise for any brick-and-mortar retailer savvy in Collectibles and this bodes well for GameStop with its existing worldwide presence. However, thereby also lies a danger. The trend governing Collectibles is the same as with toys generally. Brick-and-mortar stores are losing out to online sellers, particularly Amazon. GameStop’s problem is that the company continues to be totally committed to its retail stores and does badly in eCommerce. Unless GameStop finds a way to create a viable eCommerce strategy both for the U.S. and internationally, its Collectible business could eventually hit the same competitive roadblock now faced by its video game software.

However, even if GameStop fails to do this, its Collectible business is bound to grow and do very well in the short and medium term, say over the next five years. It is driven mainly by movie IPs and there is every expectation that the current momentum is not going to slacken anytime soon. Given this and assuming that the current Collectibles market growth rates will continue to apply, GameStop’s business in the category will in all probability represent by 2020 a quarter of its total revenue and hence fully compensate for sales declines in the software category.

In summary, GameStop’s diversification strategy seems to be succeeding and is probable to save the company over the short to medium term. However, the core problem that besets all of its efforts, the migration of consumers away from brick-and-mortar to online, is still unresolved and will need to be addressed for all its activities – Video Games products, Technical Brands and Collectibles - in the near future to ensure GameStop’s long term survival.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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