Monday, March 28, 2011

GameStop Set to Disappoint the Market in 2011?




GameStop $GME is a business that has been aggressively shorted over the last few years, but is it now becoming a contrarian play? Investors have been quick to sound the death knell for GameStop due to the ‘oncoming’ onslaught of online gaming sales, and according to Yahoo Finance the short percentage of the float was around 24% However, the recent results were superficially quite good and the stock rallied. Is it time to buy?

GameStop Earnings and Margins
A quick look at revenues over the years (year end to Feb)...


Sales ($m)20072008200920102011
New Video Game Hardware1,073.71,668.91860.21,756.51,720.0
New Video Game Software2,012.52,800.736853,730.93,968.7
Used Video Game Software1,316.01,586.72026.62,394.12,469.8
Other916.71,037.71234.11,196.51,315.2
Total5,318.97,094.08,805.99,078.09,473.7

...reveals that growth in the Used Video Game Software segment appears to be slowing. The importance of this can be demonstrated by a look at gross margins.

Gross Profit ($m)20072008200920102011
New Video Game Hardware77108.2112.6113.5124.9
gross margin7.2%6.5%6.1%6.5%7.3%
New Video Game Software427.3581.7768.4795819.6
gross margin21.2%20.8%20.9%21.3%20.7%
Used Video Game Software651.9772.6974.51121.21140.6
gross margin49.5%48.7%48.1%46.8%46.2%
Other315.2351.6414.6405452.6
gross margin34.4%33.9%33.6%33.8%34.4%
Total1471.41814.12270.12434.72537.7

Over the years, the used game segment has made up the bulk of profits but growth appears to be slowing.  I think this is an understandable issue and I would like to explore the reasons why.

GameStop Structurally Challenged?
There are four main challenges to GameStop and I think all of them are significant.
  1. Best Buy and Walmart are encroaching on their market share
  2. Online merchants are grabbing market share from in-store sales
  3. Software manufacturers are shifting to delivering the games online (avoiding piracy and protecting IP is a key driver here)
  4. They are being forced into the 'long tail' of retail (superstores are selling the blockbuster titles) which is an area that is not their forte
The likes of Best Buy $BBY and Wal-mart $WMT, as indicated in an earlier article, are seeing some of their traditional markets erode to online competition. Therefore, they are seeking new ways to sell to their captive audience of shoppers. Naturally, selling new and used gaming software fits perfectly into the sales demographic of kids making trips to their outlets. This competition is significant for GameStop.
Similarly, online competitors like Amazon are continuing to grab competition from GameStop. The advent of smart phones that can read bar codes and immediately compare prices will pressure margins for ‘bricks and mortar’ retailers. GameStop will still be able to offer the ‘retail experience’ of kids checking out new releases but as the tables indicate hardware sales are low margin, and new software sales do not make up the bulk of GameStop’s profits.
However, the key challenge for GameStop will come from how the gaming companies deliver files. With the advent of 4G and other ‘fat bandwidth’ provision, it will become feasible for games to be sold online. This has great advantages to the gaming industry because they will be able to insure against piracy by selling gaming upgrades and licences to the original purchaser. This helps avoid the kind of piracy that is rife in this form of Intellectual Property. This will be a significant problem for GameStop and I think will hurt them sooner rather than later.

A Value Trap?
I think there is a value trap here. GameStop are talking about closing 200 stores and opening 200 others in an attempt to restructure the business, but I think the decline and structural challenges are already showing in the numbers. Let’s look at sequential numbers...

Gross Profit ($m)Jan-10May-10Jul-10Oct-10Jan-11
New Video Game Hardware40.921.225.921.756.2
gross margin5.5%6.1%8.2%7.9%7.2%
New Video Game Software322.2174.5141.7182.4321
gross margin20.6%20.0%21.4%21.7%20.1%
Used Video Game Software360.7274.4260250.2355.8
gross margin46.4%48.1%46.0%47.4%44.2%
Other150.3100.789.292170.7
gross margin33.6%34.7%34.8%35.9%33.3%
Total874.1570.8516.8546.3903.7


..and margins are clearly falling in the used games category. However sales are doing ok (on a like for like comparison)

The reason for this is that I suspect Sales for the used game segment will do well for a while due to the hardware upgrading cycle causing lots of new inventory to become available. Unfortunately, for GameStop this will be sold off a lower margin and is likely to get lower still, as games shift to being delivered online. All of which creates a value trap for GameStop, they could be reporting good sales growth but I would keep an eye on used game software margins. I think they are set to fall aggressively.