GameStop $GME gave a disappointing set of Q1 results which sent the shares sharply lower. The outcome will –no doubt - delight the legions of bears who are short the stock, but is it now becoming a contrarian restructuring play?
Sadly, I think not. This business looks to be structurally challenged, and, despite sterling efforts by the management, it is hard to get too excited by its prospects.
GameStop Earnings and Margins
Before going into detail on its marketplace, I want to explain exactly how GameStop makes its money. I’ve lost count of the times that I hear or read about this company from commentators who don’t understand that, the single biggest contributor to profits is used video games. I suspect this is because, it is so much more interesting to talk about new game or console releases. No matter, as investors, we need to focus on the salient points.
Here is a six year break down of Gross Profits by Division
The evidence is clear. Used video games make up the bulk of profits. Investors need to understand this, despite what we hear about earnings being tied to the stage of the console cycle etc. It is certainly true that new hardware (4.2% of total gross profits) and consoles encourage software developers to release new titles, and they encourage footfall in the stores. All of which, leads to increased new video game sales (31.3%) and used video game sales (45.6%) so the divisions do rely on each other. However, the bulk of profits remains in the used video games segment.
Incidentally, the fast growing ‘other’ category includes digital sales.
In a sense, the console cycle thesis is a bullish case for the stock. In other words, when the new consoles come out, it will spur new software sales, increased footfall and therefore increased used video game sales. A virtuous growth cycle.
We can see the evidence behind this idea in the following table. Note, how hardware sales are falling as the console cycle gets into the later stage.
Is it a worthy case? I'm not so sure.
GameStop Structurally Challenged?
There are four main challenges to GameStop and I think all of them are significant.
- Best Buy $BBY Walmart $WMT are encroaching on their market share in retail
- Online merchants like Amazon $AMZN are grabbing market share from in-store sales
- Software manufacturers are shifting to delivering the games online via SaaS (avoiding piracy and protecting IP is a key driver here)
- GameStop is being forced into the 'long tail' of retail (superstores are selling the blockbuster titles) which is an area that is not its forte
- Efforts to increase GameStop’s digital sales may reduce footfall and cannibalize its retail sales
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 but it is also a significant problem for GameStop because it cuts it out of the sales chain.
All of these issues are well known and GameStop has made admirable efforts to restructure its business. The plan for 2012 is to open 100 new stores and close 150, so a net change of 50 stores. However, such plans require asset impairment and restructuring charges and, the sales trend is not GameStop’s friend right now.
For example, at the full year, management predicted full year comparable same stores sales to range from -1.5% to 2% but now, the forecast is for -5% to 0%. It is one thing to restructure in order to improve execution, but it is another thing when the business itself is being challenged strategically. The restructuring has improved gross margins in the key used video games segment.
But I think this a blip in a longer term downtrend. If you close lots of less profitable stores, it is entirely feasible that gross margins can be improved. However, the longer term challenges remain and the latest Q1 results were horrible. Sales declined in every category. Profits declined too, although used video game sales eked out a small gain and ‘other’ sales -which includes digital- only produced a miserly 6.6% gain. However, digital receipts were up 23% and, conversely, it is this figure that investors should be worried about.
GameStop can improve earnings with increased digital sales, but it’s not its core business. The structural and competitive challenges remain and the weakness in its retail sales figures vs. its online sales, is speaking volumes for how this industry is evolving.
Unfortunately, it is evolving away from Gamestop’s core business.