Wednesday, September 26, 2012

Game Over for GameStop?

GameStop $GME rallied after a recent set of results. I think the stock is so heavily shorted that any remotely positive news will see ‘weak shorters’ running for cover. However, on balance I do not see this report as suggesting any kind of fundamental turn around in the long-term prospects for GameStop. The business remains structurally challenged.

In this article I will discuss the reasons and explain the salient point that many journalists and analysts miss. Specifically, used video game software sales contribute over 50% of gross profits. If you want to analyze this company properly then start with this business segment.

Why Used Games Sales Matter

Of course it is much more interesting to talk about new game or console releases. Moreover, when you typically walk into a gaming shop the first you thing you notice is the new hardware and software on display. I doubt you think too much about the bucket or two of used games on sale. Well as an investor you should, because that is where GameStop makes the majority of its profits.

In the latest quarter, GameStop saw sales declines in all three major categories with only the fast growing ‘other’ category reporting growth. ‘Other’ consists of the company’s new digital and mobile channel offerings. The irony is that it is the growth of digital sales across the industry that is the biggest challenge to GameStop.

 A breakdown of sales growth in Q2.

The bullish argument in favor of GameStop is that footfall and sales are decreasing thanks to the late stage of the console cycle, but as the next generation of consoles are due in late 2012 and then throughout 2013-14 the company should see good earnings growth as new hardware and video games are released. I’m not buying this argument for three reasons.                                

Why I Don’t Believe this is Just about the Console Cycle

Firstly, the footfall issue isn’t just about the console cycle. It is about the inexorable shift to online sales in products that can be discretized. GameStop can see this in its own growth with its ‘other’ category. As for hardware, what is to stop it being sold through Amazon $AMZN? 

The second reason is that software manufacturers are shifting to delivering the games online via software as a service (SaaS) type offerings.  It has the added bonus of avoiding many piracy issues and protecting IP for the software makers. Therefore it is wrong to assume that the upcoming console cycle will be the same as previous ones.

The third reason is that – remembering how critical used video games sales are - the late stage of the console cycle appears to be a good thing for used game sales. Here is how sales have played out historically.

Note that as new hardware sales fall (in line with the console cycle) used video game sales go up. This is natural as gamers start selling off their old games due to usage and in anticipation of the next console.

Not Just Threatened by Digital

There are other challenges to GameStop aside from software digital sales.

  • Traditional retailers like Wal-mart $WMT and Best Buy $BBY are attempting to take market share in retail
  • Online merchants like Amazon are grabbing market share from in-store sales in hardware as well as software
  • GameStop is being forced into the 'long tail' of retail (superstores are selling the blockbuster titles), an area that is not its forte
  • Efforts to increase GameStop’s digital sales may reduce footfall and cannibalize its retail sales
  • GameStop’s inventory management with used game sales is unlikely to be as good as an pure online based play

Amazon is continuing to increase competition with GameStop. The advent of bar code reading smart phones means gamers can instantly compare prices and this will pressure margins at ‘bricks and mortar’ type retailers. GameStop could try and increase the sensory retail experience in the stores but hardware sales are low margin, and new software sales do not make up the bulk of GameStop’s profits.

However, the biggest challenge may come from how the gaming companies deliver files. With 4G and other ‘fat bandwidth’ provisions, it is now feasible for games to be sold online. This has a big advantage to the gaming industry because they will be able to insure against piracy by selling gaming upgrades and licenses 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.  Games publishers like Activision Blizzard $ATVI are shifting games to online play and the recent partnership with China'a largest ISP Tencent is a good example of this.

Where Next for GameStop?

Frankly, it’s hard to advocate buying a stock on the basis of it shifting sales into a sales channel (digital & mobile) that is in fact the primary challenge to its core business. However, if you buy the console cycle/footfall argument then there is a strong case for the stock being very good value. If like me you don’t, then it is hard to see how GameStop are going to be able to stem the declines.

One interesting aspect of the situation with such a heavily shorted stock is that the bears might end up delivering the stock into the valuation arms of a purchaser. Indeed Best Buy is now subject to a takeover attempt. However, I think the structural challenges at Best Buy are not as strong as with GameStop. GameStop has much to do.

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