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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 thatsoftware 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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