Video-gaming retailer GameStop’s (NYSE:GME) stock has been on a bit of an uptrend since early August, but we believe that the company may still be undervalued. While the company’s net sales for the first nine months of 2012 were down 10% from the prior year, this was a trend observed throughout the industry.  Video game sales fell by 28% in the first half of the year. The decline was somewhat mitigated in the third quarter by popular titles like Electronic Arts’ (NASDAQ:EA) Madden NFL 13, FIFA Soccer 13 and Activision Blizzard’s (NASDAQ:ATVI) Skylanders Giants, as industry sales were down 19% year-on-year. 
This downtrend is due to the fact that Microsoft’s (NASDAQ:MSFT) X-Box 360 and Sony’s Playstation 3 are in the waning phase of their product cycles, which started around 2005. With both giants expected to release their next generation consoles within the next two years, we believe that sales will improve and GameStop will have a lot more to offer than the market currently estimates. With these trends in mind, we have revised our price estimate for GameStop to $33, a premium of about 20% to the current market price.
Margins To Be Affected By Shift To Digital But Is It All Good?
The video game landscape is changing as customers are becoming less reliant on brick and mortar retailers, and many are instead looking to download games directly from the internet. The digitally distributed video game market has grown by over 200% since 2010.  GameStop reported a 30% increase in digital revenues last quarter and has maintained high double digit growth in this domain through the last few years. EA has also recently stated its intention to eventually shift its operations completely to the digital domain.  Digital revenues offer higher margins than other streams, as the physical disc is not needed.
The problem that GameStop faces is that publishers will also not rely on it for sales. For example, Electronic Arts uses its online portals, Origin and Play4Free, to earn digital revenues. GameStop will have to invest heavily in marketing and sales to remain competitive and as such we anticipate an increase in selling, general and administrative expenses for the company. An increase in digital revenues may also lead to cannibalization of sales of physical software.
Nintendo Sets The Way
Nintendo’s next-generation console, Wii U, was recently released in the U.S. GameStop reported over over 1.2 billion titles reserved pre-launch and over 500,000 customers in its Wii U reservation waitlist. This release will give a much needed boost to new video game hardware and software sales, which were down 11% and 27% respectively in the first nine months of 2012. We expect a much bigger boost in sales from the new X-Box 720 and the Playstation 4, which should be released in the coming two years.
We base this reasoning on the analysis of two of the major video game publishers – Electronics Arts and Activision Blizzard. EA reported $1.1 billion in revenues from X-Box 360 consoles and Playstation 3 consoles each in 2011, whereas the revenues from Nintendo Wii were just around $200 million. Activision reported close to $670 million revenues from Sony, $800 million from Microsoft and just $250 million from Nintendo. Judging by these numbers, we expect that X-Box 720 and Playstation 4 will have a greater impact on revenues than Wii U. The next generation consoles should also boost new video game hardware sales.
We expect a short-term spike in revenues per square foot in the coming years as a result; however, long-term we expect increasing digital sales to lead to a decline in new video game software revenue per square foot.
Stores Going Down
GameStop is undergoing a restructuring initiative, exiting some European markets and closing under-performing stores. The company has announced the closure of around 200 stores in the current fiscal year. We expect a steady decline in the number of GameStop stores in the coming years particularly as digital downloads gain popularity.Notes:
- Video Games sales in U.S. October 2012, NPD Group, 9th November, 2012 [↩] [↩]
- Market Shares of Digital Distribution Platforms in 2010-2011, Deals4downloads [↩]
- EA exec: We’ll be ’100 percent digital’ eventually, CNET, 3rd July [↩]