GameStop’s (NYSE:GME) stock jumped close to 8% after Sony announced that the highly anticipated PlayStation 4 will run used games.  The eighth generation gaming console, along with Microsoft’s (NASDAQ:MSFT) Xbox One is expected to revive video game sales which have been declining due to console fatigue.
Microsoft earlier hinted that it would allow game publishers like Electronic Arts (NASDAQ:EA) and Activision Blizzard (NASDAQ:ATVI) decide whether they would charge fees for reactivation of a used game on an Xbox One console. This raised concerns amongst investors as used game trades are GameStop’s most important business.  Used game sales account for 27% of GameStop’s revenue. However, the gross profit margin for used video game products is more than 45%, significantly higher than new video games for which GameStop earns only a 20% margin. Higher margins on used game revenue stream make it the biggest contributor to profits, with over 40% of GameStop’s gross profits coming from used video games.
GameStop’s stock has gained more than 50% since the turn of the year and is now in line with our $36 price estimate for the company’s stock
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GameStop Is Dependent On Used Games
Used video games are an intrinsic part of the company’s business model. GameStop has developed as a swap shop for video games, customers sell their video games for cash or reward points at GameStop’s stores and use these points to purchase other used or new games. There are more than 30 million members enrolled in GameStop’s PowerUp, Megacard, EB World and GameStop Plus programs in the United States, Europe and Australia.
The prolonged product cycle of the seventh generation consoles has led to console fatigue causing an 11% decline in new video game software revenue in 2012. This decline also led to a downfall in used game inventory, leading to a 7% year-on-year decline in used game revenues. We expect the launch of the new generation of consoles to spark an increase in new game sales subsequently leading to an increase in used game sales.
However, Microsoft’s used game fees might deter gamers from trading. According to our analysis, 36% of the video game sales (in terms of units sold) last year were on the Xbox platform while 30% were on the PlayStation platform.  If Microsoft maintains its stance on used games, it might completely stop trades on the Xbox One platform. Extrapolating the market share from 2012 to the end of the decade, there could be a maximum of 35% decline in our forecast for used game sales in the extreme case. There is a potential downside of 33% to our price estimate in this scenario. You can modify the interactive charts below to assess other scenarios concerning used games sales.Notes:
- GameStop Jumps on Optimism for PlayStation 4 Game Resales, Bloomberg, Jun 12, 2013 [↩]
- Microsoft defends the Xbox One’s licensing, used game policies [↩]
- VGChartz [↩]