GameStop Harnesses Digital Trends Amid Industry Shift

GameStop (NYSE:GME) continued to outperform the industry through the second fiscal quarter of 2013 despite declining video game sales. The video game retailer reported 10.7% year-on-year decline in consolidated global sales with comparable store sales down 10.2% in the U.S. and 11.6% internationally.

However, the company remains well positioned to capitalize on the expected sales revival brought on by the release of next-generation consoles later this year. GameStop reported a 9.3% year-on-year decline in new software sales while software sales in the U.S. fell 19.4%. The retailer has a market share in excess of 30% in the country.

Another positive sign for GameStop was the continued growth in digital sales. The company reported an 18% increase in digital business through the second quarter, with a 121% increase in mobile revenues. Digital sales include sales of games on mobile, extra downloadable content (DLC) and full game downloads. Most video game titles to be released in the second half of the year are expected to have DLC. GameStop has been able to latch on to the digital trend by pre-selling digital downloadable content (DLC) and selling it on the day of launch. The company expects a 25% to 35% increase in digital revenues this year. We have updated our forecast with a conservative estimate of 27% growth through 2013, followed by high growth through the next few years tapering off by the end of the decade.

As a result of this update, our price estimate for the company’s stock has gone up to $48, in line with the current market price.

See our complete analysis of GameStop

Digital Trends

GameStop has over 31 million PowerUp Reward members to whom it offers exclusive digital and physical content at the launch of each major title. The company has also built up long standing relationships with publishers which allows it to maximize its offering. During the recent launch of Disney Infinity, the company offered customers the opportunity to pre-order over $400 worth of characters playable in the game. Like Activision Blizzard’s (NASDAQ:ATVI) Skylanders, Disney infinity requires gamers to purchase characters before they can be used in the game. GameStop is also the only U.S. retailer to offer the exclusive $150 collector’s edition of Grand Theft Auto V.

For the second quarter, GameStop reported a 12% growth in U.S. digital business while the rollout of Digital Game Informer and Steam Wallet drove a 43% increase in international digital business. PC digital revenues jumped 38% while console digital grew 5%. The effect of digital sales is palpable, PC retail sales and digital revenues account for just 20% of GameStop’s sales but due to higher margins involved with the digital stream, they account for more than 40% of the gross profit. Increased sales allowed GameStop’s gross margin to grow from 33.5% in the second quarter of 2012 to 34.8% in the last quarter. We expect a continued improvement in GameStop’s margins as it shifts from a physical retailer to a hybrid digital and physical retailer.

Looking Good For The Transition

GameStop has maintained a market share of over 30% in most of the markets it operates in. The company has increased its launch period supply chain capacity by 60% to cope with increased demand for the upcoming Microsoft (NASDAQ:MSFT) X-Box One and Sony Playstation 4 which are expected to be released this holiday season. GameStop has over 700,000 PowerUp Reward customers on the Microsoft first to know list and 1.5 million on the list for Sony.

While software sales have been decreasing through the last year, we believe that gamers are still interested in traditional console style games. Sales of the top five titles increased 7% through the first six months of 2013 ^[1], even as total retail sales fell as Electronic Arts (NASDAQ:EA) and Activision reported strong sales for their flagship titles like FIFA, Madden, Call of Duty and Skylanders. Video game hardware, and software sales grew by 60% during the Xbox 360’s first full year in the market while PS3 sales grew by 30%. We expect a long term increase in GameStop’s new software sales from 2014 onwards.

The Trading Business

Pre-owned game sales are a big business for GameStop accounting for nearly 40% of sales and half of the gross profit. The company reported a 6% decline in used game sales for the second quarter, but beat the U.S. market which fell 7.7%. Used game sales are highly correlated with new game sales as the sale of new games replenishes GameStop’s inventory. Pre-owned game sales have consistently been around 65% of new software sales for the last four years and we expect this trend to continue through the next console cycle.

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