GameStop’s (NYSE:GME) stock plummeted 20% as the video game retailer announced a 22.5% year-on-year decline in new software sales for the nine-week holiday period ended January 4, 2014.  The company lowered its guidance for fourth quarter EPS from $1.97-$2.14 to $1.85-$1.95. This period is crucial for GameStop as more than 30% of its sales occur during this holiday time frame. Although new video game console sales were up 99.8%, leading to a 10% increase in comparable store sales, the single-digit margins associated with hardware sales did not inspire confidence among investors. New software sales have a gross margin of 22% and account for 30% of GameStop’s profit, while hardware sales have a margin of 7% and account for less than 5% of the gross profit.
Despite the pessimism surrounding the company, we believe that strong sales of the next generation Sony and Microsoft consoles portend a boost in earnings in the coming quarters. The console product cycle has been refreshed after eight years, and it can take some time for consumers and game publishers to catch up. This was observed in the last product cycle as well. The Xbox 360 was released in November 2005 and the Playstation 3 was launched in the following year. However, the true impact of the new product cycle was felt only after 2007, the first full year that Xbox 360 and Playstation 3 were in the market, as software sales jumped 43% in 2007.  GameStop’s sales increased nearly 200% from 2005 to 2007. We expect the retailer’s new software sales to pick up in the coming months.
Our price estimate for the company’s stock is $54, implying a premium of 50% to the current market price.
Used Games Are Still Strong
Pre-owned games are the real cash cow for GameStop, with high margins of close to 50%. Used game sales account for 30% of the company’s sales and half of its gross profit. Sales are highly correlated with new game sales, as the latter replenishes GameStop’s inventory; pre-owned game sales have consistently been around 65% of new software sales for the last four years. The company reported a 7% increase in used game sales during the holiday season, driven by strong demand for previous generation used games. Both Microsoft and Sony will allow used games to run on their eighth generation consoles, which will allow GameStop’s sales to grow further. We expectdouble-digit growth in used game sales through 2015.
Will Mobile/Digital Trends Make GameStop Obsolete?
The gaming world has been revolutionized by the advent of mobile gaming in the last few years. Casual gamers are turning more to mobile and tablet platforms. To make matters worse, publishers like Electronic Arts (NASDAQ:EA) and Activision Blizzard (NASDAQ:ATVI) have cut down on the number of titles launched and are instead focusing on efficiency through the digital domain. EA released 60 titles in fiscal year 2009 and 54 in 2010, earning $60 million per title. In fiscal 2013, the company launched 35 titles (13 on consoles and PCs and 22 on mobile and internet platforms), but its revenue per game increased to $108 million. EA has been able to achieve this through secondary streams such as time-based subscription services and game-related content that needs to be downloaded.
GameStop has been able to adapt to this trend by pre-selling digital downloadable content (DLC) and delivering it on the day of launch. The retailer 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 longstanding relationships with publishers, which allow it to maximize its offering. During the launch of Disney Infinity, GameStop offered customers the opportunity to pre-order over $400 worth of characters playable in the game. GameStop was also the only U.S. retailer to offer the exclusive $150 collector’s edition of Grand Theft Auto V. During the holiday season, the company reported a 15% increase in digital revenues, accounting for 7% of total sales. Although there is a possibility that GameStop could lose out to this trend in the long term, we believe that it is currently well-positioned to capitalize on the digital revolution.
As for casual gaming, strong sales of Rockstar Games’ Grand Theft Auto V, Activision’s Call of Duty: Ghosts and Electronic Arts’ FIFA 14 as well as the new consoles, indicate that hardcore gamers will continue to play on traditional platforms. EA has also suggested plans to integrate mobile and tablet gaming with console gaming, suggesting that the two streams might be complementary rather than competitive. GameStop is foraying into the mobile domain with the acquisition of Spring Mobile, a mobile retailer, and the launch of Simply Mac, a store for Apple products. The company reported a 24% increase in revenues from its mobile division, accounting for 3% of total revenues.
GameStop is the biggest video game retailer in the U.S., with more than half of the Xbox 360 and PS3 titles sold in the U.S. during the September quarter coming through the company’s stores. As the console cycle progresses, the company should see an increase in new and old software sales. However, considering that mobile gaming can have a cannibalization effect on console software sales, we remain conservative in our forecast. We expect a 7% increase in sales through 2014 and 2015. A double-digit (around 15%) increase in new software sales through the first two years of the new gaming console product cycle would lead to a 5% increase in our forecast for the company’s revenues and a 10% increase in our estimate for gross profits. There is a 10% upside to our price estimate in this scenario.Notes: