GameStop Q1 Earnings: Next Gen Consoles & Pre-Owned Value Gaming Drives Margins [Part 1]

Video game retailer GameStop (NYSE:GME) released its first quarter report for fiscal 2014 on May 22, reporting a 24.5% year-on-year increase in net income. Consolidated global sales were $2 billion, up 7% over the prior year period, of which 3% growth was due to technology brands, whereas comparable store sales were in line with the company’s guidance, as the figure grew 5.8%. Diluted earnings per share grew 28% to 59 cents, almost at the higher end of company’s quarterly guidance. ^[1]

Gross margins widened by 40 basis points to 31.4% due to expansion in the pre-owned product margin rate and higher margins in technology brands businesses as a result of strong wireless promotions, resulting in a first quarter record-high gross margins for GameStop. The company ended the quarter with 6,680 stores – 4,215 U.S. video game stores, 2,195 international video game stores and 270 technology brands stores.

GameStop is still positive on its outlook for the upcoming quarters, as they believe strong new hardware sales will subsequently translate into better software sales, which would be strengthened by the release of new major selling titles such as Destiny, Assassin’s Creed and Call Of Duty in the later half of the calender year. Moreover, the company is eagerly looking forward to the Electronic Entertainment Expo (E3), an annual trade fair for the video game industry, to be held in the second week of June 2014. ((GameStop Q1 earnings call transcript, May 2014)) GameStop believes that this event provides them with a chance to recognize new innovations that will help them drive revenues in future and meet the strong consumer demand.

The success of next generation consoles, growth in digital segment and the exponentially increasing technology brands segment were responsible for the strong financial and operational results in Q1. In this article, we will focus on the strong growth in revenues and margins due to the company’s core profitable businesses: Pre-Owned Products & Value segment, that basically works on the buy-sell-trade strategy of GameStop, and Video Game Hardware & Software segment. These segments combined, account for nearly 70% of the company’s total value according to our estimates.

In a later following article, we will take a look at the two new areas of focus for the company – the Technology Brands segment and Digital & Retail PC segment. GameStop has recently shifted focus to these two segments due to the growing popularity of the digital content in gaming and the scope of expansion in complementary technology.

Our price estimate for the company’s stock is $47, implying a premium of 35% to the current market price.

See our complete analysis of GameStop

Tremendous Success In Next Generation Console Sales

According to research group NPD, the first six months’ hardware unit sales of the PS4 and Xbox One are 107% higher than that of the previous generation. ((April NPD report, 2014)) GameStop had a six-month hardware unit sales growth of 182% over last generation’s sales. The first quarter witnessed an 81% growth in hardware sales as compared to a 20% decline in software sales, slightly higher than 18% market-wide decline in the U.S. The decline was due to fewer gaming titles launched this year compared to prior period last year. However, the success of new hardware consoles portends the revival of software sales and since GameStop accounts for nearly 40% of the software sales in the U.S, it is likely to benefit the most when software sales pick up the pace, which is most likely seen in the fourth quarter every year.

While the competitors are selling hardware at discounted rates, GameStop is also capturing majority of the growth in the more profitable segments, which is helping them drive the market share. New Hardware gross margins were 10.2% and software gross margins were 22.7%, both in line with the guidance presented in the Investor Day report. ^[2] Both the segments are performing well, as is evident from the fact that GameStop is driving nearly 40%  and 83% of the total dollar growth, in hardware and software respectively.

The hardware segment accounts for only 19% of the company’s total revenue and nearly 6.5% of the total gross profit, as of 2013. On the other hand, the software segment accounts for about 38% of the company’s total revenue and one-third of the total gross profit. So the next few quarters are expected to be the revenue generating periods for the retail giant, if software sales accelerate.

The upcoming Ubisoft’s Watch Dogs title have the most pre-orders for the next-gen consoles, and the trend might continue with Destiny and other games to be announced at E3. Trefis estimates an annual growth of around 8% in the new video game software revenue per square foot in 2014, most of which would be seen in the later half of the calender year as the company usually earns 40% of its revenue in the fourth quarter.

Pre-Owned & Value Products : Console Growth Drives Margins

The company’s integrated buy-sell-trade model has been a vital segment in the company’s core business for the past few years. Pre-owned product sales during the quarter grew 5.3% year-over-year, with a 7% growth in the U.S. This growth is consistent with the company’s 2014 guidance and reflects the success of new console cycle and consumer demand for pre-owned products. Around 30% of the next generation hardware and software has been purchased with the help of trade credits, indicating consumers’ interest in the model and providing inventory for growth of this segment in 2014. The highlight of this quarter was that the pre-owned and value product gross margins rise to 49.5% due to improvement in margins of consoles. The PlayStation 4 and Xbox One do not have enough volume in this segment and are yet to impact its growth rate.

GameStop is expanding its pre-owned business by adding lower-priced products to the division, including softwares with price points below $20 (Sub $20 games), resulting in an increase in the external purchases of pre-owned products by 52% y-o-y for the first quarter. The value products (sub $20 games), while still in the early stage, is performing well as the company sourced over $20 million in product from publishers and manufacturers.

GameStop’s pre-owned software sales are highly correlated with new game software sales, as the latter help replenish the company’s inventory; pre-owned game sales have consistently been around 65% of new software sales for the last four years.

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1. GameStop 8-K SEC filing, Q1 May 2014 [↩]
2.  GameStop’s Investor Day, April 22, 2014 [↩]