Strong Hardware Sales and Digital Domain Segment To Drive GameStop’s Revenue In The Holiday Quarter

Video game retailer GameStop (NYSE:GME) is scheduled to release its third fiscal quarter earnings report on November 20. ^[1] The company might deliver strong hardware sales yet again, as both the next generation consoles- Microsoft’s (NASDAQ:MSFT) Xbox One and Sony’s PlayStation 4- are still in strong demand among the gamers. According to the research group NPD, gamers spent nearly $1.6 billion on hardware over the last six months, up 102% year-over-year (y-o-y). On the other hand, consumer spending on new physical game sales over the last six months in the U.S. was nearly $1.8 billion, down 11% y-o-y, primarily due to lack of core titles for new consoles.

The digital revolution, particularly the advent of extra downloadable content (DLC), has revolutionized the gaming industry and gamers are shifting from physical games to digitalized content. However, GameStop has managed to gradually adapt to this trend and has kept itself strong in the industry. The company’s unique buy-sell-trade model has been a huge success, with gamers trading old hardware, software and other accessories for new products using trade and other reward points. Moreover, the company is more driven towards the expansion of its technology brands, due to the scope of expansion and growth opportunities in the technology sector.

Our price estimate for the company’s stock is $43, which is slightly below the current market price.

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GameStop’s Digital Shift

Many people are bidding down on GameStop, whose core business has been the sales of physical media, which includes physical software and hardware accessories. However, the company is gradually shifting its business model, by entering into the digital domain. According to our estimates, the Retail PC and Digital Segment’s gross margins were 39.5% in 2013. GameStop also believes that the future growth in the electronic game industry will be driven by sales of inter-game content available in digital form.

The company’s strategy of pre-selling extra downloadable content (DLC) at the time of launch has helped the company to sustain its market share. Gamers prefer this strategy as opposed to buying content mid-game, which generally foils their experience. To attract more customers, the company is offering PowerUp Reward points for all the digital purchases, which currently has nearly 28 million members in the U.S. and over 37 million worldwide. For the fiscal 2013, the digital receipts grew 15% to $720 million, which along with the mobile sales represents over $1 billion business. In the second quarter, GameStop’s digital receipts grew 18%, with console digital increasing 13% and PC digital rising 24%. ^[2]

With the growing popularity of the concept and increasing demand for easily accessible digital content, the segment’s margins are expected to grow in the upcoming quarters. Trefis expects margins to rise minimally in 2014, but remain a major driving force over the long term.

Hardware and Software Sales To Drive Growth

With the excellent industry-wide hardware sales and the launch of blockbuster titles by major game developers, such as Electronic Arts’ (NASDAQ:EA) and Activision Blizzard’s (NASDAQ:ATVI), one can expect the company’s core segments to outperform last quarter’s performance. In the second quarter, the sustained momentum in new console sales boosted new hardware sales to $332 million, up 125% y-o-y. This eventually led to a 22% y-o-y increase in the company’s comparable store sales, up 19.7% in the U.S. and 26% internationally.

Despite the dull software titles market in the second quarter, GameStop reported positive growth in software sales, which were up 16% y-o-y. Moreover, the company’s overall share increase by 240 basis points in the video game software market share in the second quarter, as software sales rose 8.5% in the U.S. Comparatively, there was a wide range of popular titles during the third quarter and some of them posted strong initial sales figures in North America and Europe. As a result, we can expect stronger performances from these segments in this quarter.

Pre-owned Product Segment Directly Co-related To Core Segments

GameStop’s Pre-owned and Value product segment still remains the highest revenue generating segment for the company, with $558 million net sales in the second quarter, up 5.5% y-o-y. ^[3]

The company is gradually tapping into a much wider technology market, with a huge potential for accelerated growth. In Q2, the company opened 49 new technology brand stores bringing the total count to 319 and are on pace with its target of 300-400 tech brands in 2014. GameStop ended the second quarter with 6,379 video game stores, out of which 4,197 are in the U.S. and 2,182 at international locations.

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1. GameStop: Q3 earnings conference call [↩]
2. GameStop Q2 2014: Earnings call transcript [↩]
3. GameStop Q2 2014, 8-K)) Healthier inventory positions, coupled with expansion of the international loyalty programs to engage customers drove the segment’s sales. GameStop’s game sales through buy-sell-trade model are highly correlated with new game 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. Furthermore, the transition of gamers to next-gen consoles might give a push to already strong console trades and might result in improved pre-owned inventory. An increase in software and hardware sales in the holiday quarter might further boost the performance of pre-owned product segment.

   We estimate the revenue from this segment to have a double digit growth of around 15% over the prior year and to account for nearly 43% of the company’s gross profit in the fiscal 2014.

   Technology Brands To Provide Future Growth Opportunities

   GameStop added the Technology brand segment in the fourth quarter last year, after it acquired Spring Mobile and Simply Mac brands. It is the company’s fastest growing segment, accounting for 19% of the company’s operating profit in Q2. The company witnessed higher gross margins in the technology brands segment in comparison to the margins in the Video Game Brands segment, as a result of acquisition activity in the former over the last two fiscal quarters, offsetting potential margin erosion associated with the lagging new video game software sales. The company estimates that the annual sales per store from Simply Mac. in 2014 alone will surpass the corresponding figure of GameStop’s video game stores; $2-$3 million annual sales per store as compared to $1.3 million from GameStop stores.(( GameStop’s Investor Day, April 22, 2014 [↩]