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Assessing GameStop as an interesting investment opportunity

Part 2
Assessing GameStop as an interesting investment opportunity (Part 2 of 5)

Why GameStop’s video games segment looks optimistic

Video games market overview

The video game market is somewhat asynchronous or acyclical with the macroeconomic business cycle in that the timing of new consoles tends to dominate any broader retail trend. This is not to say that GameStop (GME) shares did not suffer immeasurably in the dark days of 2008, but rather that operations held up well: sales still grew 3% and 4% in the 2008–2009 calendar years, with firm margin holds above calendar 2007 and over $800 million in free cash flow.

GME3Enlarge Graph

Far more important are console cycles: the launch of new (and more powerful) gaming hardware to replace the prior generation’s machines. There is a threefold impact across the video game landscape:

  1. New hardware sales experience a one-time surge along with greater software attachment as eager gamers add launch-day titles to complement their new systems. From GME’s perspective, this surge has typically lasted about one to two years (see FY07, which followed the November 2005 and November 2006 launches of Xbox 360 and PS3, respectively).
  2. New software sales experience a more prolonged surge for two to three years as development cycles adapt to the capabilities and consumer reception of the new software.
  3. Used game/product sales, interestingly, grow and become more profitable through the refresh phase as gamers seek to trade in their older generation hardware/software to earn credit against the new. The margin improvement is indicative of GME’s ability to extract greater share of the salvage value from gamers as perceived obsolescence leads to more price compromises on the gamer’s part.

Industry watchers who were tolling the death knell of physical formats were probably surprised by NPD’s May 2014 statistics in which gamers spent $274 million on physical software—20% more than April and 57% more than prior year. The industry pipeline for new titles is expected to be considerably stronger next year and it appears that none of these major titles are being marketed as all-digital formats.

GME7Enlarge Graph

Indeed, the console cycle’s sophomore expansion of new game supply is generally consistent with the prior game cycle. A prolonged new game cycle suggests a likely second wind for the used game refresh as gamers work through the launch year supply before turning their attention (and trade-in credits) elsewhere.

GME4Enlarge Graph

In terms of distribution, GameStop’s highest-spending gamers tend to be in smaller cities like Huntington, New York, or Laredo, Texas. Above is a map of Huntington with the locations of video game retailers relative to one another and the city center. GameStop has four stores within a 14.5-mile perimeter right outside the official border of Huntington and across the East Jericho Turnpike. World Gamer Nation (or WGN) and Play N Trade both have superior locations but lack the footprint and larger scale of GME; WGN is a single store and Play N Trade appears to be a sub-$50 million business with just over 100 stores nationwide.

The Market Realist Take

GameStop’s new video game hardware sales increased 81.1% year-over-year to $438.0 million in 1Q 2014. The rise was mainly due to a hardware unit sell-through as a result of the launches of the Microsoft Xbox One and the Sony PlayStation 4 in November 2013. These increases were partially offset by declining sales of earlier-generation hardware.

New video game software sales decreased 20.4% to $559.9 million in 1Q 2014. This was mainly due to fewer triple-A titles launched during the quarter. Pre-owned and value video game product sales increased 5.3%, mainly due to increased store traffic during the quarter related to higher video game demand due to the launch of the new consoles. Video game accessory sales rose 14.8% due to accessories for recently launched consoles.

The company said in its latest 10Q report that it expects “that future growth in the electronic game industry will also be driven by the sale of video games delivered in digital form and the expansion of other forms of gaming.”

GameStop sells various types of products that relate to the digital category, including digitally downloadable content (or DLC), Xbox LIVE, PlayStation Plus, and Nintendo (NTDOF) network points cards. It also sells prepaid digital and online timecards. The company has invested in boosting its e-commerce and in-store and website functionality to let customers access digital content easily and facilitate the digital sales and delivery process. It expects to further make investments to “grow its digital sales base and enhance market leadership position in the electronic game industry and in the digital aggregation and distribution category.”

Digital revenues were flat compared to the corresponding period a year ago. Gamestop said on its earnings call that “non-GAAP digital receipts totaled $189.7 million, an increase of 9.5% over the first quarter of 2013. Digital growth was driven by digital currency and strong PC digital sales in our international markets.” The management noted that “Digital receipts are becoming a meaningful part of our business as this quarter’s digital receipts equal about a third of our physical software sales.”

According to research firm The NPD Group, hardware sales surged 95% year-over-year in May to $187 million driven by Sony’s (SNE) PlayStation 4 and Microsoft’s (MSFT) Xbox One. Spending on physical gaming software (console plus portable) increased 57% to $274 million. Total physical gaming software (console plus portable plus PC) rose 51% to $284 million. Physical gaming accessories were up 8% to $124 million. Software performance was driven by new releases such as Ubisoft’s (UBSFF) Watch Dogs, Nintendo (NTDOF) Wii U’s Mario Kart 8, Wolfenstein: The New Order, Activision’s (ATVI) The Amazing Spider-Man 2, and Kirby: Triple Deluxe.

Liam Callahan is an NPD Group games industry analyst. Twice.com cited Callahan saying, “As seen in prior months, the lift in hardware sales was driven by console hardware, which increased 137% in May 2014 (vs. May 2013). While much of May 2014’s hardware growth was due to Xbox One and PS4, there was also year-over-year growth for the Wii U, and PS Vita.”

In 2013, consumers spent a total of $15.39 billion on video game content in the U.S. According to the 2013 Games Market Dynamics: US report from global information company NPD, “$6.34 billion was spent in the U.S.by consumers on new physical video and PC game software during 2013. The total consumer spend on other physical forms of content (used and rental) reached $1.83 billion, and content in digital format (full game and add-on content downloads, subscriptions, mobile games and social network games) generated $7.22 billion.”

NPD noted that strong hardware performance in the fourth quarter led to a positive year for the category, which ended the year 5% higher than in 2012.

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