Don’t Buy Into GameStop’s Supposed Saviors

Matt is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It’s a minor miracle in and of itself that GameStop (NYSE: GME) is still alive. Their business model within the video game industry is eerily similar to that of Blockbuster’s within the home movie industry a few years ago. How can a store which sells hard copies of a digital product persist while customers can download that same product for lower prices from the comfort of their own home? Simply put, in the long run it can’t.

Yet, GameStop’s advocates continue to cling to two bright spots in the company’s future. First, GameStop continues to show strong sales in the used game market. Second, GameStop has entered and will continue to penetrate the digital download market. Don’t buy the hype: these are nothing more than red herrings.

The Used Game System will Fall Apart

About a third of GameStop’s sales last year came not from new releases, but from the sale of video games traded in for store credit. The company’s “PowerUp Rewards” system was admittedly quite a clever idea: customers buy new games, play through them (often very quickly), and then trade the games in for store credit which gets a discount on the purchase of other used games. The result is a loyal, constantly repeating fan base which both buys from and supplies the company, to the tune of well over $3 billion per year, or a third of GameStop’s total revenue.

As a former member of this system, I cannot see it lasting much longer. The problems are two-fold; the selection of used games is weak and the deals just aren’t very good.

Which used games are available to a customer are directly connected to whatever games were redeemed at the given individual stores the customer lives near. This might not be a big deal for gamers in New York City, but it is a serious problem for people in less populated areas, especially when rare items are desired. On top of that, the trade-in values range from a mere 20-50% of the original purchase price.

Honestly, I am surprised that online retailers like Amazon (NASDAQ: AMZN) haven’t already destroyed GameStop’s used sales. Not only is the selection variety practically infinite (as of writing this, typing "video games" into their search bars net 173.5 thousand results), but resale prices are often close to 90% of the original purchase price, especially near launch day. And of course, you don’t get store credit, but cold hard cash.

It also doesn't help GameStop that Amazon continues to streamline its video game sales. Amazon now regularly sends targeted emails about new items and sales to customers of specific product lines, therefore encouraging repeat purchases. I personally receive an email every week or two about the newest video game deals offered. Amazon is even specifically targeting GameStop as a competitor. For Labor Day and Black Friday, Amazon matched nearly all of GameStop’s special sales, even at 50% discounted prices. Better yet, Amazon launched its own Video-Game Trade in program (for Amazon credit) in 2009 which beats GameStop’s redemption rates so consistently that it cannot be coincidental. In addition, trade-ins give the users discounts on video games and accessories that change weekly. While solid data isn't currently available, the trade-in system has a great design and will likely cut into GameStop’s used game market considerably.

The Digital Download Market is too competitive

Earlier in November, GameStop announced its intentions to close 1% (200) of its retail stores worldwide over the next year. The reason was obvious, physical game sales plunged by almost 30% during the first two quarters of 2012. Hard copy distribution is dying. To GameStop’s credit, they are attempting to adjust to this obvious market trend with their own DLC (downloadable content) platform which has been growing revenues at 40-50% every year for the last few years to constitute a full 46% of total revenues thus far in 2012.

That all sounds great until it is noted that digital distribution sales more than doubled every year at the same time. The digital distribution market is being flooded with more competitors than GameStop can handle. Recall that in physical distribution, GameStop only has to deal with Best Buy, Wal-Mart, Target, and a handful of other small retailers, all of whom consider video game sales to be a rather unimportant component of their overall business model. But online, GameStop is competing against Microsoft’s XBOX Store, Sony’s PlayStation Online, Nintendo’s Wii Network, Valve’s Steam, Electronic Art’s Origin, Blizzard’s Battle.net, and dozens of other smaller retailers. Furthermore, nearly all of these networks have well established (if not fanatical in the case of the XBOX Store and Steam) fan bases with engrained console and company loyalties.

GameStop’s digital distribution program’s competitive disadvantage is already showing.  It gets little to no support from the rapidly growing indie game market that has flocked to Steam’s dirt-cheap distribution costs. The actual process of downloading the games is needlessly complicated since buyers have to purchase a code online and then input it later into their console. And PC sales in general have essentially abandoned GameStop as Steam alone controls more than 70% of the PC game market.

GameStop’s Bleak Future

I cannot say how much longer GameStop will last. Its “PowerUp Rewards” system has probably instilled enough brand loyalty and created enough store credit to keep the company afloat for some time, especially with a new console generation coming up to temporarily boost hardware sales. Yet, shorting GameStop for the foreseeable future is a no-brainer for any investor with an eye on the video game industry.

 


Dormin123 has no positions in the stocks mentioned above. The Motley Fool owns shares of GameStop. Motley Fool newsletter services recommend eBay and GameStop. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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