This Gaming Company is Far From Dead

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

GameStop (NYSE: GME) had a down quarter. In Q3 2012, the company reported an 8.9% decrease in revenue and, excluding the impairment charge (a non-cash charge), had net earnings of $47.2 million. Adjusted earnings per share is down $0.01 year over year. Currently, the company has a 4.10% dividend yield and a PE of about 10 (using adjusted earnings).

GameStop is an intriguing investment. The company is a traditional video game retailer. It has 6,628 company operated stores with around 4,500 stores in the US. It has a well established trade business in used PCs, Microsoft (NASDAQ: MSFT) Xbox 360, Sony PS3, Nintendo Wii, and other video game devices. However, the company is not standing still.

In 2011, GameStop moved into the mobile device market and started to accept trades of Apple (NASDAQ: AAPL) mobile devices, i.e. iPod, iPhone, and iPad, and select Google (NASDAQ: GOOG) Android tablets. The company exchanges store credit or cash for the device, refurbishes it, and then resells it for a profit. The company also sells new Android and iOS devices. In addition, GameStop bought Spawn Labs and Impulse. These acquisitions are part of the company’s initiative to expand beyond the physical distribution of games and move into digital distribution. GameStop uses Impulse to power its GameStop PC Download, which as its name implies distributes PC games through downloads. GameStop is using Spawn Labs to develop its cloud gaming expansion.

These moves are good initiatives for the company. Mobile devices are on a massive rise. In Q3, global smartphone shipments increased by 46.4% year over year. The two leading operating systems were Android (75%) and iOS (14.9%) (IDC). Similarly in Q3, tablet shipments increased 43% year over year and Android and iOS had 41% and 57% global market shares, respectively (Strategy Analytics). GameStop is moving into mobile devices because mobile devices are also gaming devices. According to NPD Group, 59% of total gaming by app gamers is done on mobile devices. Selling gaming mobile devices (i.e. mobile devices built for gaming) fits in perfectly with GameStop’s business model. By building on its previous experiences with trades for video games, GameStop has expanded its lucrative trade business into the rapidly growing mobile device market. In Q3, mobile sales and digital receipts generated $43.2 million and $127 million in sales, respectively.

Currently, video game sales are down. In October, US sales of video games including hardware and accessories declined by 25% year over year. Console sales declined by 37% year over year. While the decline in sales is not good, it is most likely a short term trend. The current generation consoles (i.e. Xbox 360, Wii, and PS3) are near the end of their product life. Nintendo will be launching its next generation console, the Wii U, on November 18. This means that Sony and Microsoft will probably release their next generation consoles soon, likely in 2013. The declining sales can be attributed to consumers waiting for the launches of the next generation consoles.

Looking forward, in the (very) long term, some investors are probably concerned that GameStop’s video game business is in trouble because digital distribution is clearly on the rise. Digital distribution is already popular in mobile devices. If digital distribution of video games takes off, then GameStop will lose a big part of its income. In 2011, sales of new video game software and sales of used video game products accounted for 22.7% and 47.9% of the company’s gross profits, respectively. However, there are big disadvantages to the digital distribution of video games.

First, digital distribution of video games (for consoles and PCs) is at the mercy of the customer’s internet connection. Video game companies will lose the business of people who do not have a good connection. The amount of data that needs to be transferred is a lot and can take a long time even on a fast connection. Furthermore, the average amount of data in games continues to increase as games become more complex. There would have to be massive increases in bandwidth for digital distribution of video games to become favorable.

Second, under digital distribution, reselling games becomes more complicated. Instead of just handing over a disk, people would have to remove the game from their console and install it on the other person’s console all without the use of physical media. Digital distribution would kill the market for used games. Finally, the cost of owning video games would increase because people would have to keep buying external memory to store all their games. As for storing the games on the cloud, again, there would have to be massive increases in bandwidth for this to be feasible. Digital distribution of video games will not supplant physical media any time soon.

In summary, GameStop is a good investment. While the gaming industry is currently declining, investors can wait for better times while collecting a 4.1% dividend. When the next generation consoles come out, the gaming industry should recover. In addition, the company has expanded into the quickly growing mobile device market and is investing in digital distribution and cloud gaming. At a PE of about 10, GameStop is a compelling investment.

Alvin owns shares of Microsoft. The Motley Fool owns shares of Apple, GameStop, Google, and Microsoft. Motley Fool newsletter services recommend Apple, GameStop, Google, and Microsoft. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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