The Used Video Game Problem

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

Used video game sales make up about a quarter of GameStop's (NYSE: GME) business. It's an important part of the industry that the internet is slowly destroying. 

The Used Game Market

GameStop is the largest video game retailer in the world. It has over 6,500 stores in 15 countries. It competes with retail giants like Wal-Mart and Target in the video game market and, impressively, holds its own. Part of that success is the company's willingness to accept old games and game systems as trade ins.

This is such an important part of the business, in fact, that GameStop has gone on the offensive with game and console makers. The company discussed this effort at a Goldman Sach's conference, in which it highlighted that only a small percentage of new games are traded in within the first three months of release (used games are, thus, not a competitive threat to new games), that trade ins provide customers a means to purchase new games, and that customer research suggests that customers want to own physical copies of their games.

Technology is Changing

None of this, however, changes the fact that technology is making downloading games much easier. So, Sony's PlayStation 4 and Microsoft's (NASDAQ: MSFT) Xbox One will both offer enhanced downloading capabilities. GameStop offers downloadable content too, but clearly the game and console makers would prefer to cut out the middle man.

That said, GameStop should see a big boost in sales toward the end of the year as the new game consoles come out. The ability to trade in older game systems will be a huge selling point for customers looking to upgrade. Any bounce should last well into next year, so GameStop shares could extend their recent run, and fiscal 2013's top line drop should be easily reversed even if sales are weak until the consoles hit store shelves.

Self Inflicted Wounds

Microsoft, meanwhile, had originally planned to limit the ability of customers to trade and sell games. That turned off its core customers, who view buying and selling physical copies of a game as a right, not a privilege. The company quickly backpedaled on that decision, but the gaff, and a $100 price premium over Sony's PlayStation 4, may lead gamers to prefer the less costly console.

Sony, meanwhile, scored a public relations win when it  stated that it wouldn't impose any limits on physical copies of games. Moreover, as Microsoft has focused on selling the Xbox as a media center, Sony has pitched the PlayStation directly at hard-core customers. Sony clearly looks to have an early edge, though the machines aren't out yet.

The Real Winners

While Sony and Microsoft duke it out and GameStop fights to remain relevant over the long term, the new systems are likely to be particularly beneficial to game makers. True, GameStop will see a nice boost in the near term, but those sales will also flow through to Activision Blizzard (NASDAQ: ATVI) and Electronic Arts (NASDAQ: EA).

Game sales spike when a new console upgrade cycle begins. Electronic Arts will be happy about that, since its top line has fallen year-over-year in each of the last four quarters. That's likely because customers are waiting for the new game machines before spending their money. Still, the company needs to reverse the sales trend as soon as possible.

The company's profit margin is in the low single digits right now, but increased sales could quickly boost that figure since selling additional copies of a game is virtually cost free once the software has been written. While a return to margins in the low 20's is probably a ways off, low teens isn't an unreasonable expectation. If that happens, there's decent upside potential for both earnings and the shares, but investors will likely have to buy in before the consoles hit the market.

Stronger, but Still Waiting

Activision Blizzard, meanwhile, has posted higher annual sales in each of the last 10 years, even through the 2007 to 2009 recession. So, clearly, the company is better positioned than EA right now. In fact, after the bottom line dipped into the red in 2008, Activision's earnings have rebounded strongly reaching their highest levels of the decade (around a dollar a share last year), with profit margins nearing 30%. That said, it wouldn't be surprising if sales were relatively weak until the holiday season.

The shares appear to have broken out of the range they've been mired in since the end of the recession. So momentum investors might find it of interest. That said, the company's strong results with the prospect of a boost from game console launches should interest growth investors, too. Like its main competitor, though, getting aboard before the new consoles hit is probably a good idea.

Used Games

Activision and EA will ultimately benefit from both the launch of new game machines and the natural shift toward online game sales. While GameStop should see a quick boost from used game trade ins at the start of this upgrade cycle, longer term this important business is dying. That said, Microsoft's failed effort to speed up the demise of the used game market may be a strategic error that helps shift gamer loyalties to Sony.

While Activision and Microsoft have been taking the headlines when it comes to console gaming, Fools following the gaming sector would do well to also keep tabs on Electronic Arts. The Motley Fool's new special report breaks down the risks and opportunities facing the company to help you decide if EA is right for your portfolio. Click here to get your copy now.

Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard. The Motley Fool owns shares of Activision Blizzard, GameStop, 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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