GameStop Versus Digital Distribution

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GameStop (NYSE: GME) boasts the title of being the largest video game retailer and claims an impressive foothold with over 6,500 stores spread across North America, Australia, and Europe. The retail giant rode a wave of success during the seventh generation of console gaming (i.e. Xbox 360, PlayStation 3, Wii) and, even after the recession, GameStop still returned 120%.

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The way consumers purchase and consume video game content is changing. Mobile and tablet gaming was almost non-existent in 2005, but now accounts for 15% of the $65 billion worldwide gaming market; social gaming is around 12%, and PC gaming (which is almost exclusively handled through digital downloads) accounts for 18%. That is 46% ($30 billion) of the market that GameStop is missing out on due to the growth of the digital downloads.

Winter (2013) is coming…

This holiday season, Sony (NYSE: SNE) and Microsoft will release the PlayStation 4 and the Xbox One, respectively. Since their console reveals, both Sony and Microsoft confirmed that digital versions of games will release day-and-date with the physical retail disk. After E3, Sony released a video on how the User Interface of the PlayStation 4 would operate. In the video, one of the actors purchases a new title via the PlayStation Network -- which has cut out the physical retail aspect and nullified any possibility of that title being resold at GameStop.

The release of the PlayStation 4 and the Xbox One will increase foot traffic and sales revenue, but will provide only a small bump to the profit margins. This is due to the low margins that retailers get from the sale on new hardware and new games. A statement from GameStop’s 10-Q:

Typically, following the introduction of new video game platforms …The net effect is generally a decline in gross margin percentage in the first full year following new platform releases and an increase in gross margin percentage in the years subsequent to the first full year following the launch period. The planned launches of the next-generation Sony PlayStation and Microsoft Xbox by the holiday period of 2013 will negatively impact our overall gross margin percentage in the fourth quarter of fiscal 2013.

The report goes on to say:

As video game platforms mature, the sales mix attributable to complementary video game software and accessories, which generate higher gross margins, generally increases in the subsequent years.

As more consoles are sold, more games are purchased, leading to more opportunity for consumers to resell their old games back to GameStop; however, with digital downloads growing -- how will this business model hold up?

Digital sales growing

On May 7, video game developer Electronic Arts (NASDAQ: EA) released results for Q4 of 2013. In the report, a chart (shown below) shows how impact of digital sales affected EA’s revenue. From fiscal year 2010 to fiscal year 2013, EA saw revenue from digital content grow 191%, and forecasts digital sales to account for approximately 42.5% of overall revenue for fiscal year 2014.

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<table> <thead> <tr><th> <p>Fun Facts: Q4 FY13 Update (EA)</p> </th><th> </th></tr> </thead> <tbody> <tr> <td> <p><strong>Digital Revenue:</strong></p> </td> <td> <p>In Q4, grew 45% Year-over-Year</p> </td> </tr> <tr> <td> <p><strong>Growth Margin:</strong></p> </td> <td> <p>74% for the quarter, up almost 10% over the prior year, driven by digital revenue offerings</p> </td> </tr> </tbody> </table>

Chart and facts obtained from Q4 2013 – Slide Presentations

As seen from EA’s numbers, in particular the Net Revenue chart (purple), the impact of digital sales in the overall revenue stream. Take a peek at Activision Blizzard’s numbers for Q1 2013 and the impact of digital is similar with digital sales making up approximately 33% of revenue.

Will GameStop survive?

GameStop's management is sitting pretty comfortable at the moment. In the last two years, shareholders have seen their investment grow 55% along with a newly implemented dividend. In the short-term, GameStop is riding well. Despite all these facts, GameStop does have time to acquire, grow, and expand to prepare for the digital future. The question is -- will it be able to adapt in time?

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David Henry owns shares of Microsoft. The Motley Fool owns shares of 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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