If you've held GameStop (NYSE:GME) over the last year, you've likely followed your money on a wild and profitable ride. The doom and gloom surrounding the adoption of digital distribution proved premature, and a stronger-than-expected performance from the Nintendo (NASDAQOTH:NTDOY) 3DS wound up being just one of many positive indicators for GameStop's model. The company's price doubled on the calendar year, also benefiting from the successful launches of the Sony (NYSE:SNE) PlayStation 4 and Microsoft (NASDAQ:MSFT) Xbox One.
Now, GameStop has declared that 2014 is "The Year of Gaming." The company's new promotional line mirrors its desire to see November's record hardware sales continued along with a return to healthier software numbers and new opportunities to push used games. GameStop faces many challenges over the long term, however. Will 2014 once again see GameStop crowned a winner, or will it be the year that draws attention to the cracks in the company's retail empire?
New used games
After a prolonged console cycle that routinely delivered disappointing software sales at its tail end, GameStop has good reason to welcome the new systems with eager arms. November's North American hardware sales were the best on record with the 3DS, PS4, and Xbox One driving hardware figures to 58% growth over 2012's November numbers. Overall retail sales were up 7% year-over-year--software, on the other hand, declined 24% from the previous November. Sales numbers for titles like Call of Duty: Ghosts from Activision Blizzard and Madden NFL 25 from Electronic Arts are evidence that the respective series' may be suffering the onsets of franchise fatigue. Troubling as that may be, it's not the most serious problem facing GameStop.
A pivotal year for the console market
New blockbuster IPs will come along to propel the PlayStation 4, Xbox One, and to a lesser extent the Wii U to broader market adoption. Still, it's almost a certainty that fewer consoles will be sold than the last cycle. Nintendo's Wii sold approximately 100 million units worldwide, with the PlayStation 3 and the Xbox 360 both around the 80 million mark. The Wii U's performance so far is evidence that a substantial segment of the casual gamer audience courted by the Wii has lapsed, likely satisfied by any number of mobile games and fitness apps. There's also reason to believe that only one out of the three big console manufacturers will have the luxury of exceeding its previous performance.
From a philosophical standpoint, GameStop and Nintendo should be the best of friends. The house that Mario built has been notoriously slow in getting its online act together. The staggered release of legacy titles on the company's online store and its questionable account systems are comparatively friendly to retail when viewed in comparison with the direction that digital software is heading on the PlayStation 4 and Xbox One.
Smaller games find their place online
While music and movie distribution went digital at a rapid rate, the traditional gaming industry has been much slower in making the transition. File sizes are one of the main reasons that this will continue to be the case. The PlayStation 4 launch title Killzone 4, for example, is almost 40 GB. With big new IPs on the way and the gaming industry riding a wave of interest and popularity, GameStop will continue to enjoy the benefits of selling and reselling games that generate billions in revenue. The problem is, there's going to be fewer of them.
The mid-tier retail game is a thing of the past. Rising development costs and shrinking returns have transitioned the retail software game into a triple-A-or-bust model. GameStop's business has elements in common with the film industry in that respect, and hardly by coincidence. Where the gaming industry is unique in its shifting breakdown of small and big budget titles, GameStop faces its greatest challenge.
In between the widening release gaps that will separate big titles, smaller downloadable games and indie titles are going to be the assets that prop up the PlayStation 4 and Xbox One. The vast majority of these games will never reach physical retail channels, and GameStop will see very little, if any, of the revenue that they generate. Beyond that, there are micro-transactions and downloadable content expansions to account for. Both of these revenue-generators threaten to suck money out of the same spending pool that GameStop is after.
Where does that leave GameStop?
When you consider the impending distribution shift and the fact that both third parties like Electronic Arts and Activision and platform holders like Sony and Microsoft are directing money away from retailers like GameStop, it's fair to doubt the company's long-term prospects. GameStop trades at 15 times earnings as of this writing, with a 2.2% dividend. That isn't attractive enough to justify a long-term hold in light of digital distribution growth and the changing software landscape.
That said, GameStop has the opportunity to grow its price this year as it increases revenue with hardware sales. Solid software sales will be the real key to success, however. The company is right to highlight the moment with its "Year of Gaming" promotions. It represents a test that GameStop desperately needs to pass, but it's not one that guarantees that the retail giant will keep its footing down the line.
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Keith Noonan has no position in any stocks mentioned. The Motley Fool owns shares of 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.