GameStop's Old Friends Are New Enemies

GameStop reports tomorrow.

May 21, 2014 at 6:00PM

It's been a rough few years for the video game industry, but that may be changing with November's rollout of Sony's (NYSE:SNE) PlayStation 4 and Microsoft's (NASDAQ:MSFT) Xbox One. The two next-gen consoles have sold a combined 12 million systems in their first five months on the market. Tomorrow morning, we'll see if GameStop (NYSE:GME) is cashing in on the revival.

Analysts see sales climbing 9%, to $2.03 billion, for the leading stand-alone video game retailer. They see earnings per share growing even faster, up 24%, to $0.57. It seems more than a bit ambitious. Aggressive share buybacks have been padding profitability on a per-share basis; but even without that illusion of a boost, the implication is that net margins will improve.

That won't be easy. Most of the growth in recent months has come on the hardware end as folks snap up Xbox One and PS4 consoles. This is GameStop's lowest-margin business. Software sales -- where the markups are more generous -- have been slumping. There was a healthy 15% spike in the retail sale of new games in March according to industry tracker NPD Group, but that was sandwiched by a 9% drop in February and a 10% decline in April.

GameStop's highest-margin business is selling preowned games and gear. The 6,600-store chain pays a pittance for trade-ins that it refurbishes and sells as secondhand merchandise. Used-product sales slipped during the holiday quarter; if folks weren't trading in old wares to use as store credit for shiny new consoles, then is that really going to rebound now? The Xbox One and PS4 are not organically backward-compatible with older-generation games.

Companies are turning to digital delivery where there is no resale market. In short, this report may not be as great as GameStop's guidance from three months ago may seem to suggest. We saw overall sales growth during the holiday quarter as hardware gains were more than enough to offset declines in software, accessories, and used games and gear. Earnings dipped slightly. This is shaping up to be a similar situation, but with strong sales growth pushing profitability higher instead of lower. However, it will be a challenge to hit its earlier net income target of $0.55 to $0.60 a share.

The future will get even more uncertain. Microsoft is cutting the price of its Xbox One next month, offering it without the Kinect controller. This would seem to benefit GameStop. Lower prices invite buyers, and gamers will likely come back in a few months to pick up stand-alone Kinect motion-based controllers. However, Microsoft's making a big push for digital delivery, and that includes some pretty sweet downloading discounts on some of its more popular games. Some argue that Sony's success and Microsoft's desperation will be good for GameStop. R.W. Baird argued as such when Microsoft announced its upcoming moves last week. However, keep an eye on what GameStop reports, and what it does to guidance tomorrow. 

GameStop has a lean model that's ripe for juicy returns given the cheap suburban strip mall rent it has to pay; but those dynamics can sting if gamers are no longer buying physical discs and cartridges.

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Rick Munarriz 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.

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