GameStop Might Just Have a Surprise for Its Naysayers

Brick and mortar gaming product dealers such as GameStop (GME 1.07%), which sells video game hardware and related software, and Outerwall, which mainly rents out DVDs, are a hardy breed. The two companies have been defying widely-held expectations that they were going to wither and die as digital gaming became more mainstream. Outerwall has repeatedly been labeled a horse and buggy company whose death was imminent in this age of video streaming, while GameStop is likened to the now-defunct Blockbuster.

Low investor expectations for the companies have driven down their share prices. Short interest in the companies remains very high: 40% for Outerwall and 28% for GameStop.

However, it appears that investors have either missed or heavily discounted other businesses held by the companies, some of which look very promising.

GameStop traditionally sells new video game hardware and software, and also trades in used video game products as well. However, its digital and mobile platform is quickly becoming a key revenue driver.

*Figures for digital and mobile gross margin not available

Source: GameStop 10-K

Wal-Mart wants a piece of the action
GameStop has made such a success of selling used video game products that other large players have taken notice. Wal-Mart started selling used video game products in March, with a focus on PlayStation, Xbox, and Wii systems. Wal-Mart intends to sell its used video games cheaper than companies such as GameStop. With its wide network of more than 10,000 stores at home and abroad, it has the potential to cause a headache for GameStop.

However, GameStop has already built a huge and loyal following. The retailer has 31 million PowerUp Reward members in its ranks, to whom it offers exclusive digital and physical content at the launch of any major title. GameStop has a huge number of stores, too--6,700--which gives it a wide reach just like Wal-Mart. Additionally, its popular reward programs gives it a critical edge over its bigger rival.

Used games make up just 9% of video game spending. New game products make up 56% of all video games spending, while online and mobile downloads make up 35% of spending. This implies that GameStop might not have a lot of growth potential left in used game products, but can still expand its other product segments, particularly digital content.

With Digital Sales growing rapidly, why would anyone go for GameStop?
The fact that video publishers are now concentrating more on digital revenue streams seems to suggest that brick and mortar retailers such as GameStop are in for a rough ride. For instance, Electronic Arts (EA 1.30%) released 22 new titles on mobile and Internet platforms, but just 13 titles on consoles in 2013. Interestingly, the company has been releasing fewer titles over the last few years but is making more money per game.

EA released 60 new titles in 2009, and another 54 in 2010, earning $60 million per title. In 2013, the company earned $108 million per title. It therefore appears as if the new digital streams are much more lucrative for this publisher. The company now makes a third of its revenue from digital streams.

Sony launched a cloud-based gaming service called PlayStation Now that uses Gaikai's streaming technology and allows gamers to play their favorite PlayStation 3 and 4 games on PS3 and PS4 without the need for them to purchase physical CDs.

However, it's important to consider the practical limits of the service in terms of factors such as availability of high-speed Internet to stream the service and seamlessly play games. The  range of games available on the cloud platform is another critical factor.

GameStop sold off its Spawn Labs streaming service in March, noting that cloud streaming was not a good fit with its customers. The company has instead been concentrating on building out its digital and mobile business, which brought in more than $1 billion for the company in fiscal 2013.

The company has built strong and long-standing relationships with various publishers, allowing it to maximize its offerings to its customers. For instance, during the launch of Disney Infinity, GameStop allowed its loyal customers to pre-order over $400 worth of characters playable in the video game. GameStop was also the only U.S. retailer to offer the collector's edition of Grand Theft Auto V.

The company's software sales have been falling, a trend which pervades the whole industry. This has forced the company's top and bottom-line growth to remain flat for a couple of years now.

GameStop, however, guided for comparable store sales to grow 6%-12% in the current year, and its EPS to clock in the $3.40-$3.70 range vs. 2.99 in 2013.The company returned to the black in fiscal 2013 after turning the previous year's net loss of $269.7 million to a net profit of $354.2 million.

In the first quarter of the current fiscal year, GameStop continued with its strong run after recording a 7% revenue growth and 5.8% increase in same-store sales. Its EPS jumped 28.3% to $0.59.

If the company makes good on its full-year guidance, which it appears on course to do, then the shorts could find themselves in a lot of trouble.

Final thoughts
There is a possibility that GameStop's business might lose out to the digital trend in the long run. However, the company is well positioned to capitalize on the trend by growing its own digital and mobile platform, which has been coming along really well. GameStop remains the most dominant video game retailer in the country and accounts for more than half of Xbox 360, and PS3 titles sold in the country. Its shares remain a good hold.