It certainly seems like a name worth owning stock in right now. Shares of GameStop (NYSE:GME) came out of their prolonged slump in August, rallying more than 300% from July's last trade, and bumping into new 52-week highs this past week.
A recently unveiled partnership with Microsoft (NASDAQ:MSFT) looks like it could breathe some new life into the beleaguered gaming-focused retailer, and while not presently profitable, by most other measures the stock looks cheap.
The bullish case for GameStop starts to break down again, however, for investors looking beyond the next couple of months.
Lots of fresh hype
Most anyone reading this probably knows the story. Here's the abridged version anyway: GameStop was all the rage when disc-based and cartridge-based video games and the consoles that played them were necessary. Once game downloads started to become commonplace, though, GameStop's prominent place within the video gaming industry started to crumble. The retailer's revenue has been dwindling since 2012, and operating income has been shrinking since 2010. The company hasn't turned a profit in any quarter since early 2018.
The stock's 95% slide from 2013's peak to April's low reflects this persistent deterioration of GameStop's business.
What happened in August that reversed this losing streak? A combination of factors, beginning with the realization that people have been a lot more active in video gaming while the COVID-19 contagion has them sheltering at home. Fueling this newfound interest was interest from activist investors Ryan Cohen, head of RC Ventures. The co-founder of online pet supply website Chewy.com disclosed RC Ventures had taken on a 9% stake in the video gaming retailer, and though investors could only guess as to Cohen's intent, the move suggested changes for the better were on the way. A couple of analysts upgraded the stock thereafter, perhaps seeing Cohen's involvement as a positive development, but also in anticipation of GameStop's upside once Sony (NYSE:SNE) and Microsoft release their next-generation PlayStation and Xbox (respectively) game consoles later this year.
Microsoft took the relationship a step further last month, announcing a new partnership with the retailer that would give GameStop a portion of the revenue it helps create for the software giant, even if that gamer chooses to download a game rather than buy a disc or subscribe to access it.
Translation: Microsoft will share with GameStop a piece of its digital revenue from direct sales of games and subscriptions, as long as those Xbox owners purchased their console from GameStop.
The amount of money GameStop might collect from such a relationship isn't clear. For perspective, though, Microsoft reported about $10 billion in gaming revenue during the fiscal year ending in June.
And there's the rub -- or at least one of the issues it faces.
Not a lot of much-needed impact
Don't misunderstand, $10 billion is a lot of money. But GameStop isn't likely to collect a significant amount of that business, regardless of how well it's able to steer gamers toward Microsoft's hardware and software.
At its peak in 2011, GameStop only did $9.55 billion worth of business, but used consoles and pre-owned video games accounted for about one-fourth of that figure. The remainder was split up between Microsoft and rival video game brands Sony and Nintendo (OTC:NTDOY). Neither rival has gone away in the meantime, yet much of GameStop's business has. Last year's top line was a more modest $6.4 billion.
Point being, it would take a huge cut of Microsoft's gaming business to meaningfully move the needle for GameStop, but the game retailer isn't even Microsoft's biggest distribution venue. That honor probably (collectively) belongs to Amazon and Walmart.
Moreover, regardless of where a gamer may purchase an Xbox, gamers as a group are increasingly downloading games instead of buying discs. One version of the aforementioned PlayStation 5, as well as the upcoming Xbox Series S console, won't even come with disc drives. This, too, ultimately works against GameStop's future despite its revenue-sharing plan with Microsoft.
S&P Global Market Intelligence crunched the numbers early this year, determining that in 2019, digital revenue accounted for 62.8% of the video game industry's total revenue. That demand for downloads extends a long-standing shift that's only been accelerated by the COVID-19 pandemic that's kept consumers at home more than they're accustomed to.
It matters because margins on physical games have historically been pretty good. When the company last reported the data for fiscal 2018, gross profit margins on new game revenue was on the order of 23% of sales. While details of the new Microsoft/GameStop revenue sharing agreement haven't been disclosed, Wedbush's Michael Pachter suspects GameStop's cut for Xbox-related revenue it produces will be lower, on the order of 10%. In other words, GameStop's new Xbox revenue stream still may not be able to offset the revenue losses it's been suffering for some time now.
Then there's the longer-term effect of the shift away from game discs and toward digital downloads. That's the depletion of used game disc inventory, cutting into one of GameStop's bigger businesses and by far its most profitable one.
GameStop may have lived to fight another day, buoyed by name-drops like Ryan Cohen and Microsoft. The industry's underpinnings are changing, though, and GameStop just doesn't have as much of an important place in that future. Any new purchases of the stock (particularly at currently elevated prices) should be seen as purely speculative plays.