Here are two figures that should spook GameStop (NYSE:GME) bulls: 22% and 59%. The first number is the growth rate that Electronic Arts (NASDAQ:EA) logged in digital sales last quarter. The second is the percentage of Activision Blizzard's (NASDAQ: ATVI) revenue that now comes from digital channels.
And yet GameStop just reported blowout quarterly results. After more than two years of declines, it returned to sales growth in a big way, topping its own aggressive forecast and boosting comps by 20.5%. That helped GameStop deliver what almost no other major retailer could over the last three months: surprisingly strong revenue growth. Sales came in at $2.11 billion, above the $1.98 billion the Street expected.
The company can thank Take-Two Interactive (NASDAQ:TTWO) for much of that bounce, as its Rockstar division launched a little game called Grand Theft Auto V in the quarter. That title set sales records around the world and helped GameStop book a 43% spike in new software revenue. GameStop's mobile and digital initiatives also kicked in higher results, growing by 14% and 9%, respectively. All of this business success translated into a massive 45% jump in earnings, to $68.6 million. On a per-share basis, profit grew even faster thanks to the company's continued spending on share repurchases. So why did investors respond by selling the stock?
I see two major reasons. First, GameStop came into this quarter's earnings release as the fifth best-performing stock in the entire S&P 500. Sitting on a 125% return so far, the stakes couldn't have been much higher for this report, and some investors were bound to jump on any potential bad news as cause to pare back on a high-flying stock.
Second, while GameStop showed no hint of weakness in the third quarter, the outlook it gave for the holiday months was a different story. Management sees comp sales growth coming in at only 2% to 9% in the fourth quarter, with profit maxed out at $2.14 a share -- below what analysts were targeting. That's surprisingly low, especially with all the new software titles that should drive traffic this holiday, including billion-dollar franchises like Battlefield from Electronic Arts and Call of Duty from Activision Blizzard. To boot, Disney's Infinity game should keep interest high in the profitable toys-to-life category that Activision pioneered, and is defending fiercely with its Skylanders franchise. Nintendo's handheld 3DS is also selling well, and even its Wii U console could kick in some respectable results over the holidays.
However, console transitions -- namely, the recent launch of the PlayStation 4 and the Xbox One -- are a tricky time for GameStop. The device launches tend to boost new-hardware and new-software sales to a bigger percentage of the retailer's income than is normally the case. Those two business lines also tend to have the lowest profit margins of all of GameStop's divisions. In the third quarter, for example, new video game software carried a 22.7% margin for the company, as compared to the massive 48.3% margin it booked on pre-owned games.
Consistent with that trend, investors should expect GameStop's profitability to shrink next quarter and into next year -- until the point that used games and hardware once again expand into a greater part of the retailer's business.
But I don't see that as a good reason for investors to sell shares today. GameStop's momentum is undeniable, and with its digital and mobile initiatives it can benefit from the upswing in the video game industry in ways that other retailers just can't. Despite what's sure to be a volatile few quarters ahead, I believe GameStop remains a solid choice for investors who want exposure to the growing video game market.