Beginning next month, Microsoft (NASDAQ:MSFT) will offer select Xbox One games at a significant discount -- as much as 50% to 75% off their regular retail price. Xbox One owners looking to take advantage of these sales won't be heading to their local GameStop (NYSE:GME); rather, the discounts will only apply to digital copies downloaded directly from Microsoft's online storefront.
Two of the Xbox One's biggest games -- Forza 5 and Ryse -- will kick things off; many more titles will follow. If history is any indication, this could be the beginning of the end for physical Xbox One games, and by extension, the start of GameStop's demise.
History as a guide: The PC market
In 2007, something funny happened -- sales of retail PC games posted an annual decline. Analysts blamed piracy, the growth of consoles, and a waning interest in the PC platform as a whole, and media outlets declared that PC gaming was dying.
In fact, nothing could've been further from the truth. PC gaming continued to grow (today, PC gaming brings in more revenue than console gaming), but the numbers just didn't show it. In 2010, research firm NPD sampled the market for digital PC games and discovered why -- from 2006 to 2010, the growth of digitally downloaded PC games exploded, to the point where, in 2010, it accounted for more than half of the market.
Those trends have continued. Today, many PC games don't even get retail releases, and few stores still carry boxed copies. Head into your local GameStop and it's unlikely you'll find anything more than a single shelf devoted to PC games.
The rise of Steam
Why did PC games go digital? There are several factors, but nothing more significant than the rise of Valve's Steam.
Steam is to PC gaming what iTunes is to music: Users sign up, create an account, attach a credit card, and begin purchasing digital copies of PC games. Those games then become tied to that user's account, and can be downloaded to several computers, or redownloaded in the event of hard drive failure.
That's convenient, but what really sets Steam apart is its sales -- it offers sharp discounts on its games on a weekly basis, and its semiannual holiday sales are the stuff of Internet legend. The discounts offered are so aggressive (as much as 90% off) that many games are purchased and never played -- according to Arstechnica, 37% of the nearly 800 million PC games that Steam users collectively own have never been played.
Unfortunately, Valve is a private company, making its revenue difficult to ascertain. But analysts have estimated that about 7 in 10 digitally downloaded PC games are purchased through Steam.
Bringing Steam to the Xbox
Microsoft's new initiative will bring the equivalent of Steam sales to the Xbox platform. Exact pricing and plans have not been revealed, but in its release, Microsoft mentioned both Forza 5 and Ryse and promised discounts of 50% to 75% off.
If Microsoft offers both games at 75% off, they would retail for just $15. For comparison, GameStop is currently selling used copies of those titles for $45 each. Even if Microsoft only offered them at 50% off, they would still be significantly cheaper ($30).
To continue selling these games, GameStop would be forced to slash its pricing, devastating its margins in the process. As I noted earlier this year, that's exactly what GameStop did with Ryse in response to a short-lived test run Microsoft conducted in February.
But it's even worse than that. In addition to losing out on potential sales, GameStop would have fewer used games to sell. Once purchased, a digital copy becomes locked to an Xbox One owner's account and cannot be resold -- giving GameStop less used-games inventory to move.
Analysts just don't get it
GameStop shares actually rallied on Tuesday as analysts misinterpreted Microsoft's intentions. In addition to offering digitally discounted games, Microsoft will begin selling a version of the Xbox One at $399 next month, an incremental positive for GameStop, according to R.W. Baird. But with Microsoft's new plan to aggressively discount digital games, it's likely that fewer new Xbox One owners will buy their games from GameStop in the future.
Given that about half of GameStop's revenue, and 70% of its profit, comes from the sale of disc-based games, Microsoft's announcement on Tuesday is one of the worst things that could've happened to the retailer.