Shares of video game retailer GameStop (NYSE:GME) have tanked during the past year, down about 20% despite strong demand for the newest game consoles from Sony and Microsoft. GameStop faces a huge threat to its business as video game sales shift from physical media to digital, and the company is attempting to diversify by branching out into mobile and consumer electronics. With the stock now trading at just 12 times trailing-12-month earnings, is GameStop a buy?
The problem with used games
In GameStop's most recent quarter, pre-owned video game products made up about a third of sales, and nearly half of the company's gross profit, although these percentages were skewed downward a bit by strong sales of the new game consoles. Pre-owned games are the most lucrative physical products that GameStop sells, commanding a far higher gross margin than new games. GameStop's business model depends on a continued strong used-games market.
The video game market is slowly going digital, however, and this threatens GameStop's used-games cash cow. The PC gaming market has already gone almost completely digital thanks to services like Steam, with 92% of global PC game sales now in the form of downloads. The console gaming market has been much slower to transition, with digital sales currently making up less than 20% of total sales; but as this percentage marches higher, pre-owned games could eventually become a thing of the past.
There's certainly a strong incentive for console makers and game publishers to kill off the used-games market. The used-games market is worth about $2 billion annually, and Sony, Microsoft, and the game publishers don't see a dime of that money. The console makers collect licensing fees on new games sold for their consoles, but they make nothing off of used games. Activision-Blizzard, the largest video game publisher in the world, recorded revenue of $4.6 billion in 2013. Shifting that $2 billion to new-game sales could have a very positive effect on the company's top line.
The slow death of the used-game market is the most serious threat facing GameStop, and it's one that's likely inevitable. How long it takes before GameStop starts to see the effects is an open question; but sooner or later, GameStop's most profitable segment will begin to fade away.
Diversifying away from games
Part of GameStop's strategy during the past few years has been to diversify into consumer electronics, particularly mobile devices. Spring Mobile, a subsidiary of GameStop, sells AT&T phones and plans through 210 locations nationwide. Simply Mac, a store dedicated specifically to Apple products, had 23 locations in 2013, and GameStop plans to increase this to nearly 100 by 2015. GameStop also operates 37 Cricket-branded stores, selling prepaid phones and plans on AT&T's network. The company sells pre-owned and new electronics in its namesake stores, as well.
Sales of mobile and consumer electronics rose by 85% year over year in the most recent quarter, although the category still makes up just 6.5% of the company's total revenue. Gross margin is also well below that of used games; but at 36.1% in the most recent quarter, it's quite a bit higher than new video game software and hardware. The focus on used electronics might be the saving grace of this strategy, because selling new phones, tablets, and laptops comes with low margins and plenty of competition.
Is it a buy?
GameStop appears inexpensive, trading at just 12 times trailing earnings, and analysts are expecting earnings to rise to $3.70 per share this year, and $4.39 per share next year, up from $3.28 per share in the past 12 months. New game consoles sales are still in the early innings, so this holiday season is sure to be a strong one on that front.
With half of GameStop's gross profit depending on used games, it's difficult to get too excited about the growth prospects of the company. There are incentives in place that will ensure that the used console gaming market eventually goes away, and that's bad news for GameStop's bottom line. Consumer electronics can pick up some of the slack, but the category doesn't have the same lush margins as used games, and GameStop faces a lot of competition in that area.
Analyst estimates for earnings seem optimistic to me. While it may take until the next generation of game consoles for digital downloads to overtake physical copies, it's a trend that's not going to reverse. Because of this massive long-term risk to GameStop's business, investors should require a large margin of safety before buying into the company. The current price of GameStop's stock, even after its 25% decline, isn't low enough.
Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard. The Motley Fool owns shares of Activision Blizzard, 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.