GameStop's (NYSE:GME) business model is broken, and the company has yet to find a solution.
Shares of the video game retailer plunged following the release of its third quarter earnings last week. New video game software sales -- GameStop's second-largest profit driver -- fell 9.3% on an annual basis. GameStop blamed a difficult comparison for the decline: last year's third quarter saw the release of Destiny, a much-hyped (though critically maligned) first-person shooter. The release of Electronic Arts' (NASDAQ:EA) Madden NFL 16, Metal Gear Solid 5, Halo 5, and Guitar Hero Live (among other games) were not enough to equal the demand for Destiny last year -- at least according to GameStop's management.
I've been a longtime GameStop bear and remain skeptical of the stock. The popularity of full-game downloads continues to increase, and GameStop's management is unable to address the threat.
Dodging the question
GameStop's business centers around the sale of video game discs, both new and used. Last quarter, 33.5% and 24.9% of GameStop's net sales came from new video games and used video games, respectively. GameStop sells new video game discs to consumers, and then buys them back later, only to resell them for a sizable profit. More than one-third of GameStop's total gross profit came from the sale of used games last quarter.
The continued shift toward digital downloads presents an existential threat to this model. If all (or most) video games are sold digitally in the form of a direct download, there's no disc for GameStop to sell (and then eventually resell).
During GameStop's earnings call, Sterne Agee's Arvind Bhatia asked management what the company could do to crack into this market -- which, according to Electronic Arts, now represents about 20% of new game sales.
Bhatia: What do you think is your market share in digital downloads?...how do you become more of a destination place for digital downloads...?
GameStop CEO Paul Raines: I would say that, remember, that we are a player in digital downloads. I mean you don't do $228 million of digital receipts without having technologies, APIs, relationships, and all those things that you need to sell digital download...
GameStop COO Tony Bartel: Let me share some of that, Arvind. We don't give out specific market share of digital downloads or digital receipts, simply because it's really difficult to find that information. But let me give you some information from DFC...we find it to be one of the most credible source when we..look at digital share...According to DFC, in the third quarter, digital AAA sales for $60 game releases increased 6% over last year to 6% in total. And it represented only 9% of the total AAA sales mix. So that's coming from a source that we find very credible. So it grew 6% off of a very small base....
Raines: And you know the difficulty, of course, here is that digital is a complex animal and people, every publisher measures it in slightly different ways, et cetera...
Bartel: ...And we anticipate that digital is going to continue to grow. And remember, that we grew 14% before [foreign-exchange], which is right in line with where the publishers grew. So we continue to see our digital continue to march forward at about the same rate that the publishers are seeing their digital growth.
In short: nothing. Rather than address Bhatia's question, GameStop's management stepped around it, offering no plan or strategy to capture demand for downloads. Instead, the company attempted to downplay the popularity of full-game downloads, and pointed to total digital receipts -- which is misleading. GameStop's digital business is composed of many different types of products, including pre-paid currency cards that can be used to purchase digital games through the various console storefronts, and Kongregate, its mobile game publishing platform.
The bulk of GameStop's digital business is likely coming from the sale of add-on (DLC) content. In recent years, major video game publishers have begun to supplement their games with additional downloadable content released several months after a game's debut. GameStop sells this content alongside physical game discs, encouraging customers who purchase a new game to pay for its DLC at the point of sale.
The issue is that these DLC sales are intrinsically linked to the demand for discs, and if gamers stop coming into GameStop's stores, there's no reason to believe this business will survive. I can't say for certain because GameStop won't disclose it, but I would assume it sells virtually no full-game downloads at all. There's simply no reason to purchase a full-game download through GameStop when you can just buy it through your Xbox or PlayStation console. To use an analogy, it would be the equivalent of going to Blockbuster to purchase a code for a digital movie you then redeem on iTunes -- an utterly nonsensical proposition.
Star Wars disappoints GameStop, but sets a digital record
EA's Star Wars: Battlefront wasn't included in GameStop's third quarter report, but will play a key role in its fourth quarter results. It made its debut earlier this month, and according to GameStop, suffered from soft sales. "Battlefront fell short of expectations," said Bartel during the call.
But did it fall short of Electronic Arts' expectations? In a blog post released (perhaps not so coincidentally) shortly after GameStop's call, Electronic Arts wrote that the game was "the largest digital launch in the history" of the company. Rather than head to GameStop for their copy of Battlefront, gamers may have stayed home, purchasing it directly through their consoles.
GameStop is profitable, and pays a fairly sizable dividend (it currently yields more than 3.5%), but with so much of its sales and profit tied to video game discs, it remains immensely challenged.
Sam Mattera has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.