Behind The Numbers: How GameStop Is Conforming To A Digital Economy

[GameStop is a retail behemoth that is steering its ship towards digital distribution. Can the retailer adapt to survive? Gamasutra analyst Matt Matthews investigates.] As the video game industry has shifted dramatically over the past couple of years, so too has the world's largest video game retailer, GameStop, begun its own transformation. The industry is evolving from a traditional focus on consoles and packaged software to a fragmented collection of platforms that increasingly rely on digitally distributed content. It's a brave new world for video game retail. Known for its ridiculously profitable used game business and aggressive pre-order programs, GameStop had to know years ago that its present business model was threatened by publishers relentlessly seeking higher profits and the advent of a highly-networked economy. How can a video game retailer with a heavy brick-and-mortar footprint also insert itself into the digital economy? In precisely the same way it made itself an indispensable part of the economy for packaged video games. An Effective Model The genius of GameStop's retail business model is that it combines a quick trade-in program with a large selection of games, both new and used, which can then be bought with trade-in credit. A highly-optimized distribution network ensures that many stores are well-stocked and GameStop's employees are trained to zealously promote products to consumers and extol the benefits of the trade-in system. Publishers grumble, but the retailer is simply too big to ignore. For example, in its last quarterly statement Electronic Arts reported that 16 percent of its total net revenue came from direct sales to GameStop. Walmart, the biggest retailer in the world? They're just 10 percent of EA's revenue. Regardless, publishers are moving more commerce to digital venues, like Xbox Live and PlayStation Network, a move that could leave GameStop out of the picture. After all, a consumer who buys their downloadable content (DLC) like map packs online won't give GameStop any of that cash, will they? That's where you'd be wrong. Consumers still largely buy their games from brick-and-mortar stores, and GameStop now sells that DLC at the cash register right alongside the packaged software. More importantly, they have begun promoting their trade-in program as an easy way to get the cash – or more precisely in-store credit – to buy that DLC. Publishers can benefit because DLC is a high-margin product. If more of it gets sold, through GameStop or otherwise, a publisher's profit margin goes up. Even when GameStop sells a second-hand copy of a game (instead of a new copy, as publishers might prefer), there is now an immediate opportunity to pair the used game with a high-margin DLC package, and that again benefits the publisher. Consumers can benefit from having a straightforward way for used games to subsidize the purchase of other games, and the DLC that comes with those other games. Even if we don't agree with GameStop's trade-in values, the fact remains that they've provided a service for the consumer. And, of course, GameStop gets its cut. The beauty for GameStop is that they not only get a small cut of the DLC sale, but will also get to keep any used games to use as part of their own highly-profitable used game program. (As an aside, I hope GameStop will elaborate at some point how it makes these transactions work. Does it pay a publisher or a platform holder or both when it sells DLC? How is their commission determined, and how does it vary from product to product?) One key point about GameStop's model is the value proposition that they promote to consumers. A gamer with $60 in cash is in a position to buy the newest big game from GameStop or Walmart. But that same gamer with $60 in cash and $15 in trade-in credit from the games he purchased a few months ago will find more options at GameStop. That subtle tipping of the scales has helped the company build its marketshare over the years. Just for a sense of scale, GameStop says it provided over $1 billion in trade-in credit to consumers last year. That's a slippery figure – since we don't have an external measure of its value, just what GameStop says it's worth – but it's still a significant amount of credit that gamers could begin putting toward digital products. Millions of consumers are engaged in the trade-in system, and now GameStop has to convince publishers of the value proposition on the other end of that transaction. Are they, the publishers, willing to accept the used game market more readily if cooperating with the retailer means that the extra $15 of trade-in credit can go toward its high-margin DLC? Look for GameStop to push this angle more in the coming year. Even while GameStop exploits DLC as a growth opportunity now, it is building paths into other parts of the digital economy for the future. Without them, the company will find it difficult to reach its $450 million goal of digital revenue for its current fiscal year, and it certainly won't reach its 2014 goal of $1.5 billion. The $450 million goal looks rather modest, when compared to GameStop's current business. The company expects total revenue of less than $9.8 billion for its current fiscal year. Under that assumption, the figure below shows that GameStop can expect about 5 percent of its revenue to come from digital products this year. The Other Category Even if GameStop manages to grow its business by 4 percent per year for the next few years, achieving its $1.5 billion goal would still represent a large chunk of its business. By our estimates, that would mean that $1 out of every $7 that the company earned would come from its digital sales. At that point virtual goods would be just as important to GameStop's revenue stream as console and handheld hardware are today. GameStop would likely welcome a diminished dependence on hardware. It is clearly the least profitable segment of GameStop's business, since they get to keep only 8 cents out of each dollar of hardware revenue, on average. For comparison, new software brings in 20-22 cents on the dollar, while used product (including hardware and software) is more lucrative at 44 cents - 48 cents per dollar. When reporting its quarterly results, GameStop currently packs all its digital revenue into a nebulous "Other" category, along with accessories and packaged PC software sales. (I'd like to see them break that category out more in the future.) This varied Other segment has traditionally had a profit margin of about 33 cents - 35 cents per dollar of revenue. This is precisely where we can see GameStop's digital strategy starting to pay some modest return. The Other segment saw its margin jump from 33.3 cents on the dollar at the end of its last fiscal year to 37.1 cents on the dollar in the first quarter of its current fiscal year. That margin then jumped again to 41.7 cents in the second quarter and finally to 43 cents in the latest quarter. Given the current trends, it is entirely possible that GameStop's margins in the Other segment – driven by digital sales – could end up equal to the margin on used products during the final quarter of its fiscal year. Last year, during that crucial holiday season, GameStop's margin on used product dropped to 44.1 cents – tantalizingly close to the current 43 cents margin for the Other segment. The recent six months of significantly higher margins have come immediately after the May 2011 acquisition of Impulse, Inc. from Stardock. That purchase added Impulse, a digital delivery platform for software, and Spawn Labs, a game-streaming service, to GameStop's portfolio of products. It is possible that digital delivery of PC games, particularly sold through the company's online storefront, are helping to fill out its profit margins. Given what GameStop has said, however, we can't pick out a single piece of its digital strategy yet as the primary driver of growth. It could be that a completed roll-out of shopping kiosks and DLC training to all of its staff has finally begun driving that segment's revenue and margins up. As an example, the company has reported sales of 600,000 Call of Duty Elite memberships – priced at $50 each – alongside the launch of Activision's Call of Duty: Modern Warfare 3. That single product launch will probably account for nearly 10 percent of the company's expected $450 million digital revenue goal when the full fiscal year's results are reported. Even its PowerUp Rewards loyalty program, again bundled into the Other segment of its business, is a kind of digital business. The program tracks the game purchases of over 14.5 million members and then targets those consumers for specific trade-in deals and pre-order promotions. It's not hard to imagine that digital revenue will increase as those members are educated to use trade-in credit to buy DLC. The hardcore consumers – video game consumer whales, if you will – can be identified and milked of their spare cash and trade-in credit. According to the company, publishers are also interested in exploiting the data contained in the Rewards program – so expect publishers to begin targeting buyers of their games through GameStop, and for GameStop to levy a fee on the publishers for that privilege. Further, GameStop now has its own Android tablet program, tied to a GameStop Android app store and Kongregate casual gaming portal. It's certainly true that the retail side of the video game industry has suffered over the past few years. Even if November and December sales are up over last year, the packaged software market in the U.S. will have contracted for a third year in a row, down by about $1 billion from its $10 billion peak back in 2008. However, GameStop has not stood idle while traditional retail falls apart. Rather, it has opened up several channels into the digital economy – DLC at retail, software sales through Impulse, casual gaming on Kongregate, an app store for Android tablets. When the digital apocalypse comes – not if, but when – and the majority of the industry revenue is generated by virtual product, the GameStop will still be with us. It will survive but won't still be the juggernaut we've come to know over the past few years. As the company strives to leverage its leadership at retail into a relevant role in the new digital economy, some of those efforts are bearing fruit, mostly in terms of margin if not revenue. But look again at that pie chart above, the one showing the breakdown of GameStop's revenues. Software – by which I mean packaged software, both new and used – accounts for well over half of the company's $10 billion of revenue. Even though digital revenue is growing extremely quickly and GameStop is in a position to take a cut, it seems impossible for that share and its corresponding profit margin to make up for what must inevitably be a decimation of the packaged software business.