In-Depth: Inside The Business Of GameStop, Part Two

[In part two of his analysis of GameStop, Gamasutra analyst Matt Matthews finds the retailer's U.S. marketshare in new games and hardware grew to 22 percent in 2009, and suggests that digital distribution poses an imminent threat.] Our previous look at GameStop's financial results focused on the revenue and profits the company has been making from hardware and software, with a special interest in the used software market. In this second part, we'll see how the company's revenues come from the various regions in which it does business and provide a rough estimate of its marketshare in the United States. We'll also look at some interesting additions to GameStop's list of threats to its business model and how it might be planning for the future. GameStop's Global Reach While GameStop is still primarily an American company, the distribution of its revenue base is shifting. When we looked at GameStop's revenue last year, just over 14 percent or $1.2 billion of the company's sales came from Europe, compared to 73 percent or $6.5 billion from the United States. During its fiscal 2009 (which ended on 30 January 2010), the company recorded $6.3 billion in revenue from the United States, a decline of 3%. In contrast GameStop's European revenue increased 40% from fiscal 2008 to fiscal 2009, to a total of $1.8 billion. The regional distribution of the company's revenue can be seen in the figure below. Europe now accounts for 1/5 of all of GameStop's sales. It seems likely that some of the growth in Europe can be attributed not only to new store openings there but more significantly to increasing used game sales in that region. In its comments on used product sales, in fact, the company calls out “the strong growth of used video game product sales internationally” as a key factor. Certainly used product sales spiked in fiscal 2009 – as we took time to analyze in our last piece – but we believe that European sales in particular were stronger. Consider that GameStop now operates 98 more stores in the United States than it did during its last fiscal year and yet revenue declined. In fact, the average annual revenue per store in the United States declined 5% to $1.42 million per store. GameStop's retail locations in Europe increased by almost the same number during fiscal 2009 – up to 1296 stores from 1201 – but the annual revenue per store increased 30 percent, from $1.05 million to $1.37 million. We also acknowledge that the company may have tightened the operation of its European stores (many of which were part of an acquisition that began in 2008). As the figure below shows, GameStop's growth in fiscal 2009 was entirely due to the increase in European sales. Revenue from Australia was essentially flat while GameStop sales in Canada decreased by 10 percent, despite increases in the total number of stores in each of those regions. We would expect that in the coming two years we will see the revenue streams continue to shift with GameStop's European revenue accounting for fully 25 percent of the company's sales while revenue from the U.S. drops to 65 percent. GameStop Marketshare Increases For fiscal 2008 we estimated GameStop's share of the U.S. market at 20 percent, excluding accessories and PC software. For the sake of comparison, Wedbush analyst Michael Pachter estimated GameStop's U.S. marketshare, including all new products, at 25 percent in his July 2009 report on the videogame industry. (He also estimated that Wal-mart, Target, and Best Buy accounted for just over 50 percent of the U.S. market.) In recent notes, Pachter also stated that he believes GameStop lost hardware marketshare to big box retailers through the last holiday season but grew its software marketshare. Using the same metric that we used last year, we now estimate that GameStop's U.S. marketshare grew in the last fiscal year, from 20 percent to 22 percent, as shown in the figure below. Again, we have excluded PC software and accessories since these figures cannot be suitably estimated from the “Other” category under which GameStop reports their sales. Our estimate, shown in the figure below, relies on data provided by the NPD Group for software and hardware sales during the months of GameStop's fiscal 2009. We expect that GameStop's share of the U.S. market will grow throughout the rest of the year, but to no more than 24 percent, by the measure used here. When we examine GameStop's fiscal 2010 figures a year from now, we can test that hypothesis as well as compare with Pachter's latest estimates due sometime after mid-2010. An Updated List of Threats In its report on fiscal 2008, over a year ago, GameStop updated its language about threats to its business model. In particular, we observed that GameStop broadened its description of the threat posed by software distributed online to include consoles and, presumably, handhelds. Previously that section of GameStop's 10-K had referred only to PC software. That segment of GameStop's filing has been expanded yet again, and the language is even more interesting. The relevant section is included below in its entirety: Technological advances in the delivery and types of video games and PC entertainment software, as well as changes in consumer behavior related to these new technologies, could lower our sales. While it is currently only possible to download a limited amount of video game content to the next generation video game systems, at some point in the future this technology may become more prevalent. If advances in technology continue to expand our customers’ ability to access the current format of video games, PC entertainment software and incremental content for their games, as well as new types of browser and casual games through these and other sources, our customers may no longer choose to purchase video games or PC entertainment software in our stores. As a result, sales and earnings could decline. While the Company is currently pursuing various strategies to integrate these new delivery methods and competing content into the Company’s business model, we can provide no assurances that they will be successful or profitable. The words “consumer behavior” are new to GameStop's filings. This suggests that the company has moved beyond simply noting the existence of online channels of software distribution to the recognition of a shift in consumer behavior. GameStop caters to the core gamers, the ones who buy one or more games per month, and these may well be the gamers who most quickly shift to online distribution for their software purchases. That is, GameStop is clearly positioned to extract revenue from core gamers who purchase via retail, but that means they are also the ones most hurt if these gamers start downloading their games instead. This is also the first time that GameStop has mentioned browser games and casual games in its 10-K filings. As games like Farmville take up more of the recreational time of GameStop's potential customers, the company foresees a possible decline in its earnings. While the company already does sell some games through its website as direct downloads, we would suggest that it consider investing some part of the $500 million it still has on hand (left over after the recent $247 million stock buyback) in buying a larger stake in the production and distribution of games. With the purchase of a middle-tier publisher or other industry intermediary (like one or more of the larger, existing software distribution services) it is possible that GameStop could ensure its survival well beyond the point at which the market tilts more toward the online channel than the retail channel. GameStop's efforts in this direction have been small. In November 2009 the company completed the purchase of a controlling interest in Omac Global Media Limited, described as “an online video game developer and operator”, and also known as Jolt Online Gaming, and the creators of Trukz and Legends Of Zork. This cost the company a mere fraction of its cash reserves ($3.8 million). According to the company's business and growth strategy, it will “continue to make significant investments in e-commerce, online game development, digital kiosks and in-store and Web site functionality” to increase its stake in the digital business. We think our suggestion of spending its capital to gain a larger stake in the production and distribution of games is reasonable, especially given the increasing number of threats that GameStop sees in casual games and digital distribution. Better to spend cash available now in order to lay a foundation for what seems an inevitable future, than to get to that future with less cash and no leverage to buy a stake. For balance, note that Wedbush's Pachter disagrees. According to his notes on GameStop's latest results, he believes that the decline of physical media could take another decade to complete. In that regard, GameStop will continue to generate strong margins amid a growing videogame retail industry. To that end, he suggests that GameStop should “cease new store growth”, cut expenditures (on IT and GameStop's possible new customer loyalty program), and eliminate its reserve set aside for acquisitions. The increase in cash flow could then be returned to investors and drive growth of the company's stock price.