Shares of leading video game retailer GameStop (GME) have been selling off after Microsoft (MSFT) announced that more than 100 Xbox 360 titles will be playable on Xbox One.
The investing world has (mis)construed this to mean that people won’t be ditching their old Xbox consoles as often as they used to, which is basically bad business for GameStop.
GameStop makes a bulk of its revenue selling used gaming hardware, with Xbox consoles being one of its most important products. About one-third of GameStop’s revenue comes from used video game products.
But, that’s just part of the picture for GameStop stock.
The Good News for GameStop Stock
Backward compatibility of Xbox consoles is actually a positive for GameStop stock. Look at it this way: Xbox 360 titles that were only playable on the older consoles can now be played on Xbox One. People also don’t need to keep holding on to their old 360 consoles and can now chuck them off to companies like GameStop.
GameStop’s used video game products sport very good margins — around 47% gross margin compared with 23% for new video game products. But the company’s pre-owned segment has not been doing very well. The segment’s revenue fell 3.5% during the first quarter, the only segment to record negative growth. Nevertheless, the company’s same-store sales were up a healthy 9% — 300 basis points better than management’s forecasts.
It probably won’t be long before GameStop starts seeing an influx of used Xbox 360 consoles. People are buying the new consoles in droves — Microsoft’s Xbox One console sales were up 63% Y/Y in the month of April, trouncing PS4 sales for the first time since the two consoles were released.
That surge in Xbox One sales probably has something to do with Microsoft’s price cuts on the new console — the company recently made the $349 promo price a permanent fixture, way below its $500 introductory price. Microsoft’s strategy of bundling popular games with the consoles also seems to be working.
Short Squeeze
GameStop stock is one of the most heavily shorted stocks in the New York exchange on concerns regarding the looming obsolescence of physical gaming in the wake of cloud and web-based gaming.
One big worry for GameStop stock is that Microsoft and Sony (SNE) will decide to go fully digital and start releasing new games via download only. This is a common theme advanced by GameStop bears, but seems to be overdone. Demand for physical discs remains strong, given the enormous hard drive space required to store many digital games.
GME has been successfully making bold diversification moves to bolster GameStop stock. The company has opened more than 200 new Technology Brands stores. The segment consists of consumer electronics as well as cell phone services.
The segment grew at a blistering pace — with revenues up 70% during the quarter to $102 million, or 5% of GameStop’s overall revenue. At this rate, the segment will easily make 10% of GameStop’s revenue in maybe five or six quarters, at which point it will have a tangible impact on the company’s top line.
The fact that GameStop issued rather soft guidance for the current quarter should not be taken as a sign of weakness but should rather be viewed in the context of difficult comps the company is facing. GameStop stock enjoyed a blockbuster second quarter in fiscal 2014 after Watch Dogs and Mario Kart 8 hit gaming stores and went viral.
Of course, GameStop will have sales of The Witcher 3: Wild Hunt and Batman: Arkham Knight to fall back on in this quarter, giving investors hope of an earnings beat — especially now that expectations have been lowered. But they’re still competing against high comparisons.
Many investors have burned their fingers shorting GME stock. Despite the latest selloff, GME is up 29% YTD, after they tucked on gains of 10% in May following the company handily beating first-quarter expectations.
GameStop stock remains a prime holding for the long haul.
As of this writing, Brian Wu did not own any of the aforementioned securities.
