There is plenty of discussion these days about whether leading video game retailer GameStop (NYSE:GME) is doomed to follow a Blockbuster-like path to irrelevance and/or whether would-be rivals like Netflix (Nasdaq:NFLX) and Coinstar (Nasdaq:CSTR) can get into its kitchen. Unfortunately for GameStop bulls, there are some real reasons for concern. (For other companies that are threatened by strong competition and a changing market, check out Companies Playing Catch-Up With The Competition.)
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Digital Isn't Everything
A recent article on TheStreet.com tried to point toward growing digital sales as a sign that GameStop is adapting with the times and capable of staying competitive. To be fair, online revenue is growing nicely - up 69% in the recently-announced second quarter - while overall revenue dropped 3%. Unfortunately, there's more to the GameStop story than that.
GameStop thrives in large part due to its very lucrative used game business. Used games account for roughly one-third of company sales, but more than half of company gross profit. Needless to say, digital downloads do not lend themselves to customer resales and high-margin used sales for GameStop.
But wait, you say, isn't digital content much higher margin? GameStop does not provide enough information in its financial statements to strip out the gross profitability of digital sales. Nevertheless, investors can look at other digital retailers to get a sense of what GameStop may expect. Netflix sports a sub-40% gross margin, as does Amazon (Nasdaq:AMZN), and Sega Sammy's efforts to drive more digital download has not shown any real economic benefits for the company either. (For more on margins, see A Look At Corporate Profit Margins.)
... But It's Cheaper To Compete?
Maybe GameStop cannot reap the same gross margin on digital revenue as on used games, but surely the operating profits have to be better, right? Perhaps. It is certainly true that digital delivery does not demand the sort of occupancy costs that a retail store network requires. But has GameStop talked seriously of shutting down large numbers of stores?
Let's just say that GameStop does pull back significantly on its retail operations - ceding the in-store fight to big box retailers like Best Buy (NYSE:BBY) or Wal-Mart (NYSE:WMT). What then of the company's relationships with the likes of Microsoft (Nasdaq:MSFT) and Sony (NYSE:SNE)? If GameStop is no longer going to be useful to these console makers as a hardware distribution point, it would certainly stand to reason that they will move to marginalize GameStop as a game vendor - Xbox and PlayStation owners can already buy direct (and digital) from Microsoft and Sony with their boxes, and further marginalizing GameStop may not be so hard.
Oh, and don't forget that GameStop isn't exactly the only company looking to sell digital game content. Activision Blizzard (Nasdaq:ATVI) and Electronic Arts (Nasdaq:ERTS) are likewise looking to increase their digital businesses and they have the advantage of brand working for them.
The Bottom Line - Maybe Not Doomed, But Certainly Threatened
The online giant that is Amazon has arguably already had a big role in killing two competing retail concepts (Borders and Circuit City), and it certainly seems that there are some risks of irrelevancy to the GameStop model. That said, GameStop has at least one thing going for it - those used games are still popular (sales up 12% this past quarter) and still very lucrative.
What's more, GameStop does have some opportunity to use online distribution to its benefit. There could well be a place for GameStop to engage independent developers and become the favored distributor for them in both the offline and online world - something akin perhaps to the eBay Store or Amazon Associate concepts.
For now, though, investors would likely to do well to be cautious with this name. Few companies manage to transition and transform their business models without major disruptions and GameStop needs to prove that a digital delivery model can replace in growth and margins what it will likely cannibalize from used game sales. (To gain a better understanding of business models, check out Getting To Know Business Models.)
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