Should You Invest in Video Games?


GameStop is about to enter an interesting and telling phase. What you see from GameStop over the next year will likely indicate the company's long-term potential. This is solely based on an upcoming event that hasn't taken place in six years.

The big event
Video game platforms are usually replaced after four-to-five years, but it has been six years since the latest generation of gaming platforms has been renewed. And as you might already know, Sony's PlayStation 4 and Microsoft's Xbox One are both due for release this holiday season. Information about these gaming consoles is important, because it has the potential to impact GameStop.

PlayStation 4 is due out on November 14, 2013, and it will cost $399. Sony states that the gaming console was designed with a frictionless and seamless gaming experience in mind. PlayStation 4 games include Deep Down, Destiny, Diablo III, Driveclub, The Witcher 3: Wild Hunt, Final Fantasy, Infamus: Second Son, Killzone: Shadow Fall, Knack, and Watch Dogs.

Potential Sony investors should know that the company expects initial PlayStation 4 orders to be 40% higher than initial PlayStation 3 orders were in the mid-2000's. Sony also expects PlayStation 4 to be profitable much faster than it took PlayStation 3 (four years), thanks to a more attractive price for the PlayStation 4 -- $399 vs. $599. Based on 1 million pre-orders in August, Sony looks to have a good head start, as it expects to ship 5 million units between launch and March 31, 2014.

The Xbox One is more expensive at $499, but it comes with many features since Microsoft is aiming for the living room experience. On the Xbox One, you will be able to watch TV and movies, use Skype, and of course, play games. The expected release date for Xbox One is rumored to be November 29. Xbox One games include Assassin's Creed 4, Battlefield 4, Call of Duty: Ghosts, Dead Rising 3, FIFA Soccer 14, Forza Motosport 5, Just Dance 2014, Zoo Tycoon, and more.

Microsoft's Xbox Live revenue jumped 20% in the fourth quarter year over year -- a positive sign for the brand's future digital potential. Also in the fourth quarter, Microsoft "only" shipped 1 million Xbox 360 units versus 1.1 million in the year-ago quarter. But this is a potential positive, because it indicates that gamers might be preparing for the next generation -- Xbox One.

The release of these gaming consoles and games has the potential to act as a big upside catalyst for GameStop simply because it sells games for these platforms.

There has been much debate over whether or not game sales will surprise to the upside, disappoint, or be inline with expectations. While no one knows the answer to this question, two factors are likely to play tug of war with each other.

On one hand, since Sony PlayStation 3, Microsoft Xbox 360, and Nintendo Wii were introduced between 2005 and 2007, there's likely to be a great deal of pent-up demand. On the other hand, the consumer is now more value-based than in 2005-2007, and gaming consoles are expensive.

Regardless of whether gaming consoles -- and then game sales for GameStop -- surprise, disappoint, or are inline with expectations, GameStop's revenue is highly likely to increase. But game sales don't lead to higher gross margins. This trend takes place when hardware sales fade and gamers begin to purchase complementary software and accessories. Therefore, you should expect to see higher sales and lower margins followed by lower sales and higher margins.

Digital trends
GameStop feels as though it's well positioned for continuous growth in the digital market by selling network point cars, prepaid digital cards, and online time-cards for Xbox Live, PlayStation, and Nintendo. Based on GameStop's strategic positioning in the market, it expects digital sales to increase in the second half of FY 2013.

More strategic moves
In FY 2011, GameStop began selling and accepting trades for mobile devices and accessories. This option is now available in all domestic stores, as well as most international stores. This was a good move at the time, since it brought more people into the store. As you can see in the five-year chart below, revenue peaked in 2011:

GME Revenue TTM Chart
GME Revenue TTM Chart

GameStop revenue trailing-12 months data by YCharts

This revenue decline has more to do with a hesitant consumer than management. Management has much more control over the bottom line. Therefore, it's important to consider the trend below:

GME EPS Diluted TTM Chart
GME EPS Diluted TTM Chart

GameStop EPS diluted trailing-12 months data by YCharts

Some key metrics also indicate whether or not management is doing an efficient job or not. A net margin of (3.5%) and an ROE of (12%) are far from impressive, but at the same time, the company's debt-to-equity ratio of 0.02 is a big positive, as is a 2.2% yield.

Geographic exposure
GameStop has exposure in the United States, Australia, Canada, and Europe, with 6,505 stores in total. If near-future sales surprise to the upside, then it's possible that GameStop will look to increase its international exposure. But even if that's not what transpires, GameStop knows the digital market is ever-growing, and the company will aim for continued growth in this area. GameStop also knows that there's a low barrier to entry in the digital market, which makes strategic positioning imperative.

The bottom line
GameStop has a lot of upside potential, but it's also a very risky investment, perhaps too risky. Despite future potential, revenue and earnings-per-share trends are concerning, net margin and ROE are negative, the company must contend with a low barrier to entry in the digital market (could lead to increased competition at any time), and it relies too heavily on consumer discretionary income.

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Dan Moskowitz has no position in any stocks mentioned. The Motley Fool owns shares of GameStop and Microsoft. 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.

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Originally published