Why GameStop Is a Bad Bet

Why GameStop Is a Bad Bet

2013 was a dramatic year for GameStop . Sluggish numbers from the preceding holiday season mixed with the rising threat of digital distribution, and rumors that new consoles from Sony and Microsoft would introduce technology to block used games, were causes for the pessimistic outlook. After a pricing recovery, news that the Microsoft's Xbox One would actually implement such features prompted a sell-off. The hardware manufacturer's later reversal and decision not to clamp down on the pre-owned market prompted more bullish takes on the gaming retailer.

The successful North American launches of the PlayStation 4 and Xbox One have helped GameStop double year over year. But are the numbers and data driving the pricing swell misinterpreted? Is GameStop a sound investment or a leaky ship?

It's all about software
The November 2013 tracking estimates from NPD Group arrived bearing numbers that are both superficially reassuring and troubling. Overall retail sales rose 7% year over year on the strength of the new console debuts. Hardware sales were up 58%, aided by a strong performance from the Nintendo 3DS. This made for the best November hardware sales on record.

At the same time, software sales were down 24%, which is bad considering 2012's November software sales declined 11% compared to the previous year. It's obvious that the new consoles sucked money away from software, but there is also evidence of franchise fatigue and doubt as to whether the new IPs in the pipeline are capable of carrying the torch.

Everyone knows that digital distribution is coming, albeit hindered by increasing file sizes and bandwidth caps. What is not presently understood is how the software breakdown of this generation will differ from the past.

Pop goes a bubble
The collapse of mid-tier games and subsequent concentration of efforts on AAA goes hand in hand with the death of Nintendo's Wii U. Last generation saw the Wii sell 100 million consoles worldwide and act as a haven for family and budget titles. Most of the casual gamers that Wii brought in are being absorbed by mobile or have lapsed altogether, leaving only the Nintendo faithful to drive software sales on the company's new console.

The Wii was a huge part of the industry growth that occurred during the last cycle. The lack of a comparable successor will surely be felt by GameStop.

The real growth is in other stores
The rising development costs associated with the PlayStation 4 and Xbox One, and the consolidation of studios mean that there will be fewer retail games released this cycle. The gaps between big titles will largely be filled by smaller games and indie software sold through the PlayStation Network and Xbox Live.

The PlayStation 4's lineup is already largely buoyed by PSN titles and indie games, with Xbox One set to receive its first indie games in early 2014. A look at the PS4's release slate for the first quarter of 2014 shows just how central PSN games will be to the system's success.

While games have the potential to grow in scope and stature, there will be fewer of them. What's more, these games now feature additional built-in monetization schemes that threaten to suck up the spend-pool that GameStop relies upon. $60 rarely buys all the features and content that a modern game has to offer, with publishers looking to microtransaction models and downloadable expansions that increase gross spend and product lifecycles.

GameStop currently has access to a portion of this revenue with sales of premium game editions and "season passes" for updates. But publishers are increasingly steering these dollars away from the middleman. Microsoft's initial product vision for the Xbox One may have been largely rebuked, but it is the direction in which the industry is inevitably headed.

Japan opts out
Making matters even worse for GameStop, the big Japanese publishers are in various states of disarray. Companies like Square Enix, Capcom, and Konami have stumbled with their console efforts, and are retreating to mobile with hopes of reduced costs and softer competition.

Increased strength from European developers will help pick up some of the slack, but not enough. In the coming years, GameStop's shelves may face waning variety and a narrower pitch.

The game has changed
Storage limitations and download restrictions will keep digital distribution at bay for several more years, but the new software ecosystem threatens to rattle GameStop. Casuals will get their fix through mobile offerings, while more involved gamers purchase the big game of the season, punctuated with smaller releases that the retailer will see no part of. If the latest console war produces clear winners, don't expect GameStop to be among them.

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The article Why GameStop Is a Bad Bet originally appeared on Fool.com.

Keith Noonan has no position in any stocks mentioned. The Motley Fool owns shares of GameStop. 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