Distribution changes
GameStop’s biggest competitive advantage is as a middleman in the used-game market. The company earns very high margins by buying and selling used games. Used video games accounted for 30.7% of GameStop Corp. (NYSE:GME)’s revenue last quarter, but nearly half of the company’s gross profit. The health of this business is key to keeping GameStop stock afloat.
However, console manufacturers and software publishers would prefer to see higher sales of new games rather than lots of trading. Failing that, they want a cut of the profits from trade-ins. Microsoft Corporation (NASDAQ:MSFT) is pursuing this goal very directly. The new Xbox One console will require online activation of games, which gives Microsoft Corporation (NASDAQ:MSFT) complete control of the trade-in market.
Trade-ins will still be permitted, but the lion’s share of the profit will be taken by Microsoft Corporation (NASDAQ:MSFT) and the game publisher, according to Forbes contributor Erik Kain. This could leave gross margin for retailers like GameStop Corp. (NYSE:GME) as low as 10%, compared to the 47% margin GameStop recently achieved on used games.
While Sony Corporation (ADR) (NYSE:SNE) and Nintendo Co., Ltd (PINK:NTDOY) do not seem to be taking such a draconian tack yet, Xbox is the leading game console platform in the U.S., GameStop Corp. (NYSE:GME)’s primary market. A significant decline in the profitability of used Xbox game sales would be a major blow for GameStop.
Not worth the risks
GameStop Corp. (NYSE:GME)’s management has taken a very shareholder-friendly stance by committing to return 100% of free cash flow to investors. This seems to have driven GameStop stock’s strong performance over the past year. Unfortunately, the long-term disruptive threats I laid out above are likely to lead to sharp erosion in the company’s FCF.
It is possible that GameStop Corp. (NYSE:GME) will manage to adapt to the quickly evolving market, especially if the release of new consoles from Microsoft Corporation (NASDAQ:MSFT) and Sony Corporation (ADR) (NYSE:SNE) this year drive a strong upgrade cycle. However, the company faces too many serious competitive threats to give GameStop stock an acceptable risk-reward profile. Investors might do well to consider avoiding the stock.
The article Don’t Put Your Faith in GameStop Stock originally appeared on Fool.com.
Fool contributor Adam Levine-Weinberg owns shares of NVIDIA Corporation (NASDAQ:NVDA). The Motley Fool recommends Google Inc (NASDAQ:GOOG), Nintendo Co., Ltd (PINK:NTDOY), and NVIDIA. The Motley Fool owns shares of GameStop, Google Inc (NASDAQ:GOOG), and Microsoft Corporation (NASDAQ:MSFT).
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