New Video Game Consoles Are Hurting GameStop

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Were this any other transition period for the video game industry, GameStop stock would be soaring these days.

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Instead, the stock has been largely flat — climbing less than one point year to date, noticeably underperforming the market's seven percent gains — as well as other companies in the gaming space.

At issue are a pair of clouds that refuse to go away: used games and digital distribution.

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Used games are the bread and butter of GameStop's earnings. In its most recent fiscal quarter, 28 percent of the company's overall sales were from used video game products — bringing in $496.3 million. Used games represented over 48 percent of GameStop's gross profits.

So reports that Microsoft's next iteration of the Xbox won't allow the use of used games has investors nervous. Adding to the agita is remaining cloudiness about how Sony's PlayStation 4 will handle them.

While Sony officials said they don't plan to block used games on the system, people familiar with the PS4 say that technology is built into the console — but Sony has left the decision up to individual game publishers on whether to utilize it through the use of watermarked game discs.

"Used games are a big frustration among publishers," said John Taylor of Arcadia Investment. "I'm guessing there are a lot of discussions between the console companies, the publishers and GameStop on how to share that windfall of profit. … The catalyst of new platform is changing the stakes at the table. It's increasing the leverage the content people have over the distribution people. … In a zero sum world, that's going to be viewed as a negative for GameStop. "

While Microsoft's not addressing the rumors and Sony has said its peace for now, GameStop isn't letting the whispers go unanswered. The company has used the media to warn console manufacturers that internal surveys of its customers show they would be much less likely to purchase a system that didn't support used games.

Analysts have downplayed talk of a used game 'ban,' noting that neither Microsoft nor Sony would risk alienating players that way. And publishers, they note, would have to change their terms of business.

"The missing link is you need a publisher to say we're not selling packaged products anymore, we're selling a one-use license, like Microsoft does with Office," says Michael Pachter of Wedbush Securities.

While the fate of used games remains a question, investors are equally worried about the rise of digital distribution with new consoles.

In the near term, no one is expecting any sort of sea change—but the PS4 and next Xbox are both expected to offer day one downloads on most big titles. And as consumers get more comfortable with buying digitally — and distribution methods improve — that could further impact brick and mortar retail.

"To the extent that the industry evolves and the medium evolves, that has implications on their physical presence.," Taylor said. "I can see a scenario in 3-5 years where their store base is smaller than it is now, but they're doing a lot of Amazon-type business and still able to do alright. But it's going to look a lot different. … What GameStop management is tasked with now is, in a sense, changing from spots to stripes."

To make that transition, GameStop has begun selling downloadable content (DLC) in its stores — offering it as an up-sell when a customer buys a game. Buyers who choose to do so receive a code they can redeem on their Xbox or PlayStation at home, where it will download.

That's not an ideal way to buy DLC, though. In a perfect world, customers would purchase the content at GameStop; then the retailer (through a secure handshake with the console company) would confirm the transaction had taken place and the DLC would be instantly put into the user's Xbox or PlayStation account. And that's something the company is painfully aware of.

"We thought we'd have to have that in place," says Brad Schliesser, director of digital content for GameStop. "Making this a little easier for consumers is the icing on the cake. Our goal on this is 'let's make it a better process for the consumer. … Our goal in 2013 would be to get one partner to convert to a 'push to box' model."

Schliesser says GameStop is still on track to reach its goal of $1.5 billion in digital revenue by the end of its 2014 fiscal year. Physical sales, though, are likely to continue to suffer — and even if digital sales do take off, the company still faces an uphill challenge due to, you guessed it, its reliance on used game sales.

"The problem with a digital sale for GameStop as opposed to a disc sale for GameStop is every time you sell a disc, you sell something into someone's library that can be recycled," Taylor said. "When you sell a digital copy, there is no second sale. … Digital distribution could have a cascading effect on used game business."