Balancing On A Knife's Edge: A Look At GameStop's Financial Statements - Noobtubin8er Blog - www.GameInformer.com
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Balancing On A Knife's Edge: A Look At GameStop's Financial Statements

A couple of weeks ago, I posted a blog that was read by a few concerning the treasure trove of information that can be gained by looking at financial statements. Taking the advice of a GIO friend, I wanted to take a look at the financial statements of GameStop. What follows are facts and quotes derived directly from GameStop's 2011-2012 financial information reported to the SEC and my interpretations of that data. This is not meant to be investing advice, if you want such advice, call a financial planner.

Profitability
One cannot avoid numbers when looking at how profitable a business is, so let's not shy away from them. In a retail business it is important to understand that you may make a large amount of sales from one or two products but that you make more money on a completely different product. This is definitely the case when it comes to GameStop.

GameStop makes its money in four distinct areas: new video game hardware, new video game software, used video game products, and other items (digital content, GameInformer Subscriptions, etc...). Here is a breakdown of their sales (in millions):

 

 

From this chart, you will notice that the vast majority (42.4%) of their sales are derived from the sale of new video games. Now, take a look at the difference in their profitability (profitability = sales minus the cost of attaining the product for inventory):

 

 

While the majority of its sales are derived from new game sales, nearly half (45.6%) of GameStop's gross margin is derived from used video game sales. It is also important to note that the cost of new games is reduced by credit that is given to them by publishers as part of their partnering ad campaigns (those ads you see all over the place in GameStop):

"The Company and its vendors participate in cooperative advertising programs and other vendor marketing programs in which the vendors provide the Company with cash consideration in exchange for marketing and advertising the vendors' products. Our accounting for cooperative advertising arrangements and other vendor marketing programs results in a portion of the consideration received from our vendors reducing the product costs in inventory. The consideration serving as a reduction in inventory is recognized in cost of sales as inventory is sold."

While it may seem, from the outside, that GameStop makes hand over fist on its used game sales and that this clearly shows that GameStop makes too much money on its used games, we need to take one other item into consideration, the company's net income.

Change in Used Game Sales - The Effect
Looking at the 10-K filed in 2012, GameStop's consolidated net income (the total amount of money left over after all expenses are accounted for) was $339.9 million. If all of the profit from used games was taken away, the company would experience a loss of $881.3 million in a single year.

Now, some might say that new game sales would rise because fewer people would buy used games but would still want to buy titles. I can buy into this idea, so let's look at it.

If every dollar of used games sales was shifted to new game sales (a highly unlikely possibility) new game sales would rise by $2,620.2 million. However, GameStop's bottom line would not increase by 1,221.2 (the profit on used game sales. GameStop generally only makes a profit of 20.7% on new game sales, meaning their profit on these additional new games would only equal $542.38 million. If this is the case, GameStop would still experience a $338.9 million dollar loss.

While the shift out of used games in the future is not likely, the advent of on-line passes will undoubtedly affect the sale of used games, I want to look at the possibility of GameStop increasing the amount of credit they give to customers for trade-ins and how that affects their bottom line. This is somewhat of an over-simplification as there are a number of accounting variables, but the end result is representative of what would happen.

For purposes of this analysis, we will look at a game traded in for $25 (while the actual amount does not change the effect on net income because we are looking at percentages, I want to use the $25 to show the effect to an individual as well as the company). What I show below is, based on a percentage increase in credit given to customers, what the customer would see and what would happen to the Company: 

% Raise in Credit

Trade In Value

Ending Net Income

0%

 $               25.00

                            339.9

10%

 $               27.50

                            200.0

15%

 $               28.75

                            130.1

20%

 $               30.00

                               60.1

25%

 $               31.25

                               (9.9)

While some investors would be ok with an increase of 10%, I imagine most others would start jumping ship if the store offered much higher. To top it all off, if GameStop started giving its customers an extra $6 in credit towards their now-$25 trade in, it would actually be losing money every year.

Yes, they could comfortably raise the value and give you an extra $2 on the game, but would it make all that much of a difference to those who don't like the current trade in value? Probably not as most are looking for $40 instead of $25. If GameStop jumped that much in their prices, they wouldn't exist anymore and gamers would have fewer choices to unload their unwanted games.

A New Generation
Taking a step away from the serious numbers, one aspect of GameStop I think few of us consider is the effect the next generation of gaming has on the financial performance of companies like GameStop. In discussing risks inherent with the industry, the financial statements make this note:

"The electronic game industry has been cyclical in nature in response to the introduction and maturation of new technology. Following the introduction of new video game platforms, sales of these platforms and related software and accessories generally increase due to initial demand, while sales of older platforms and related products generally decrease as customers migrate toward the new platforms. New video game platforms have historically been introduced approximately every five years. The current generation of video game consoles were introduced in 2005 and 2006. If video game platform manufacturers fail to develop new hardware platforms, our sales of video game products could decline."

As developers continue to hold off on the next generation of gaming, GameStop faces serious risk of losing sales. At some point, it becomes imperative for console designers to put out new systems and new technology to revitalize dwindling sales and keep places like GameStop open.

While I have no interest in the Wii U and do not perceive it as a true "next-gen" console, I believe it will sell decently well and help to revitalize sales of games and peripherals at retailers like GameStop. Especially when many people are looking to digital distribution as a shift in the future of gaming, an area that GameStop stands little chance of being able to effectively compete in.

 

While GameStop is currently remaining a profitable company and is able to maintain its performance year over year, they also balance themselves on the edge of a knife, balancing between fast-paced technology and customers always looking for the next "thing". It is a trait that makes me respect the company itself a little more.

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