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The Science of Hitting
The Science of Hitting
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Gamestop Managment Talks Digital and PowerUp

September 27, 2011 | About:

Seven months ago, Borders, the second-biggest bookstore chain in the U.S., filed for bankruptcy. At the time, this event only increased the focus on brick-and-mortar specialty retailers, with many believing that this transformation would hit video game retailer GameStop (NYSE:GME) as well, which fell below $20 a share and was trading at less than 7.5x earnings despite EPS growth of 17.7% in the prior fiscal year. Since then, the stock has been on a roller coaster ride, peaking more than 40% higher at the end of May ($28 per share) before falling back in the low $20s by August; today, the stock goes for just under $24 per share.

Three weeks ago, management was present for a question and answer session at the Goldman Sachs Global Retailing Conference; here are some of the key notes from the event, specifically on digital and the PowerUp Rewards program:

As with almost any company, GameStop is dependent upon the consumer, specifically through employment; however, it was interesting to hear CEO Paul Raines talk about the fact that industry development is actually more relevant to GME than the macroeconomic environment: “As far as what we see, our business is largely driven by title, count, and hardware pricing activity more than it is the macro. Gaming is an inexpensive entertainment solution. The average video game has 20 to 40 hours of game play, so we have seen consumers in previous downturns flock to gaming and go to gaming as an entertainment source.”

Importantly for investors, Mr. Raines thinks that the holiday season will be strong due to an influx of new games: “Our title count for holiday is extremely strong. As we said on our second quarter call the strongest title lineup we've seen in a long time, perhaps ever. We think holiday will be very compelling in terms of the new title count.”

Obviously, management was not getting out of there without talking about their digital strategy. Here are some of the key points from Mr. Raines' lengthy response:

GameStop is in the midst of a pretty significant transformation. We started a strategic review of the company about two and a half years ago at the request of our board. We spent a lot of time looking at the external/internal factors, used some outside expertise, [and] did some internal work. And we launched a strategic plan in the spring of 2009.

If you look at our strategy, it revolves around making and maximizing our stores and bringing digital content sales into those stores. We've launched a PowerUp Rewards program they use data from PowerUp to plan store openings and closures], which is much more than a loyalty program (more on this in a moment). We're starting to call it a digital engagement program where we have over 13 million members now who engage GameStop in store, on the web, through a digital locker at poweruprewards.com, through mobile apps, and through a series of touch points that drives all of our businesses.

We've acquired a company called kongregate.com, which is a casual game portal that's growing very well, 40% up year-over-year. We're selling digital content sales in store. You hear us talk about DLC, which means that we're launching Map Packs and digital content for console games… We've acquired a PC download business called Impulse, which now is integrated with gamestop.com. So we're in the PC download business. We're very happy with that. And we're in a very exciting beta test with our streaming service…

So we've got some exciting pieces, but all of it is based on a strong foundation round the store...

The numbers they have put up are pretty good, highlighted by $290 million in digital revenues last year. CFO Rob Lloyd expanded on their digital plans: “Our goal is to get to $1.5 billion [in revenue] by the end of 2014. In the second quarter, we had 69% growth year-over-year. Digital was a significant contributor to our gross profit growth, so we're very pleased with directionally where the business is going. And as part of our 50% CAGR plan to get to that $1.5 billion, we're on track to the $450 million or so that we expect for 2011.”

The PowerUp program is a membership at GameStop, which comes in two varieties: paid and free. With the free membership, you get access to an online account which keeps track of the games that you have purchased; however, the paid membership (which is $14.99 per year and accounts for more than 60% of all PowerUp members) is what grabbed my attention, because it gets you discounts on pre-owned games in addition to a membership for Game Informer, “the fourth highest circulation magazine the United States.” Interestingly, more than 60% of the company’s sales now come from PowerUp members. This may prove to be an important competitive advantage when competing services are launched, and GameStop is fighting to retain digital customers; as noted by Mr. Raines:

“PowerUp Rewards is a tremendous asset for us because we know we now have in our membership — our model says that membership represents 25% to 30% of all video game consumption in the United States. If you think about launching digital businesses, if you think about launching a PC download business, a streaming business, our ability to market to the consumers who are the heavy spenders in video gaming is really unrivaled by anyone in the market. So we are finding that as a customer acquisition tool to launch new digital businesses, PowerUp Rewards is also a huge asset.”

In regards to brick and mortar, management has repeatedly said that they expect flat to low single-digit growth through 2014 on physical product sales in the console gaming space. It will be interesting to see how fast technology changes the competitive environment in gaming, and whether or not GameStop will come out ahead in digital or go the way of Borders before them.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct". I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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