Gamestop Needs an Intervention Part 2: WTF Edition

I am a bit behind the times, but I just read gamedaily's interview with Gamestop's new CEO and it kind of made me feel icky in my tummy. This guy is in charge of about a third of the video game sales and he is not on our side. His positions on digital distribution and used games make him sound either delusional, or like an ostrich with his head in the sand.

BIZ: What are your thoughts on the digital distribution options that connected consoles are introducing to gamers today? Do you see today's gamers bypassing retail one day, as music consumers currently do with iPods and iTunes?

DD: The first digital distribution was Napster and it was illegal. Let's just start there. The software publishers are afraid to death of piracy. Once a full game is lying on a hard drive, there's the potential for piracy. Aside from the games, the bandwidth, etc., our studies have concluded that the network won't be in place to do digital distribution of full games until 2020 to 2025. And that's using today's size, but as consoles get more powerful, games get bigger. Right now, a 30GB game with your best T1 line is about 72 hours to do it.

He is running our biggest retailer, but doesn't understand the market forces operating in his favor. Or maybe he just won't talk about them publicly. This guy is the proverbial little boy with his finger the dike. He is trying to hold his position as toll taker between consumers and publishers, while pressure is building on both sides of the wall. Consumer and publishers both want direct downloads. This model is currently failing Hollywood because, as he correctly points out, technology circumvents distribution chokeholds. The game industry is tracking a few years behind music and television, but there are definitely cracks forming in the dike. Poor Mr. Gamestop CEO does not realize placing his finger in the dike will not stop the leaks. He believes bandwidth the impediment to game downloads, but it’s not. Publishers want to put games on line, but can’t for fear of alienating the retail channel, and hardware manufacturers can’t allow it for fear of losing the opportunity to sell at retail. Once this fear is allayed, the market for game downloads will flood into existence like music and television before it.

Gamestop, Wal-Mart, Target and all the retailers hold shelf space over the heads of the publishers and console manufacturers. If publishers undersell or consoles allow full game downloads, the retailers won't stock them. It's their only weapon. When we look back to the music industry, downloads were initially slow, but a billion downloads starting happening overnight. When Apple made it easy, a billion sales happened over night. The adoption curve was so steep it all but bent over on itself. Television is following the same adoption curve, and there is no reason to believe games won't follow the same curve. The impediment is not technological, and it is not a problem waiting for a breakthrough, it is artificial, and will disappear on its own. Today, publishers and the consoles need retail to get hardware into market, but as we move to the back half of the console cycles and there 50 million plus of each console in the home, expect to see more direct downloads of whole games. Once it happens, Mr. Gamestop CEO is going to get very wet. Like Sony music who kept trying to come up with new CD encryption and NBC who tried to leave iTunes, he will realize, you can't stem the tide. The publishers will go direct, because they can. He tries to make an argument he publishers will make less money direct, but unlike his store, they will get paid for every unit sold on the console.

BIZ: Do you feel threatened by the lower cost digitally distributed games offered to consumers?

DD: I would argue that the average value of a current generation game is about $20. We will give $1 billion out to consumers this year, who will use that money to buy new -- not used -- games. Consumers have been conditioned that their video games have residual value, just like a car. The real cost of a game today isn't $59 but $39. Nothing that has been digitally distributed retains the same value as a retail version; it's always less. Let's say a retail game is $39. Microsoft and Sony are the gatekeepers for their consoles. And if you're a third party that should scare the hell out of you because that's the only way to get to your customer. They'll take 10 to 15 percent. Video game publishers sell me games today for $48 wholesale. If they go direct to the customer they'll probably get about $30 for them. They'll get less for the game if they bypass retail.

If games are really worth USD 20, why is he paying USD 48 to get them - because he sells them a lot of times. As I addressed in an earlier post, his used game policy drive the value of the game to USD 20. Games do not have a value of USD 20. Games in Gamestop have a value of USD 20. If publishers got paid on each download sale, something which does not happen at Gamestop, not only would they more than make up the difference, they would maintain the higher price. He also tries to argue used games are a sales driver, but the argument just doesn't hold up.

BIZ: What are your thoughts to those in the publishing business who say used game sales are hurting the games industry?

DD: I do talk to many publishers about this. We will give out $1 billion worth of credits that will be used to purchase new video games this year. New games in the U.S. this year will be $10 to $12 billion, so 8 to 10 percent of the total dollars used to buy new games this year will be from currency from GameStop's trade-in program. What we see is that consumers want to buy new games, but they don't have the cash because our trades go up as our new game sales go up. They're using trade-ins to buy games because more money is going into their gas tank. It's a source of currency that helps drive the video game business. I think the argument that it competes with the new games is false. Imagine what new car sales would be like if you couldn't trade in your old car.

Used game credits are stored value held by Gamestop. The contribution of the stored value credit toward the new game puts the new game into the stored value system. The publisher gets paid once on the transformation, but then the game becomes currency in the Gamestop system. Once in the system, the unit is sold an unreported number of times. The total Gamestop currency grows with games in circulation, and each unit of growth removes value from the publishers. Mr. Gamestop CEO assumes used games are only used for acquisition of new games. They are not. One billion dollars worth of credits are used to pull the games off the shelves the first time, but how many times are other used games sold? There answer, is enough to generate about another USD 2 billion in revenue. The publishers don’t get paid on those. Gamestop has a 50% margin on used games, much better than the 21% margin on new games. According to their SEC filing, 44% of their gross profit is attributable to used games and on a unit basis,53% of all game sold are used. If the industry generates USD 12 billion next year, Gamestop’s game sales, based on market share would account for USD 4 of those 12 billion dollars. My math skills aren’t so great, but this would mean USD 2 billion in sales are attributable to used games and publishers are only paid on 2 billion for new games, with an additional billion in stored Gamestop value going toward new games. Consumers are actually subsidizing Gamestop’s inventory with used game returns. Even if we assume every purchase made with credits comes from someone who would otherwise not purchase the game - major leap of logic - game publishers still lose 2 billion dollars a year.

I don’t buy Mr. Gamestop’s residual value argument either. Sure I look at depreciation when I buy a car, but I’m not buying a car from Gamestop. I am buying a game. Moreover, the auto industry makes money from used cars through the sale of parts and dealers make money through service. Game publishers make money once, on the sale - at Wal-Mart and only sometimes at Gamestop. Which brings up a good point. Wal-Mart has roughly the same market share as Gamestop, but there is no game trade in. They do the volume, at full price without the subsidy. Gamestop didn’t create the concept of residual value, they created the concept of the cheap game. When you buy a game at Gamestop, it goes something like this:

“Oh I see you are buying Super Death Ray Auto Blaster 17.” says the counter guy. “You know its an “M” rated game.” Gamestop did have a 94% compliance rate in the most recent FTC study.
“Yes.”
“Would you like to buy it used. You can have a [10 to 50%] discount.”
“But it ust came out two days ago.”
“I know, but we got some back, you can get a discount and it’s guaranteed to work.”
The consumer hears “Would you like a kick in the balls or this nice shiny game?” Mr. Consumer, who already decided to purchase the game and not rent, buys the used game. He would be stupid not to.

Mr. Gamestop CEO please be straight with us. You figured out a way to make money without paying for inventory. That’s cool, it’s the American way. While its self defeating in the long run, in the short term you will make money in a crack dealer kind of way. Please don’t insult our intelligence though. In reality you are not any different than the dude selling bootleg Batman DVDs on Canal Street in New York, you just have a bigger table. And don’t delude yourself, those publishers and consoles who say they like you, they do, because you are selling 33% of their product. Let’s see who shows up at your birthday party once your market share falls. I have a sense you will lose some support. If you want to take a look at the Ghost of Christmas future, talk to your counter parts at Circuit City and Toys R Us. They used to have your market share too.