GameStop Getting Played Out?

GameStop (GME - Analyst Report) shares sold-off about 6% on Tuesday due to concerns that the world’s largest video game retailer is quickly becoming the next Blockbuster (BBI - Snapshot Report) or Sam Goody.

Specifically, at the Electronic Entertainment Expo (E3), Microsoft (MSFT - Snapshot Report) announced that it is going to roll out a new service called "Games On Demand." Xbox 360 console owners will be able to download full video games (not just demos) to their hard drives. The downloading service is scheduled to begin on August this year. Initially, "Games On Demand" will offer 30 videogames, including Mass Effect, BioShock and Call of Duty 2, and will add new games each week.

The initial take on this announcement is that Microsoft is plotting to cut out the middleman, i.e., retailers like GameStop. We disagree. While we like the idea of being able to download certain videogames, we do not believe the download service will be a substitute for regular visits to GameStop. Microsoft plans to offer a limited selection of older games and will probably avoid selling newer games that are still selling well in retail stores.

By limiting the selection to older titles, it is unlikely that "Games On Demand" will replace GameStop anytime soon. Xbox Live general manager, Marc Whitten, shares our view. He indicated that Microsoft has been working closely with its retail partners. And Whitten personally believes that "going into a store and seeing that back of the box of the game, talking about the game - that's not going away."

In addition to the limited selection, the price of the downloaded games could prevent the service from taking much business from GameStop. The downloaded games will be more expensive than buying the discs at GameStop or other retailers. Microsoft plans to price the downloaded games in line with current retail prices.

To play the downloaded games, however, Xbox 360 owners will need to save those games to their hard drives. A standard Xbox 360 console comes with 10 gigabytes of hard drive space, and a downloaded game will eat up about 6GB to 8GB of hard drive space. As a result, a 360 owner will need to buy additional hard drive space if he/she wants to own more than one downloaded game. A new 120GB hard drive for the 360 costs about $120.

What’s more, Xbox 360 owners will be essentially stuck with their games because they will not have the option of trading in the games that they are finished playing. The older games will be deleted to make space for new games or continue to take up valuable hard drive space.

In its present form, Microsoft’s Games On Demand is not going to impact GameStop at all over the near term. As a result, we continue to expect GameStop to deliver impressive results in the back half of 2009, driven by a strong video game release schedule and a probable price cut on Sony’s (SNE - Analyst Report) PlayStation 3. We also continue to believe the stock is cheap based on estimates for 2000 and 2010. Our six-month target price on the stock remains $34, which is just 12 times the Zacks consensus estimate for 2009.