GameStop (GME) soared over 40% in intraday trading, following a halt on the announce of a multi-year partnership with Microsoft (MSFT), aimed at providing benefit to both companies. Yet the ‘strategic partnership’ doesn’t seem to be providing as much value to GameStop, although shares are reflecting heavy optimism. Connecting dots between historical trends and performance indicators offers insight in to the nature of the deal, and why it doesn’t seem like a grand-slam for GameStop.

From the agreement, GameStop will “standardize its back-end and in-store solutions on Dynamics 365…[to integrate] finance, inventory, eCommerce, retail and point of sale [channels].” This allows employees to gain “insights about customer preferences and purchasing history, real time information on product availability, subscriptions, pricing, and promotions.”

GameStop’s employees will also be utilizing new Microsoft Surface devices as well as Microsoft 365 and Teams to boost “productivity and collaboration” and provide a different in-store experience from the sales associate side.

GameStop also is expanding its Xbox line to include “Xbox All Access, which provides an Xbox console and 24 months of Xbox Game Pass Ultimate to players with no upfront cost,” ahead of the launch of the Xbox Series X|S. Microsoft looks to build gaming revenues from this partnership, pointing out that “GameStop has been a strong go-to-market partner for our gaming products.” Pre-orders of the new Xbox console and Xbox All Access isn’t exclusive to GameStop, as multiple other retailers have the same deal.

Yet the press release doesn’t dive in to much detail about the nature of benefits to the partnership, only offering this blanket statement – “GameStop and Microsoft will both benefit from the customer acquisition and lifetime revenue value of each gamer brought into the Xbox ecosystem.” That revenue share at the gamer level could be seen as a positive, and provide a long-term stream of revenue over the course of the agreement, but it might not be all too significant.

Microsoft, even as GameStop’s third largest vendor, only accounted for 6% of new product purchases during FY19. Nintendo (OTCPK:NTDOY) (OTCPK:NTDOF) and Sony (NYSE:SNE), the top two, accounted for 28% and 18%, respectively. Microsoft is still an important piece for GameStop, but its impact as a vendor has been waning – Microsoft did account for 10% of new product purchases in 2018 and 2017, while Nintendo had 23% and 22%. It’s no longer as large of a contributor to new product purchases.

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The expansion of GameStop’s Xbox line ahead of the launch of the Xbox Series X|S also is a two-edged sword – GameStop could see incremental increases in revenues from the new console cycle, as it witnessed lower demand for Sony and Microsoft products in FY19 due to those consoles nearing the end of their respective cycles, but also that hardware sales are lower margin.

Even so, Microsoft’s relatively small percentage of new product purchases doesn’t provide much benefit, when taking in to account the overall size of Microsoft’s gaming business.

Microsoft doesn’t provide a clear picture for gaming, rather just lumping it together under its ‘More Personal Computing’ segment, but based on YoY growth of 2% for $189 million, the gaming segment is estimated between $9.6 billion and $11.8 billion for FY20 (going for a midpoint estimate due to potential rounding gives $10.7 billion).

Now, gaming revenue increase came from higher demand of Xbox content and services, which grew $943 million, or 11% – that puts FY20 revenues for content and services near $9.5 billion; with the $10.7 billion midpoint estimate, that leaves $1.2 billion for hardware, where revenue declined 31% for FY20, due to volume and price declines.

There doesn’t seem to be much overall benefit in it for GameStop. Microsoft only contributes to 6% of new product purchases, and if that comes from hardware alone (new series of console), there’s not much room for growth, given that hardware is only a small portion of overall gaming revenues for Microsoft plus the competitive factor with other consoles and other retailers. Assuming GameStop does generate that 6% partially from content and services sales as well (say 15% to 20%), the overall benefit is still likely to be under $200 million; that’s hardly enough to move revenues significantly higher, or even enough to benefit upon from an earnings standpoint.

There’s still some potential that comp store sales for GameStop could be driven higher due to increased demand around the release of the new consoles, but GameStop is seeing an increase in hardware’s share of sales, which impacts margins.

FY19 saw hardware sales drop to 42.1% of revenues, down from 44.9% in FY18; the company saw a $1 billion decline in hardware sales, and a related $850 million decline in software sales. Software sales as a percentage of revenue remained the same at 46.5%.

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However, for FY20, GameStop is seeing hardware sales as a percentage of revenues climb once again. Q2 saw hardware account for 46.9% of revenues, while for 1H, the segment is up to 48.6% of revenues. Hardware’s revenues for 1H came in at $954.7 million, while software came in at $803.5 million (41.0% of sales), as this segment could be on its way to lag hardware sales for the first time in over three years.

The partnership essentially looks to benefit off of the upcoming new console cycle, aided by supplementary purchases in software and DLC; however, those aren’t the focus of the partnership, and likely won’t see huge gains without similar gains in hardware.

It’s also a challenging competitive environment. GameStop faces competition from Amazon (AMZN), Walmart (WMT), Target (TGT) and Best Buy (BBY) domestically and in some international markets, while European sales have competition from major consumer electronic retailers and hypermarkets. Combining that with heavy hits to traffic in GameStop’s primary venues of strip malls and shopping malls further threatens revenue declines, which have been in play since 2016, although the release of the Nintendo Switch and related popularity helped 2018 revenues to a degree.

ChartData by YCharts

So, as revenues have continued the decline, with 1H revenues down 30.7% (TTM revenues are at $5.6 billion, with FY20 consensus at $5.5 billion), weakness in margins will impact bottom line performance as GameStop heads for a third consecutive year of losses. Net margin has drifted consistently lower, even from its razor thin level a few years ago; a 4-quarter moving average for net margin now hovers near -5%. Shifting to a higher mix in hardware won’t bring as much benefit to margins due to it being a lower margin segment.

GameStop also has been cutting costs, and while that’s been in play for many companies as a result of the pandemic, GameStop had taken efforts to reduce costs prior to the outbreak. Cutting costs aren’t exactly necessary in growth, and are typically implemented when expecting difficult conditions, reduced profitability (as cost-cuts attempt to boost such figure), or ahead of distress.

While Q2 pointed to a $133.7 million decrease in SG&A, that figure is down about $200 million for 1H, yet cost cuts aren’t exclusive to pandemic-impacted quarters. These measures have been in play prior, just not at the same degree. Cost cuts for FY19 were $71.5 million, or 3.6% of expenses. This falls in line with the deterioration of revenues, profitability and margins.

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Reversal in falling margins won’t solely come from finding revenue growth, or recovery, as it does come down to product mix and expenses. Cost-cutting probably could continue in order to reverse some losses, as well as a shift back to software generating more sales than hardware, even though promotions for software products do cut in to margins to a degree.

Overall, the agreement with Microsoft doesn’t look to have much benefit for GameStop, as the new product sales derived from Microsoft have shrunk from 10% to 6%. Microsoft does seem to have the better deal, implementing its cloud software, video-services and data solutions to GameStop’s full corporate structure, while GameStop simply is receiving an Xbox All Access bundle (no extra upfront cost to the customer) and some benefit from customer acquisition. Based on FY20 numbers from Microsoft’s gaming sector, and the relatively small percentage of new product sales, estimated benefit to GameStop is quite small, and doesn’t seem to have much of an impact on falling revenues. Even though the new console cycle could help sales, competitive pressure from big-name stores in e-commerce and brick-and-mortar could dampen holiday sales; net margin has also drifted considerably weaker, now into negative territory, not aided by product mix shifting to hardware. Cost-cutting measures, which do aid to boost profitability, had been in play even before the outbreak, aligning with weaker revenue streams and consecutive annual losses. Optimism surrounding the partnership between the two has sent shares up over 40% intraday following the announcement, although the beneficial impact might not be so great.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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