Since Microsoft introduced the Xbox One last week, the conversation surrounding it has been about how

the company intends to handle trade and resale of used games. The company hasn't made all details public yet, and there is speculation that the final details are still being worked out, but the world's biggest video game retailer, GameStop, stands to lose significantly if there is a change to the status quo. Last year, I began saying we should expect both of the new systems to try to block some video game resales and that now seems to be happening.

Party's almost over for GameStop's used games business

Last year, I began saying we should expect both of the new systems to try to block some video game resales and that now seems to be happening. It's time to look at how a change in the resale process might affect GameStop's business.

Instead of speculating about what sales will be like in the future and trying to model the changes in a used market and the launch of two new consoles, I'm going to look back at previous results and ask this question: What would GameStop's last four years of results look like if only a modest change were made in its trade and resale business?
GameStop's Segments and MarginsI currently expect that the resale of games on the Xbox One and PlayStation 4 will be permitted with retailers like GameStop acting as middlemen to handle the deauthorization and reauthorization of disc licenses. The actual details of the systems are not relevant to me, since the net effect of any new system will be to cut into GameStop's pre-owned product margin.

By way of explanation, let me begin by describing GameStop's business, as described by the company itself in its financial documents. GameStop typically breaks its market into four segments: New Hardware, New Software, Pre-owned products, and Other.

The first two are pretty straightforward, and as you might imagine that third category is a catch-all for the products that GameStop resells, including software, hardware, and accessories. The fourth category, Other, covers primarily PC software, digital content, cards for online services, new and refurbished mobile devices, and Game Informer subscriptions.

GameStop measures these segments with two key numbers. The first is net sale, or the actual amount of money taken in for products in each segment. The second is gross profit, or the amount of money left over after the cost of the products has been taken out.

For example, if GameStop spends $250 to buy, ship, and stock a brand new PS3 Super Slim in a store and then sells it to a consumer for $270, then the net sale is $270 and the gross profit is $20.

I'm going to think of gross profit as number of cents profit for each dollar in revenue, which is essentially gross profit margin. The gross profit margin on New Hardware is generally 5 cents to 9 cents while on New Software it ranges between 19 cents and 23 cents.

GameStop has a very efficient used product business, and its gross margin in that segment ranges between 44 cents and 51 cents.

The Other segment has changed in the last few years. Prior to 2011, the company's Other segment generally had never broken 38 cents per dollar of revenue, but since that time its gross margin has moved as high as 43 cents in a given quarter as the company has seen a greater uptake in digital goods and refurbished mobile devices, both of which have nice margins.

A brief history of these margins can be seen in the figure below. The shift in the Other segment is clearly visible starting around February 2011.


What if Pre-Owned Product Margins Fell?Now, here's the basic thought experiment: What would the last four years look like if we moved GameStop's gross profit margin on pre-owned products down from about 48 cents per dollar down to 35 cents per dollar?

Roughly speaking, GameStop currently gets 50 percent of the sale price of its pre-owned products, most of which is used software, back in gross profit. So, for example, if it sells a used copy of Bioshock Infinite for $50, then it gets to keep approximately $25. Suppose Microsoft and/or Sony impose flat fees on the retailer that work out to between $5 and $10 per disc deauthorization and reauthorization.

Then, everything else remaining equal, the retailer would realize gross profit of $15 to $20 on that $50 resale, down from $25. That's a gross profit margin of 30 percent to 40 percent per dollar of revenue. (Depending on the base resale price of a game, such a flat fee would provide GameStop with a greater or lesser margin.)

In the table below, I've put together the actual data for the last four years, with the actual gross profit margins that GameStop achieved.



If the gross profit margin had actually been 35 cents per dollar during that period, and no other changes were made, the results would have looked like the table below. The figures I've changed are marked in purple.



(I also put together graphical demonstrations of this change, but it's somewhat less compact. You can see historical net sales and gross profit here, along with operating earnings here. The modified model, with the new margin assumption, are here for net sales and modified gross profitand here for modified operating earnings.)

I'd point you to the operating earnings line, which shows how much money the company has left from its net sales after the cost of goods sold and general administrative costs have been taken into account. Over the past four fiscal years GameStop's operating earnings totaled just over $1.8 billion.

If the only change to the company's business over those last four years were to reduce it's gross profit margin to 35 cents per dollar, those operating earnings would fall to $645 million, a reduction of about 65 percent.

GameStop's business leans heavily on the gross profit margin for its pre-owned sales. That means that even a change from 50 percent to 35 percent in that segment can have a much larger effect on the company's business overall.

As you can see, if GameStop's margins can be pushed down, even just a few points, publishers can begin to weaken the company's previously unassailable position in the marketplace.

One note before I finish up: GameStop had a rather technical increase to its operating expenses in its last fiscal year. That's not expected to happen again, and operating expenses for the current year are expected to return closer to the level of fiscal 2011. Without that extra expense, GameStop would have had an operating profit, not loss, in 2012.
The Beginning of the EndI admit that the thought experiment above is unrealistic. Naturally, one cannot simply drop the gross profit margin on used games in the way I've described. However, I do think that it is instructive.

Even if GameStop's Xbox 360 and PS3 software sales were replaced with Xbox One and PS4 software sales, this would probably not alone bring the margin for the entire Pre-owned product segment down to 35 percent. Pre-owned games for Nintendo's platforms as well as pre-owned console and handheld hardware from all manufacturers would still carry a stronger margin, unaffected by whatever new consoles choose to do. So moving the margin as low as I did above is probably too strong a change for GameStop's business even in the next three years.

On top of that, GameStop's New Software and Other segments would likely be affected by any change in the Pre-owned Product segment.

In terms of New Software, as GameStop has repeatedly noted, customers put $7 out of every $10 in trade value back into new game purchases. If the margin on pre-owned software is reduced, then GameStop could respond by offering less trade value to consumers -- and that would reduce the available trade credit to go toward new games. Therefore when consumers are trading less in at GameStop, publishers can expect to see retail sales of their new games go down as well.

Alternatively, if GameStop continues to offer aggressive trade-in values, it can still retain some of its pre-owned product margins by raising the price it charges the consumers who then buy those pre-owned games. However, raising its selling prices would make GameStop's pre-owned products less attractive to consumers, and decreasing the net sales in its Pre-owned Product segment.

Even GameStop's Other segment, where it puts its digital revenue, could be harmed by a change in its pre-owned business. GameStop has been at the front line of attaching DLC purchases to games sales, both new and used. If either new or used software sales decline at retail, it is quite likely that retail DLC sales will go down as well. Consequently, harming GameStop's Pre-owned segment also diminishes its digital business.

Finally, GameStop has built an impressive network of 30 million Power Up Rewards customers worldwide, each of which has a unique card identifying what they have bought and traded. Even that relationship will be under attack with the new generation of consoles. Both Sony and Microsoft will try to leverage connections to social networks to reach consumers directly, and add their own innovations like Sony's Share button on the new DualShock 4 controller.

Those consumers will likely be presented with options to buy games directly based on the activities of their friends, obviating a trip to a physical store. If Microsoft or Sony begin to build incentives into the system, it could be even more powerful. For example, a game might be offered to you with a small discount if you buy it through a friend's recommendation -- or your friend might be offered a small virtual currency gratuity for a successful recommendation.

My point in this discussion is not that GameStop will soon be dead -- but I do think the company could be gravely diminished in the next five years, especially as the next generation of consoles supplants the old one. It is clearly benefiting from the decline of Best Buy, and is positioned well for the launches of the new systems. GameStop is still growing its mobile resale business, and the margins on resold iOS and Android devices are apparently quite high. And while its digital business looked like it stalled a bit last quarter, it could still be earning over $1 billion in digital revenue by late 2014.

But its greatest strength, the pre-owned game business, is under assault and any changes to the basic assumptions of that business model need to be thought about carefully. Regardless of which side you're on, it's going to be interesting to watch.