Analyst: Cheaper Xbox One a Positive for GameStop, Industry

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The following is an excerpt from a report compiled by Michael Pachter of Wedbush Securities.

On Tuesday morning, Microsoft (NASDAQ:MSFT) announced the June 9 introduction of a new $399 version of the Xbox One that does not include Kinect. The current version of the Xbox One that comes bundled with Kinect retails for $499, a $100 premium to Sony’s (NYSE:SNE) PlayStation 4.

Microsoft has adjusted its strategy after losing the first battle of a long console war. We believe the existing $100 price difference between Xbox One with Kinect and PS4 has been a leading contributor to Sony winning the next-generation console war thus far. On April 16, Sony announced PS4 sell-through of over 7 million consoles worldwide as of April 6. In comparison, on April 17, Microsoft announced Xbox One sell-in of over 5 million consoles worldwide since launch.

In our view, the sales delta was not driven primarily by Xbox One’s later release date, or by inferior content (on the contrary, as EA’s Titanfall was exclusive to Microsoft consoles). Instead, we believe that in the minds of many consumers, Microsoft failed to justify charging $100 more than its rival for Kinect. Microsoft also announced that Kinect will be available as a standalone item for Xbox One later this fall, although a price was not disclosed. In our view, Kinect is not seen as a must-have item by many core gamers, at least not yet, and we expect a modest attach rate as a standalone item initially.

Microsoft also announced that beginning in June, gamers will no longer need an Xbox Live Gold membership to access certain entertainment apps. Xbox One and Xbox 360 owners will be able to access certain Microsoft apps (including Internet Explorer, OneDrive, OneGuide, and Skype) and third-party apps (including HBO Go, Hulu, and Netflix, among others) for free.

Currently, Xbox users have to pay for an Xbox Live Gold subscription ($60 per year) before getting access to many popular apps, including third-party apps that require their own subscription fees. Additional announcements on Tuesday included that Games with Gold (subscription-based access to free games for Xbox Live Gold members) will debut for Xbox One in June, while Xbox 360 members will receive an additional game for free. Also, Deals with Gold (discounted games for Xbox Live Gold members) will debut for Xbox One in June, as well.

We have put our global industry sales estimates for the period 2014-2016 under review after Microsoft’s announcement this morning. Our early bias is that a more affordable Xbox One model will be a positive for the industry and GameStop (NYSE:GME) as the console’s popularity should improve, and gamers will have additional cash to spend on new games.

GameStop will report Q1:14 results after the market close on May 22. We will publish a preview note ahead of that date with our formal views on the quarter.

Maintaining our OUTPERFORM rating and 12-month price target of $60 for GameStop shares. Our price target is based on 15x our FY:14 EPS estimate of $4.02. Although many quality retailers trade at 20x EPS, GameStop faces headwinds from digital and the impact of the next-gen console transition on current-gen sales.

Investment thesis: We continue to believe that GameStop’s core business will have a long tail. As long as physical video game products are produced, we expect GameStop to remain the market leader at retail, and we believe that the company’s large used-game business solidifies its relationship with a very large segment of the gaming population that values used games as currency to fund new game purchases.

Given that next-generation consoles contain disc drives and there are no plans by the manufacturers to block used games, we think that GameStop has at least 10 years of runway left in its core business. In the meantime, the company is leveraging its preeminent position in selling used game consoles by offering used smartphones, tablets, and other consumer electronics, and we expect substantial growth from this category over the next several years. GameStop management has consistently returned the company’s free cash flow to investors, and we expect them to continue to do so, suggesting to us that EPS growth will continue for much of the next decade.

Risks to attainment of our share price target include changes to game release timing, the effects of competition, supply of video game products, macroeconomic factors, and slower-than-expected consumer demand for video game hardware and software.

Michael Pachter is an analyst at Wedbush Securities. 

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