Microsoft's "All Digital" Xbox One S Raises Red Flags for GameStop

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Microsoft (NASDAQ: MSFT) will launch a disc-free Xbox One S in early May, according to leaked German marketing images from WinFuture. The console will reportedly cost 229 euros ($259) when it launches in Germany, and Microsoft's habit of using the same price points in euros and dollars suggests that it could cost $229 in the U.S. as well. The console comes with a 1TB hard drive and pre-installed copies of Minecraft, Sea of Thieves, and Forza Horizon 3.

Selling an affordable disc-free console could boost Microsoft's Xbox sales as market demand wanes in the current console generation's sixth year. It reduces production costs, undercuts the Sony (NYSE: SNE) PS4 and Nintendo Switch, and advances the strategy of locking users into its digital ecosystem. An all-digital Xbox One could also eventually serve as a launchpad for Microsoft's upcoming cloud gaming service.

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Those strategies make sense for Microsoft, but they raise red flags for GameStop (NYSE: GME), which is already struggling with the digital obliteration of its core business.

GameStop is being left behind the tech curve

GameStop generated 30% of its sales from new software in 2018. Another 25% of its sales came from "pre-owned and value" video game products like used physical games and hardware.

Revenue from new software fell over 5% last year, and its sales of pre-owned and value products tumbled over 13%. Those declines can be attributed to the rise of digital download platforms like Sony's PlayStation Store and the Microsoft Store.

Game publishers prefer to sell digital copies of games, which have much higher margins, because they don't require discs and boxes. That pain, which initially hurts GameStop's new software business, also carries over to its pre-owned business since there are fewer physical discs to be traded in.

GameStop tried to escape this downward spiral by selling digital download codes on its website and in its stores, but its digital commissions only accounted for 2% of revenue last year. To make matters worse, Sony recently pulled all its PlayStation download codes from brick-and-mortar retailers to lock players into its PSN ecosystem.

Microsoft still allows brick-and-mortar retailers to sell digital download codes, but it wouldn't be surprising if it followed Sony's lead. The company's decision to launch an all-digital Xbox One S indicates that it's prioritizing the growth of its digital ecosystem, and it would make sense to cut GameStop out of the loop.

Could GameStop be the next Blockbuster?

Last year, various reports indicated that Sony and Microsoft's next-generation gaming consoles could be cloud-based devices. Sony's ongoing expansion of its cloud gaming service PS Now and Microsoft's development of Project xCloud support that theory. Adding fuel to the fire, Alphabet's recent introduction of Google Stadia suggests that even the usual process of buying and installing a game could be rendered obsolete in the near future.

Moreover, cloud-based games are playable on a wide range of devices, which eliminates the need for dedicated consoles. That shift would torpedo GameStop's hardware business, which generated 21% of its sales last year.

These factors strongly suggest that GameStop may become the next Blockbuster, but the company still has a few cards left to play. Its sales of pop culture collectibles rose 11% last year and accounted for almost 9% of its top line. Sales of accessories, boosted by robust demand for gaming headsets, surged 22% and accounted for close to 12% of revenue.

Activist investors are trying to replace GameStop's board of directors, and its new CEO George Sherman, who started the job on Apr. 15, plans to completely overhaul the business -- so the company might still pull off an eleventh hour turnaround.

But time is still running out ...

I think it's premature to call GameStop the next Blockbuster, but Microsoft and Sony's actions suggest that time is running out for the struggling retailer. GameStop needs to accept that physical games aren't coming back, and it must pivot its business in a bold new direction to survive.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Leo Sun has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), and Microsoft. The Motley Fool owns shares of GameStop and has the following options: short April 2019 $13 calls on GameStop. The Motley Fool recommends Nintendo. The Motley Fool has a disclosure policy.