These 3 Quotes Show Why GameStop Is in Trouble

"We are often a really poorly understood company," Paul Raines, GameStop's (NYSE: GME  ) CEO told CNBC on Friday. Raines is right -- if investors understood GameStop, they wouldn't have bid up shares of the retailer nearly 9% on Friday.

GameStop is a company with a fundamentally broken business model, one whose prospects should continue to deteriorate in the coming quarters. As its chief suppliers -- Sony (NYSE: SNE  ) and Microsoft (NASDAQ: MSFT  ) -- turn into competitors, and GameStop sees more competition from traditional retailers like Wal-Mart (NYSE: WMT  ) , GameStop's business is poised to shrink significantly.

The following three quotes are taken from GameStop's recent earnings call. Collectively, they highlight the myriad challenges GameStop is facing.

GameStop's CEO on increased competition:

Consumers have low top of mind awareness of buy-sell-trade and new competitors will drive greater overall awareness of the category, which has always been very good for our business.

With more than 6,400 stores, it's difficult to find a town or even strip mall in the U.S. that lacks a GameStop. Anyone who has ever shopped at the chain will know that its associates push pre-owned software aggressively, and that it often runs specials on pre-owned products with brightly colored banners adorning the store's windows. GameStop has 27 million members of its PowerUp Rewards program -- a frequent shopper program that, for a $15 annual fee, offers discounts on games and accessories.

In other words, I think it's absolutely ludicrous to suggest that consumers (particularly gamers) are not aware of GameStop's used-games business model. Raines didn't refer to Wal-Mart specifically here, but he seemed to be heavily implying it. Wal-Mart's entrance into the used games space is, as I've already noted, a major challenge to GameStop. Management didn't confirm it, but GameSpot reported last week that GameStops in the vicinity of a Wal-Mart were offering extra trade-in credit -- certainly not a sign that GameStop is welcoming the increased competition.

GameStop can't compete in the cloud

GameStop has made the business decision to shutdown Spawn labs based on the lack of demand from customers to adapt this type of streaming game service at a strong enough level to build the sustainable business.

Almost exactly three years ago, GameStop acquired Spawn Labs, a video game streaming start-up. At the time, GameStop bragged that it had big plans for Spawn Labs, and would work to develop a cloud-based streaming game service. Then the launch window (summer of 2013) came and went, with GameStop's management remaining mum.

I speculated that GameStop, as a relatively small retailer, would have a difficult time competing with technology giants like Sony, who also plan to enter the space. Indeed, that appears to be the case -- yesterday, GameStop officially announced that it has shuttered Spawn Labs.

While GameStop's management cites a "lack of demand," I find that hard to believe -- and I'm not alone. Guy de Beer, the CEO of Playcast, a European-based cloud-gaming service, told VentureBeat there is a great demand for cloud gaming, so much in fact, that he plans to bring his company to the U.S. in the near future.

Cloud-based gaming stands as a major threat to GameStop, as it would cannibalize (or even eliminate) the sale of video game hardware and software. More menacing than Playcast, however, is Sony's forthcoming PlayStation Now service. Expected to launch this summer, subscribers to Sony's service will be able to stream games to their PlayStation 4 directly over the Internet -- giving them little reason to head over to their nearest GameStop.

GameStop thinks the pre-owned business is coming back

The thing you got to think about is, we know historically the pre-owned business will have very strong growth in the first two to three years of a console cycle. There is going to be a lot of demand from the value people.

GameStop's management believes this new console generation is just like any other, that, based on historical trends, sales of used video game software should tick up in the coming months. But they won't -- this time really is different.

Although Microsoft scaled back its digital ambitions for the Xbox One, the console heavily encourages gamers to purchase their games digitally. Right from the Xbox One's dashboard, gamers can head over to Microsoft's online store and buy a full digital copy of any game ever released for Microsoft's platform. It may take an hour or two to download, but gamers can begin playing almost immediately -- saving themselves a trip to the store. Microsoft has even begun to offer digitally only discounts on select titles, a practice GameStop has been forced to respond to. Sony's PlayStation 4 functions exactly the same.

The long-term effects of gamers buying digitally will be disastrous for GameStop. Even if the number of games sold digitally remains in the minority, the effects will multiply over time -- first by eliminating the sale of new game software, and then again by preventing GameStop from reselling used games (digital copies can't be traded in). GameStop's management seems to be aware of this -- citing supply constraints, GameStop said it will work with publishers to procure older titles no longer in circulation. Unfortunately for shareholders, these games will offer lower margins.

GameStop is the classic value trap
At these levels, GameStop is yielding a healthy 3.50%. But in this case, investors shouldn't reach for yield -- the company's core business model is facing competition from nearly all sides. GameStop has new initiatives in the pipeline (like Simply Mac), but it's prior ventures, including GameStop Kids and now Spawn Labs, were complete failures. With games going digital, and Wal-Mart moving in, GameStop is a dangerous company to own.

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