Despite Soaring, Is GameStop a Clear Sell?

Source: Wikimedia Commons

March 28, 2014 was a pretty good day to own shares of GameStop (GME -3.05%). Despite revenue and earnings that fell shy of analysts' estimates, an upbeat forecast by management propelled shares 9% higher. In light of this positive news, should the Foolish investor consider owning shares of the gaming retailer, or is the business bound for failure?

Revenue and earnings fell short
For the quarter, GameStop reported revenue of $3.7 billion. This was 3% higher than the $3.6 billion management reported in the year-ago quarter but fell shy of the $3.8 billion investors hoped to see. The growth driver was a near 8% jump in comparable-store sales led by the introduction of Microsoft's (MSFT 0.59%) Xbox One and Sony's (SONY -2.71%) PlayStation 4.

In terms of profits, the situation was worse. For the quarter, the company reported earnings per share of $1.89. After factoring in adjustments relating to a change in accounting principles and subtracting impairments, the business' earnings would have been $1.90 per share. This fell $0.03 short of what analysts expected and was 12% lower than the $2.16 per share the company reported in the year-ago quarter. 

Even though GameStop's revenue came in higher for the quarter, a mix in products sold negatively affected its profits. For the quarter, the company saw sales of its new video game hardware rise 191% from $43.6 million to $127 million, while new video game software and pre-owned products fell in relation to sales.

Based on industry data, Sony successfully sold 5.1 million PlayStation 4 units from its release in November through the end of GameStop's 2013 fiscal year. Microsoft's Xbox One also did well, selling almost 3.4 million units over the same time span. Using each product's retail price and assuming that GameStop sold each one in proportion to total units sold globally, we can conclude that the company sold almost 289,000 units.

Source: VGChartz

The increase in new video game hardware may seem nice. But the fact that the sales will revert to a lower level as the new-console market becomes saturated, combined with lower gross margins related to those products, makes the picture particularly worrisome.

But are GameStop's days numbered?
On top of reporting revenue and earnings that fell shy of analysts' estimates, GameStop has another problem that investors must consider. On March 26, Wal-Mart Stores (WMT 0.07%) began buying used video games. Customers can exchange the used games for in-store credit that can be used at any Wal-Mart or Sam's Club as well as at either company's website. Later in the year, the retailer will begin selling these "certified" pre-owned games.

With a gross margin exceeding 40% (compared to Wal-Mart's gross profit margin of 25%), the company aims to jump into a line of business that management believes could bring in revenue of around $2 billion per year. It's impossible to tell what kind of impact this will have on companies like GameStop in the short term. The likely long-term scenario, however, is one where GameStop is forced to increase its trade-in price or lower the amount it charges for any pre-owned games.

Source: Wal-Mart

In spite of Wal-Mart's efforts to beat out GameStop, the retailer's outlook is positive. For its 2014 fiscal year, GameStop expects to report revenue ranging between $9.8 billion and $10.3 billion, roughly 8% to 14% higher than 2013's $9 billion. Top-line results will be driven, for the most part, by an increase in comparable-store sales. Profits are expected to increase even more during 2014.  If management is correct, the business will report earnings per share somewhere in the range of $3.40 and $3.70, up from the $2.99 the business reported during its 2013 fiscal year.  

Foolish takeaway
Due to solid sales for Microsoft's Xbox One and Sony's PlayStation 4, GameStop reported higher sales and earnings but ultimately fell shy of what analysts anticipated. In spite of these troubles and the concern that retail giant Wal-Mart is stepping into the arena, a very strong 2014 forecast enticed shareholders to forgive the company's shortcomings and launch shares higher.

In the event that management is correct about its assumptions, the company could still make for an attractive investment. But if increased competition from Wal-Mart causes a downward revision in the company's results, then the downside could be considerable. For this reason alone, shareholders should be very cautious but shouldn't necessarily stay away from the company. Rather, any investment should be monitored and researched in greater depth so that investors can act on any indication that GameStop is wrong about its future.