Shares of GameStop (GME 3.08%) have shed over a third of their value in the past three years, as shifting industry trends take their toll on this brick-and-mortar retail business.
But even with the stock trading at just 7 times trailing earnings -- investors may still be best served by avoiding the company.
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1. Plunging sales
GameStop revenue fell 8.1% to $8.6 billion in 2016, driven by an 11% drop in comparable store sales.
The decline accelerated in the fourth quarter, as the company's total global sales tumbled 13.6% on a 16.3% plunge in comps. In the U.S. -- GameStop's largest market by far -- comps actually fell 20.8%.
GameStop attributed the drop to weak sales of recent video game releases and "aggressive console promotions" from competing retailers during the holiday shopping season. In turn, fourth-quarter new software sales decreased by 19.3% and new hardware sales plunged 29.1%.
Despite these significant challenges, there is an even more powerful force at play: the shift to digital distribution.
2. The digital evolution
As the world's largest gaming retail chain, GameStop is wholly exposed to the growing popularity of digital downloads.
Major video game publishers like Activision Blizzard and Electronic Arts are moving toward full-scale digital distribution, which offers higher margins than the sale of physical game discs. In fact, Activision's digital sales soared 50% year over year to a record of $1.39 billion in the first quarter and compromised 80% of total revenue. Electronic Arts' most recent results were likewise fueled by strong digital growth, with 61% of its fiscal fourth quarter net revenue coming from digital game sales, compared with 55% in the prior-year period.
Console companies such as Microsoft are also making a push toward increased digital content. The tech titan recently announced a subscription service that gives Xbox One owners access to over 100 older titles. GameStop fell hard on the news, as many investors see this as a direct threat to the company's large pre-owned/value game business, which accounted for more than 46% of its gross profit in 2016.
3. It's about to get worse
Beyond the shift to digital sales, GameStop is about to face another fearsome threat: Amazon.com, which is positioning itself to become a bigger player in video games.
The e-commerce giant has established a beachhead in the industry by offering its millions of Prime members a 20% discount for new video game releases. That's a powerful advantage over GameStop, which typically sells new games at the full retail price.
And now, Amazon has begun placing "buy" buttons on its massively popular Twitch game-streaming site. This will make it even easier for the roughly 100 million people who visit Twitch each month to purchase games directly from Amazon.
Valuation isn't everything
It's understandable that value hunters would be attracted to GameStop and its bargain basement P/E ratio of just 7 times, especially when the S&P 500 average is about 24. The generous 6.4% dividend yield is also going to be tempting to a lot of income investors, as it more than triples the yield of the S&P.
But much like beautiful sirens luring sailors to their doom, those figures fail to tell the whole story. If the company's earnings and cash flow deteriorate in the face of the continued digital disruption of its business, its stock may be far more expensive than its current valuation would suggest. And the dividend could ultimately prove unsustainable at these levels. In turn, it's possible -- some would say likely -- that GameStop shareholders end up suffering major losses in the years ahead. As innovation in the video game world powers on, investors may wish to consider selling their GameStop shares and look elsewhere.
