Investors could hardly be less optimistic about GameStop's (NYSE:GME) upcoming earnings results. Shares are trailing the broader market by over 50 percentage points this year, the retailer's dividend yield is approaching double digits, and its stock is valued at less than five times the $353 million in profits it generated last year.

Numbers like these usually describe a business that's in deep retreat and bleeding cash. GameStop isn't near that point yet. In fact, sales are holding steady and its cash flow is on pace to easily cover its dividend.

Two children react while playing a console game.

Image source: Getty Images.

But Wall Street is still predicting a quick deterioration in business fundamentals. Let's look at the trends that will tell investors whether that's happening when GameStop reports its third-quarter numbers after the market close on Tuesday, Nov. 21.

Where the growth comes from

GameStop's broad revenue trends have been healthy this year, with comparable-store sales rising by 2% in both the first and second quarters. A look behind those number reveals a big red flag, though. The core video game business is shrinking as gamers enthusiastically shift their spending to online sales channels and, as a result, give up the ability to participate in GameStop's profitable used games ecosystem.

The e-commerce demand has been great for video game publishers. Activision Blizzard (NASDAQ:ATVI), for example, just announced record third-quarter results that were driven by spiking digital spending. Yet GameStop's pre-owned gaming products segment is suffering as a result of the industry shift. The division has fallen to $1.03 billion, or 27.5% of sales, from $1.1 billion, or 30.6% of sales, a year ago.

The retailer is offsetting most of that decline through growth in new business lines such as consumer tech and collectibles. But GameStop's strategy relies on the video game operations holding roughly steady while it develops these complimentary revenue streams. An accelerating shift away from disc-based video game sales, as Activision Blizzard's latest results imply, would threaten those plans.


GameStop's gross profit margin has ticked lower over the past six months, mainly because sales gains in the consumer tech segment were overwhelmed by losses in the pre-owned gaming business. A key contributor to this trend is the fact that the retailer is seeing its strongest growth in new video game hardware, which is by far its least profitable division.

Expenses are rising, too, as it closes its least profitable stores. That trend has led to a decline in bottom-line profitability to 2.2% of sales through the first half of 2017 compared to 2.6% over the same period last year. A further dip on this metric would suggest GameStop is finding it challenging to attract customer traffic across its retailing portfolio.

Holiday outlook

That profit trend will reverse itself to the extent that GameStop can capitalize on demand for new products over the holidays. There's no shortage of opportunities here, including a refreshed Apple iPhone lineup, new video game consoles, and major software releases from Activision and its rival publishers.

Back in August, CEO Paul Raines and his executive team predicted that this flood of innovation would drive customer traffic over the final two quarters of the year and allow the company to post roughly flat comps while earnings declined by just 4% at the midpoint of guidance. Those targets describe a moderately healthy business, and so Wall Street bears would likely be caught by surprise if GameStop doesn't reduce these targets as part of its earnings release on Tuesday.

Demitrios Kalogeropoulos owns shares of Activision Blizzard, AAPL, and GameStop. The Motley Fool owns shares of and recommends Activision Blizzard and AAPL. The Motley Fool owns shares of GameStop and has the following options: long January 2020 $150 calls on AAPL and short January 2020 $155 calls on AAPL. The Motley Fool has a disclosure policy.