Please ensure Javascript is enabled for purposes of website accessibility

Why the Bears Might Be Right About GameStop Stock

By Demitri Kalogeropoulos - Dec 15, 2017 at 8:00AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

This company isn't for investors who prize predictability.

GameStop (GME 3.27%) was one of dozens of retailers to announce surprisingly strong third-quarter results over the last few weeks even as it boosted its holiday-season forecast. And yet, unlike many of its peers, the video game seller's stock didn't benefit from management's brightening outlook. In fact, shares are down sharply over the past year and aren't far from their all-time lows.

Let's take a closer look at why the pessimists might be right in pushing this growing business' dividend to an 8% yield -- and its stock to a fire-sale valuation of less than 6 times earnings.

Two kids play a video game on the floor.

Image source: Getty Images.

Less profitable growth

Comparable-store sales expanded by 1.9% last quarter to mark GameStop's third consecutive quarter of positive comps. Importantly, this increase included growth in the core video game business, just as management had predicted it would.

Digging deeper into the results reveals a warning sign for investors, though. GameStop's biggest gains came in its video game hardware division, which benefited from strong demand for Nintendo's Switch console. This segment is by far the retailer's least profitable, with a gross margin of 12% compared to the pre-owned game division's 44% margin.

GME Operating Margin (TTM) Chart

Data by YCharts.

This shifting sales mix led to a drop in overall gross profit margin, down to 34.7% of sales from 36.1% a year ago, and a worsening of operating earnings to 4.1% of sales from 4.9%. These results don't do much to ease investor fears that GameStop will lose earning power as the buy-sell-trade video game model gets disrupted by the rise of digital content delivery.

New businesses aren't booming

GameStop's new business lines were supposed to pick up the slack as the retailer transitions away from that lucrative old model. But the technology brands division that includes the Simply Mac, Spring Mobile, and Cricket stores isn't putting up great numbers, either. It posted a 10% sales decline last quarter and a 52% drop in operating earnings.

Management blamed the spotty supply of Apple's iPhone X for the stumble, and they left the door open for more weakness ahead. Depending on how well supply meets demand for that device over the holidays, GameStop might not meet management's growth goal, executives warned.

While investors shouldn't panic over short-term sales volatility like that, it's still worth keeping tabs on this underperforming operating segment. After all, GameStop is relying on it and the collectibles business to deliver an increasing portion of profits between now and 2019.

Intense seasonality raises risks

GameStop's full-year guidance predicts profits of $3.10 to $3.40 per share in 2017. The top of that outlook range would mark flat earnings compared to 2016 as comps improve to around 3% from last year's 11% slump. It also means ample coverage for the generous dividend, which costs GameStop $1.52 per share each year, or less than half of the profits the company is targeting.

However, there's a big risk built into this result. GameStop has only booked $1.39 per share in profits through the first nine months of the year, which leaves $2 per share, or close to 60% of the total, left to be generated in the 13 weeks that make up the holiday quarter.

That intense seasonality threatens to amplify even tiny missteps -- whether it's a supply issue around devices like the iPhone X or Nintendo Switch, or weak demand for a major game title -- into a major drag on sales and earnings. Thus, many investors are likely opting to wait before making the judgement that this is a healthy retailing business. Steady sales growth to date suggests that it might be, but a lot is riding on GameStop's performance in the next several weeks.

Demitrios Kalogeropoulos owns shares of GameStop. The Motley Fool owns shares of GameStop and has the following options: short January 2018 $19 calls on GameStop. The Motley Fool has a disclosure policy.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

GameStop Corp. Stock Quote
GameStop Corp.
GME
$40.74 (3.27%) $1.29

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
400%
 
S&P 500 Returns
128%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 08/13/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.