Video game retailer GameStop (GME -0.68%) managed double-digit comparable-sales growth during the fourth quarter thanks to strong demand for the Nintendo Switch. But that's where the good news ended. Adjusted net income tumbled, and the company booked a massive write-off related to its technology brands business.
That write-off, which may not seem like that big of a deal, is an admission from the company that its strategy of diversifying beyond games isn't working. GameStop plans to "pause on investing in additional new businesses or acquisitions" this year as it tries to shore up profitability. In other words, it doesn't have a real plan to return the business to growth.
Image source: GameStop.
Growth where it doesn't count
GameStop reported comparable-sales growth of 12.2%, driven mostly by a 44.8% surge in hardware sales. The popularity of the Nintendo Switch was the company's saving grace during the fourth quarter. The problem is that hardware sales are by far the lowest-margin portion of GameStop's business. The company managed a 7.3% gross margin on hardware during the fourth quarter, down from 10.1% in the prior-year period.
Another bright spot was collectibles, which produced year-over-year sales growth of 22.8%. But sales of pre-owned and value video game products slumped 2.6%, and gross margin for that category contracted by 1.9 percentage points to 45%. Sales of technology products cratered 14.2%, with the company blaming changes in AT&T's dealer compensation structure.
GameStop's adjusted earnings per share came in at $2.02 for the fourth quarter, down from $2.38 in the prior-year period, and it expects earnings to decline again in 2018. GameStop expects to report adjusted earnings between $3.00 and $3.35 per share this year, compared to $3.34 per share in 2017. Comparable sales are expected to be flat to down 5%, excluding technology brands.
A massive write-off
When GameStop announced its holiday sales results in January, it also disclosed that it would be taking a non-cash impairment charge primarily related to its technology brands business. The technology brands business is comprised of Spring Mobile, which owns AT&T-branded wireless retail stores and Cricket-branded pre-paid wireless stores, and Simply Mac, a seller of Apple products.
GameStop has built out this business partly through acquisitions as it attempted to diversify beyond games. But it's now clear that the company paid too much for that diversification. It ended up taking a $358 million asset impairment charge and a $32.8 million goodwill impairment charge during the fourth quarter. That's equivalent to more than five times the adjusted operating income for the technology brands business in 2017.
Why the giant write-off? GameStop blamed the compensation structure changes and the negative impact of a longer upgrade cycle for new mobile devices. The smartphone market in the U.S. is mature, and devices aren't improving each year by nearly as much as they once did. This reality led Best Buy to recently announce the shuttering of its stand-alone mobile stores. It looks like GameStop bet on the wrong business.
At the very least, GameStop is pausing its acquisitions and investments in new businesses this year. That will give it some time to come up with a new strategy, which it desperately needs to offset the inevitable shift to digital on game consoles. Once consoles go completely digital, the concept of used games, and GameStop's main cash cow, will all but disappear.
I said this about a year and a half ago: "I think GameStop's transition away from physical games is going to be a lot messier than those who are bullish on the stock assume." After a disastrous write-off tied to what was supposed to be a growth engine for the company, I'm starting to think I wasn't pessimistic enough.
