In March, Gamestop (GME -6.77%) reported its fourth-quarter and full-year 2017 earnings. Fourth quarter revenue came in at $3.5 billion, beating analyst expectations by $230 million, and adjusted earnings per share came in at $2.02, topping the consensus by $0.05.
However, guidance for continued sales declines of 5% to flat in 2018, along with adjusted net income between $3.00 and $3.35 per share (which would mark another decline from the prior year despite benefits from tax reform) scared investors. To make matters worse, an analyst downgrade the following day sent shares sinking by double digits.
While the situation is challenging, Gamestop trades at only four times forward earnings and offers a dividend yield over 11%, which means the stock is priced for near-extinction. Meanwhile, new CEO Mike Mauler just took the helm in February. Here are the big problems he'll be tackling.
1. Is it getting too promotional?
One of the concerns investors have expressed is the forecast for continued declines in pre-owned game margins. Pre-owned game sales usually have high margins and are the biggest driver of gross profits for the company. However, they declined in 2017, and gross margins also shrank from about 47% to 45%. Management now forecasts this profitability to further deteriorate to the low-to-mid 40s on an ongoing basis.
On the other hand, management believes a more promotional stance around pre-owned games is an opportunity to grow sales, as only 30% of Gamestop customers trade in games. This will be an attempt to expand the audience of savvy traders to customers that might not know about the trade-in program. The bad news? That will also require more advertising.
Lowering prices while spending more clearly made investors nervous. If the tactic expands Gamestop's trade-in customer base, it will be positive. Otherwise, this important segment is in for a lot of trouble.
2. Can it change with the times?
In the recent past, Gamestop has attempted to diversify its shrinking core businesses by getting into collectibles (a strong move that has exhibited solid growth), as well as technology brands, which are franchised AT&T and Simply Mac stores (which have seen rockier results).
Mauler aims to put a stop to all acquisitions and refocus on improving what Gamestop currently has. That means renovating stores to carry cool products like proprietary collectibles and revamping store layouts for an expanded customer base. That may have seemed like an admission that the physical game business is in permanent trouble, but management thinks there is still opportunity to grow outside of games:
We need to expand our customer demographics and when we develop that strategy, we need to change the shopability of our stores to be a better value proposition to moms and families, for example. We need to expand our range of cool and relevant products and the type of merchandise we sell, so when we bring in these new customers, that once we get them into the GameStop ecosystem, that we can market other products to them. And tie it along with that, we need to do a better job at the value proposition from our loyalty program. Right now, it's very focused on video games, and there's an opportunity for us to have that more focused on collectibles and these new customer demographics.
So, Mauler is trying to both diversify away from games while also winning over non-enthusiasts. That seems like a tall order.
Will technology brands ever improve?
Earlier in January, the company revealed it was taking a writedown on its technology brands business, and Mauler aims to improve this segment. After AT&T changed its compensation structure last year and more people delayed getting smartphones due to Apple's staggered rollout of the iPhone 8 and iPhone X, the segment's sales were down 14% last quarter, although profitability improved.
After the acquisition spree, management will now be focused on improving the compensation agreement with AT&T and closing underperforming stores. Management predicts improvements in this segment in the upcoming year, though the jury is still out.
It should be noted technology brands is still profitable, bringing in about 16% of the company's gross profits last quarter, even after the declines, so stabilizing that segment will be another important goal for investors to monitor.
Gamestop has several businesses that are struggling, and shareholders are skeptical Mauler and company can turn things around. Potential investors should keep a close watch on pre-owned sales, the new store formats, collectibles, and the relationship with AT&T in 2018. The stock is so cheap that an improvement in any one of these segments could boost the stock, but be careful as the long-term story is still very shaky.