GameStop (GME 1.85%) shares have been bludgeoned in recent years. Shares of the struggling video game retailer are down more than 70% from the highs they reached in November 2013 as shifting industry trends have taken a toll on the one-time high flyer.
Unfortunately, more pain may be ahead for GameStop and its investors. Here are three reasons why.
An investment in GameStop stock is fraught with risk. Image source: Getty Images.
1. Digital disruption
In its heyday, GameStop was a mecca for gamers. People would line up outside its doors when popular games were released. New console launches also boosted in-store traffic, and GameStop made a bounty off accessory sales. In addition, a thriving trade-in and used-game business generated hefty profits and helped to strengthen customer loyalty.
Now, however, all of those aspects of GameStop's business are at risk.
The video game industry has shifted toward digital game downloads, which eliminate the need for physical game discs. Digital downloads are more profitable for game makers, which have made it a point of emphasis to drive digital adoption. Game titan Electronic Arts, for example, saw its digital sales rise to 70% of its total revenue in the fourth quarter, up from 61% in the prior year period.
While GameStop does offer digital game sales, the company has little competitive advantage here compared to an e-commerce site like Amazon.com, a streaming site like Twitch (which Amazon acquired for $970 million in 2014), and a digital distribution platform like Steam, as well as the console and game makers.
Worse still, digital game downloads reduce the supply of trade-in games that fuel GameStop's used-game business. Fewer used-game sales means less profit, and there's no clear answer to this threat to GameStop's highest-margin and most important business segment.
2. Consoles may also disappear
As games have gone digital, GameStop has relied on new console launches to drive traffic to its stores. Actual console sales, however, are GameStop's lowest-margin segment.
More troublesome is that traditional consoles may disappear in the not-too-distant future. Microsoft, NVIDIA, and Sony are just some of the companies betting on cloud gaming. With cloud gaming, much of the computing is completed in data centers, which eliminates the need for powerful consoles. Instead, the games can be streamed directly to smart TVs and mobile-devices.
While technology limitations have so far prevented cloud gaming from catching on in a major way, recent advances in cloud technology could help accelerate this trend. And by eliminating lengthy console hardware upgrade cycles -- since much of the upgrades would be delivered via software -- cloud gaming can usher in a period of far more rapid innovation than has traditionally been possible in the video game industry.
But what's good for gamers and game makers may not be good for GameStop. If consoles go the way of the dinosaurs, people will have one less reason to shop at GameStop's stores. And while this is a longer-term threat, it's a risk that should not be overlooked by investors.
3. Its other businesses aren't enough
GameStop is aware of these risks and has been trying to diversify its operations. The company added more toys and collectibles to its stores, along with wireless products and services. It also spent millions of dollars to acquire hundreds of AT&T authorized retailer stores to further reduce its reliance on video game and console sales.
Yet the results have not been promising. GameStop recently booked asset impairment and other charges related to these businesses totaling $406.5 million. GameStop blamed these writedowns on changes to AT&T's compensation structure and slower smartphone sales caused lengthening upgrade cycles. In turn, the company decided to end some of its wireless partnerships and pause its investment in this area.
And while GameStop's collectibles business has delivered some positive growth -- sales rose 29% year over year, to $636 million, in fiscal year 2017 -- the segment comprises only about 7% of the company's total revenue. It's simply too small of a market to offset the decline in GameStop's core video game business. Moreover, it's hard to see any meaningful competitive advantages GameStop will have in this area versus e-commerce competitors over the long term.
This is not a short recommendation
Although there are multiple reasons why GameStop's stock can fall, there's also one big reason it could rise: the possibility of a buyout.
GameStop recently confirmed that it's in "exploratory discussions" after Reuters reported that the video game retailer had received interest from private equity firms regarding a potential takeover. However, GameStop noted, "There can be no assurance any agreement will result from these discussions."
GameStop's shares rose sharply following the news, and it's possible that the stock could rise further if a buyer is willing to acquire the company near the $20 range proposed by some Wall Street analysts. Such a buyer would likely look to sell-off GameStop's underperforming wireless assets, cut costs, and harvest as much cash flow as possible before a resale -- or perhaps even an outright liquidation -- of the company. It's unlikely that a buyer of this nature would expect to return GameStop to meaningful growth.
With the possibility that a deal could be announced at any moment -- perhaps at a sizable premium to today's $15.70 stock price -- I would not short GameStop. And I would understand if investors who already own shares decide to hold on to them a little longer to see if a deal materializes. But if you're a GameStop shareholder, understand that you could suffer large losses if the struggling retailer's suitors decide to walk away from deal talks, or if GameStop's management rejects their offers.
