Video-game retailer GameStop (GME 2.74%) saw the writing on the wall way back in 2013. The company's core business of selling video games out of thousands of stores nationwide faced an existential threat from the digitization of games. Just as the PC gaming market had moved away from physical discs, the console gaming market would eventually do the same.

GameStop acquired Spring Mobile, an AT&T authorized retailer with 90 locations, a little more than five years ago. The company added more stores via acquisitions, eventually pushing the store count well over 1,000. The goal of this push into selling smartphones was diversification, and the plan appeared to be a success, at least for a while.

But it didn't work. And now GameStop is giving up on it altogether.

A cracked smartphone.

Image source: Getty Images.

Getting out of smartphones

GameStop announced on Nov. 21 that it was selling its Spring Mobile business. The company will receive $700 million from Prime Communications, which will be used to reduce debt, fund share repurchases, and reinvest in the video game and collectibles businesses.

GameStop executive chairman Dan DeMatteo said: "This transaction enables GameStop to enhance our performance with an increased focus on the video game industry and the rapidly growing collectibles space. These are areas where we have considerable experience and where we are well positioned to capitalize on our competitive position." 

GameStop's technology brands segment, which houses Spring Mobile, grew rapidly as the company acquired new stores. But the business hit a wall toward the end of 2017. Segment sales plunged after AT&T changed its dealer compensation structure, and the company took a massive $406.5 million charge in the fourth quarter of last year. GameStop blamed the compensation changes and a longer mobile-device upgrade cycle for the write-offs.

To say that GameStop overpaid for its diversification would be an understatement. Those charges were more than five times larger than the annual adjusted operating income for the technology brands segment. What was supposed to be a growth engine for the company turned out to be an albatross.

Selling smartphones is ultracompetitive, and it's even tougher now that the U.S. is largely a replacement market. Cellphone penetration is around 95%, and smartphone penetration is nearly 80%, according to the Pew Research Center. And smartphone users are holding on to their phones longer. The average smartphone upgrade cycle in the second half of 2017 was 32 months, up from 25 months in the prior-year period, according to NPD.

GameStop doesn't have a competitive advantage in the smartphone market, and making money selling phones will only become more challenging. Dumping Spring Mobile is the right move, although it doesn't fix the company's core problem.

What now?

GameStop's new strategy is to focus on games and collectibles -- basically what it was doing before its foray into smartphones. The used-games business is still the company's cash cow. Pre-owned and value video-game products enjoyed a gross margin of 43.7% in the second quarter, nearly double that of new video game software and quadruple that of new video game hardware.

But the used-games business is in decline, and there's no such thing as a digital used game. Collectibles alone can't support GameStop's massive store base. The influx of cash from the Spring Mobile sale will shore up the balance sheet, allowing the company to pay off most of its debt if it wants. But it does nothing to halt the shift toward digital games.

GameStop is getting out of a bad business with the Spring Mobile sale, but the games business that remains is facing its own problems. With a strategy that amounts to staying the course, the retailer is in deep trouble.