Investors could hardly be more pessimistic about GameStop's (GME +2.69%) business these days. The company's attempt to diversify away from its physical video game retailing model was a failure, and management's efforts to sell the company to a private buyer fell flat as well. Thus, while key metrics like cash flow and profitability are holding up, the stock has had a brutal year, falling over 65% in 2019.
That situation sets low expectations heading into the chain's fiscal second-quarter report on Tuesday, Sept. 10. Yet the probabilities still appear tilted toward GameStop underperforming targets rather than shocking Wall Street with good news.
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Signs of stability
Now that the company has sold the Spring Mobile segment that accounted for the bulk of its consumer tech business, its growth avenues are limited. The main areas to watch here are around new video game software and hardware and pre-owned games. These segments each declined last quarter due to the combination of two negative trends: an underwhelming game release calendar and the continued shift toward digital game purchases.
These issues contributed to a 20% slump in the pre-owned game segment last quarter, along with a 35% drop in hardware sales and a 4% lower software revenue. We'll find out on Tuesday whether sales trends continued weakening beyond the 10% decline GameStop saw in the fiscal first quarter or are moving toward stabilizing as the chain enters the back half of the year.
Costs and profits
GameStop made several aggressive financial moves over the last few months that have the potential to dramatically improve its earnings profile -- assuming the core business returns to growth or at least stops shrinking. It has slashed costs and lessened promotions across most product categories. The early results of those initiatives included a higher gross profit margin in the first quarter. However, GameStop risks weaker sales growth as a trade-off for that profitability boost.
The important point to follow is whether the strategy continues lifting margins without threatening market share. If, on the other hand, management switches gears again, then investors will have more disappointing evidence that the company has lost control of its expansion path.
Finding smart uses for cash
GameStop executives have access to lots of resources today, thanks to their decision to suspend the dividend and sell off a large piece of business. The way they choose to use that capital will determine whether investors see decent returns from the business over the long term.
So far, the consumer discretionary stock has directed cash toward paying down debt, which provides an immediate boost by retiring notes that carry over 6% interest rates. GameStop has also made a huge commitment to repurchase shares, to the tune of 12% of the outstanding stock base in recent weeks.
Those buybacks occurred at a price of over $5 per share, and since then the stock has fallen by more than 20%, indicating a consensus opinion on Wall Street that management wasn't creating shareholder value through the stock purchases. CEO George Sherman and his team can shift the narrative in a more positive direction, but first they'll have to demonstrate that they're executing a rebound strategy that's delivering stabilizing revenue and earnings trends despite historically weak selling conditions in the industry.
