Everything Goes Wrong for GameStop

An already bad year just got much worse for video game retailer GameStop (GME 0.29%). The company's second-quarter report was a train wreck, with adjusted losses more that tripling as sales tumbled by a double-digit percentage. Another gigantic write-off erased the remaining goodwill on the balance sheet, leading to a GAAP net loss in excess of $400 million.

Sales are falling off a cliff

GameStop fell short of analyst estimates across the board:

Data source: GameStop.

Total sales slumped 14.3% year over year, with comparable sales tumbling 11.6%. Operating costs increased from one year ago, despite much lower sales.

In terms of product categories, sales were down nearly everywhere:

Data source: GameStop. YOY = year over year.

The steep decline in new game hardware is understandable -- both Sony and Microsoft have begun to unveil details about their next-generation game consoles likely coming out next year. The slump in pre-owned sales is the biggest problem, as that category carries a gross margin of more than 40%. That compares to 21% for new video game software and less than 10% for new video game hardware.

The pre-owned business has been in decline for years, and it's not getting any better. While next-gen game consoles will have disc drives, the shift toward digital downloads and streaming all but guarantees that physical game discs are on their way to obsolescence. The very concept of a used game is poised to disappear, along with GameStop's biggest source of profits.

Image source: Getty Images.

A guidance cut, and a questionable strategy

Given the weak second quarter, GameStop lowered its already terrible full-year guidance:

Data source: GameStop.

The midpoint of GameStop's adjusted EPS guidance represents a year-over-year decline of 54%.

GameStop's strategy is to double down on cost cutting. The company now expects to improve operating profit by $200 million by 2021, up from a previous goal of $100 million. This plan involves supply chain efficiencies, operating improvements, expense savings, and changes to pricing and promotions.

The other parts of GameStop's strategy sound like things that every retailer should be doing by default. These include improving the store experience, investing in digital capabilities, and transforming vendor partnerships.

"While we experienced sales declines across a number of our categories during the quarter, these trends are consistent with what we have historically observed toward the end of a hardware cycle," said CFO Jim Bell in prepared remarks included in the earnings release. That's true -- GameStop suffered steep sales declines prior to the launch of the PlayStation 4 and Xbox One in 2013.

But the used games business has been declining for years, and it's now much smaller than it was in the past. GameStop has changed its reporting segments over time, so this comparison isn't quite apples-to-apples. But the $373.1 million of revenue from used and value video game products in the second quarter of 2019 is down 34% from the second quarter of 2012. Segment gross profit is down 41% in that time.

Total sales will almost certainly be boosted by the next-gen game consoles, but they won't change the long-term trends affecting the used games business. Selling new hardware and software is a low-margin affair for GameStop; the performance of the used games business matters much more for the bottom line.

GameStop has over $400 million in cash, which buys it flexibility and time. But if cost cutting is the best strategy the company can come up with, it won't matter in the long run.