GameStop's (NYSE:GME) stock was cut in half last year as the video game retailer struggled with plunging sales and profits. The suspension of its dividend and a failed bid to sell itself exacerbated that decline.
Value investors, who note that GameStop trades at less than one times its book value and next year's sales, might think this battered stock is too cheap to ignore. Unfortunately, I think it's headed much lower this year, for four simple reasons.
1. A dying core business
GameStop generated 34% of its revenue and 23% of its gross profit from new video game software last quarter. This core business is losing gamers to digital distribution platforms like the Microsoft (NASDAQ:MSFT) Store for Xbox consoles, Sony's (NYSE:SNE) PlayStation Store, and Valve's Steam. Publishers prefer to sell digital games because they don't require any physical disks or packages.
A smaller number of physical games in circulation hurts GameStop's pre-owned and value video game products business, which generated 24% of its revenue and 43% of its gross profit last quarter.
There's no clear way for GameStop to escape this vicious cycle. Microsoft released a disc-free version of the Xbox One last year, and it will likely launch a disc-free version of its next-gen Xbox as well. Sony also banned third-party retailers like GameStop from selling digital download codes for the PlayStation Store last year. Both companies also offer cloud gaming services -- Sony offers PS Now, and Microsoft started testing xCloud in late 2019.
The writing is clearly on the wall. Physical games, the lifeblood of GameStop's business, will eventually suffer the same fate as physical copies of movies.
2. Competition for its non-gaming businesses
GameStop tried to diversify away from games by selling accessories and collectibles. However, sales of accessories are highly cyclical and follow console launches and certain trends like the battle royale craze, which temporarily boosted headset sales. Moreover, most of those products can be bought from a bigger retailer like Amazon or Walmart.
GameStop offered a few exclusive collectibles at its stores, but the vast majority could also be easily purchased online or from larger retailers. I visited a few GameStop stores over the past year and found that it was constantly offering markdowns on its collectibles -- which explains why the unit's gross profit fell last quarter as its revenue slightly improved.
Those markdowns also indicate that it's struggling to clear out its inventories and compete against larger online and offline retailers -- and that pressure could intensify throughout 2020 as it tries to sell more accessories and collectibles to offset its declining software sales.
3. No real turnaround plans
GameStop was led by three different CEOs between 2018 and 2019. Its current leader, George Sherman, has only held the top job since March 2019.
Sherman's "GameStop Reboot" turnaround plan includes four main strategies:
- Optimizing its core business by closing stores, reducing its inventories, and growing its higher-margin product categories.
- Becoming a "social hub" for gaming by expanding its loyalty program and testing esports-oriented stores.
- Expanding its e-commerce platform and trying to secure digital exclusives from publishers.
- Trying to gain more exclusive products from its vendors.
GameStop claimed that its "Reboot" plan slightly reduced its operating expenses last quarter, but it did nothing for its revenue, which plunged 26% annually. That's probably because most of Sherman's plans don't line up with reality.
Gamers won't suddenly consider GameStop stores to be "social hubs" again since most "social" gaming is now done online. It's also doubtful that companies will eagerly give GameStop exclusive products since they can easily sell their products through their own platforms or bigger retailers. To be blunt, GameStop's turnaround plans will likely lead nowhere in 2020.
4. The "Burry boost" will fade
GameStop's stock rebounded in the last four months of 2019 after Scion Asset Management's Michael Burry, best known as the hedge fund manager portrayed by Christian Bale in the film version of Michael Lewis' book The Big Short, took a 3% activist stake in the company.
Burry claimed that GameStop's balance sheet was in good shape, urged the company to repurchase more shares with its cash on hand, and dismissed the notion that digital distribution platforms would doom the retailer. Burry also noted that the arrival of new disc-based consoles like the Xbox Series X and PS5 in late 2020 would extend the retailer's life.
I previously stated that it was a bad idea to follow Burry's lead, since his thesis underestimates the impact of digital games and overestimates the effectiveness of GameStop's listless turnaround strategies. Therefore, I believe that that "Burry boost" will fade over the next few quarters.
The bottom line
GameStop is stuck between a rock and a hard place, so its stock is cheap for obvious reasons. Investors looking for a turnaround retail play should stick with retailers with better management, clearer turnaround plans, and more promising growth engines instead.