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Should You Avoid GameStop No Matter How Good the Price?

By Keith Noonan – Sep 25, 2020 at 10:00AM

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The video game retailer is valued at a small fraction of this year's expected sales, but its future is dim.

GameStop (GME -1.98%) stock has surged recently thanks to excitement about a fresh console hardware cycle and news that Chewy co-founder Ryan Cohen and his firm RC Ventures have taken a roughly 10% stake in the company. Cohen will reportedly push to restructure the business so that it has a broader online retail focus and sells goods outside of the video game space. The Bloomberg report outlining the plan states that Cohen and RC Ventures view the business as potentially evolving into a competitor to Amazon.

Between the start of a new console cycle and interesting plans from an activist investor, GameStop hasn't looked this exciting in years. The company also still trades at just a small fraction of this year's expected sales. On the other hand, the stock remains a risky proposition despite the company's low valuation, and the business's long-term outlook remains dismal. 

A pair of hands holding a video game controller on a yellow background

Image source: Getty Images.

This console cycle is different

GameStop has yet to comment on whether it will pursue any of Cohen's proposals. Before investors consider get too excited about the retailer's hypothetical future as an e-commerce powerhouse, they should be familiar with the outlook of the business as it stands today. 

The stock has historically seen positive momentum corresponding with the release of new consoles. The video game retailer is currently valued at roughly $600 million and trades at a 1/10th of this year's expected sales. Sony will be launching a next-generation PlayStation this November, and Microsoft will also be introducing its next-gen Xbox family the same month.

Sony and Microsoft will both have cheaper versions of their next-gen hardware at launch that do not include disc drives, meaning that owners of those variations won't be buying their games at GameStop or cycling titles through the company's trade-in system. Sony and Microsoft's last consoles each eventually had disc-less versions released, but the upcoming hardware generation will be the first time that major platforms will launch on day one with digital-only options. 

Gamers will be able to purchase digital-only consoles that are significantly less expensive than the models with disc drives. High adoption for all-digital versions of the new PlayStation and Xbox platforms could quickly undermine the value-based bull case for GameStop stock and weaken its ability to pursue new growth strategies. 

The numbers game doesn't add up for long-term investors

GameStop's revenue should soar in the fourth quarter and see continued tailwinds thanks to new consoles. The problem is that the retailer gets low margins on hardware and depends on new and used video game software sales for the large majority of its gross profits. 

GameStop's hardware and accessories segment accounted for $2.72 billion, or roughly 42%, of sales last year. The company didn't break out gross profit figures by segment for 2019, but it did in fiscal 2018. It also provided a more detailed breakdown of product categories by revenue that year -- listing "new video game hardware" as a separate segment instead of grouping it together with accessories and pre-owned hardware.

New video game hardware accounted for just 6% of the company's gross profit in 2018, despite making up roughly 21% of total sales. The segment's gross profit was also elevated by the inclusion of higher-margin video game software that was bundled together with new consoles.

2018 was also the last year that GameStop separated new and used game sales into separate reporting segments. New games accounted for about 29.5% of the company's $8.29 billion in sales for the year, and roughly 22.8% of total gross profit for the period. GameStop's pre-owned and value video game products made up 22.5% of sales for the period and 35.1% of gross profits. Software is the company's lifeblood, and it's going to keep draining.

GameStop's bottom line has been hit with a ton of writedowns and impairment charges over the last several years, and the company's earnings should improve substantially in the near term now that failed mobile and computer hardware businesses have been cast aside. However, its gaming business will continue to trend downward due to disruption from digital distribution

The current growth bets are bunk...

GameStop is experimenting with social-focused gaming stores that would host tournaments and other events and have seating areas with gaming PCs and consoles for players to use. It's an idea that could boost brand strength and improve foot traffic at some locations. However, many GameStop stores simply aren't big enough for hosting events, and renovations would be costly.

The retailer is also testing out stores that specialize in older video games, but this market is too small to spur a broader comeback. And players seeking retro games have a range of competing online retailers and third-party-seller platforms to choose from. 

The company's collectibles segment, which includes video game and pop culture merchandise like figurines and clothing, has been a relative bright spot in recent years. But it can no longer be counted on as a growth driver. A substantial portion of GameStop's collectibles sales came from Funko figurines, and it looks like those toys are starting to lose steam.

Collectibles revenue for 2019 climbed just 3.7% year-over-year, and sales for the segment in the crucial fourth quarter actually fell 9.2%. Segment revenue in the first quarter of the current year, which was negatively impacted by the coronavirus pandemic, fell 42.5% year over year. Q2 sales for the segment fell 34%. At least for the time being, the collectibles-driven growth story is dead.

Amid rising digital-distribution tides, GameStop's software business is a sinking ship. And the decline appears to be irreversible.

...and the rumored pivot has a high risk of failure

Ryan Cohen's bid to pivot GameStop's business toward being a broader purpose e-commerce business appears to implicitly acknowledge that the company doesn't have a sustainable future as a specialized gaming hardware and software retailer. Cohen proved himself a capable e-commerce innovator and manager during his time at Chewy, and the prospect of him taking on a more activist investor role with GameStop and attempting to move the business in a new direction is admittedly intriguing. 

On the other hand, it's rare that companies can pull off pivots on the scale of what's reportedly being proposed. The possibility that GameStop can become a serious challenger to Amazon is incredibly slim.

The overall e-commerce market is poised for long-term growth, and GameStop wouldn't necessarily have to become a leading online-retail player in order to justify a valuation increase. However, building a bigger position in the space will likely be resource-intensive, and the company will have a very difficult time gaining share from competitors that can run online retail operations at a loss for a decade if need be. 

With GameStop's gaming retail business likely poised for disappointing performance after a short-term boost from new console hardware, a comeback remains a long shot. 

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Keith Noonan has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon and Microsoft. The Motley Fool recommends GameStop and recommends the following options: long January 2021 $85 calls on Microsoft, short January 2021 $115 calls on Microsoft, short January 2022 $1940 calls on Amazon, and long January 2022 $1920 calls on Amazon. The Motley Fool has a disclosure policy.

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