GameStop (NYSE: GME) shareholders endured a brutal 2017, during which the stock shed over a quarter of its value even as the market gained more than 20%. That underperformance is no reason, by itself, to sell this stock -- especially since the retailer is posting steady sales growth while generating ample profits to support its generous dividend payment.
You shouldn't simply hold the stock no matter what happens to the business, either. But the following red flags might mean it's time to move on from your GameStop investment.
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Management misjudges the holidays
GameStop announced a 2% increase in comparable-store sales in late November. While that was an admittedly modest uptick, it marked the retailer's third straight quarter of positive comps. It also means the business is on track for overall sales gains in 2017.
That would be an impressive turnaround from the 11% decline that GameStop posted in the prior year. It would also suggest that this business is growing a bit stronger, considering executives had started the year forecasting as much as a 5% sales decline but are now projecting an increase in the low to mid single digits.
Image source: Getty Images.
Yet management has been wrong about its holiday forecast before -- and by a wide margin. In late January 2017, CEO Paul Raines and his executive team had to slash their sales and profit outlook due to surprisingly weak customer traffic and plunging demand for prior-generation gaming consoles. Because of that misreading, sales fell by 11% for the full year rather than the 8% decrease management had predicted at the start of the holiday season.
Another miss like that would suggest GameStop's core video game business is weaker than management had hoped and likely can't support the broader business while it builds up its new operating segments.
Profit margins collapse
All sales growth isn't equal, though, as investors learned from GameStop's most recent quarterly report. Sure, the retailer managed higher comps overall during the period. However, most of those sales gains came from the segment dedicated to new hardware sales, which benefited from excitement around the Nintendo Switch release.
The problem is that GameStop generates far weaker profits from these hardware sales than it does from its used and new video game divisions. Gross profit margin on hardware was 12% of sales last quarter, compared to 24% for new video games and 44% for pre-owned games. Thus, its shifting product mix led overall gross profitability to decline to 35% of sales from 36%. Operating earnings fell, too, down to 4.4% of sales from 5% a year ago.