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GameStop – It's hard to disagree with the market – GameStop Corp. (NYSE: GME)





Key Fourth Quarter Highlights

GameStop (GME) reported a fourth quarter that seemed solid when we focused on the Revenue and Comp trend, but somehow confirmed a scenario of continuing challenges as we entered the exclude positive effect from multiplication tables Sources of revenue or continued pressure on margins

Fourth-quarter sales increased 15% and Comps 12%, the highest rate since the second quarter of 2014. This was driven by strong sales of new hardware, software and collectibles. The biggest contributors were the Nintendo Switch (OTCPK: NTDOY), which performed well during the Christmas season (which was somehow predictable) and the strong performance in the software sector, fueled by strong stock runs such as Call of Duty : World War II "

The good part of the earnings release seems to end here as margins continued to shrink, though much higher sales and leadership were not so exciting. Gross margin declined 380 basis points in the quarter, driven by a hardware mix and more intense advertising activity. The adjusted operating margin decreased by 243 basis points from 11.30% to 8.87%.

The positive drivers of revenue growth remain one-time contributions and do not significantly change long-term challenges. Let's take a look at the performance of each segment to understand why.

Hardware sales increased 44.8%, driven by the aforementioned strong performance of the Nintendo Switch and good sales of the PS4 Pro and the Xbox One X

Sales of collectibles were also strong, with an increase of 20% yoy, but the numbers showed a significant slowdown of 26.5% in the third quarter and 36.1% in the second quarter. While 20% is a solid growth rate, it is a little disappointing to see such a significant slowdown, considering that the division is indeed the ultimate source of potentially sustainable growth for the company. Considering that core business is challenged by the secular growth of digital downloading of video games, the rising percentage of PC games and margin pressure from other retailers (including ecommerce giants), a 20% increase is somehow disappointing Division accounts for only 7.5% of total sales.

The development of Tech Brands has been very disappointing, with a fall of 14% due to the changes in the compensation structure of AT & T (NYSE: T) staggered launch of the iPhone 8 and iPhone X and operational execution challenges. It is clear that following aggressive expansion, backed by a large number of new store openings, the division is facing significant problems and is unable to help the company diversify as much as the collectibles segment does. While the company expects at least an improvement in operating margins in the division, it also expects a further slowdown in business volume and expects some business closures for 2018:



Source: Q4 Profit Call

The 12.4% increase in software sales was supported by exceptionally strong Call of Duty performance and solid sales of other titles , like "Star Wars: Battlefront II". On the other hand, second-hand business continued to fall, with a 3% decline in the quarter. The main problem that I see is, in addition to the weak performance in the used business, the margin reduction achieved despite the solid sales growth. Hardware and software core margins declined significantly due to mix of sellers and co-operative marketing finance, as well as increased advertising activity. Together, as we have already seen, they led to a gross margin decline of 380bp.

The tricky part of analyzing GameStop's business is to separate the one-time benefits and the one-time performance from the actual underlying trend. Nonetheless, the situation is clearer when we focus on annual figures and take management's leadership into account.



Source: Q4 earnings

In 2017, sales increased 7.2%, while comparable store sales increased 5.8%. This means that both sales and orders are expected to show a modest increase on a two-year basis, which is not bad given the one-off items this year. So we could see a modest increase on a two-year basis, indicating some soft signs of stabilization that not many would expect. But the main problem, in my opinion, is the quality of this revenue growth and the possible margin dilution from additional promotions.

Strategic Initiatives

It is clear that with its loyalty, the company wants to increase the awareness of both customers and non-customers to expand trade-in games (only 30% of customers swap games) It is less clear how this can be achieved unless sales promotion is increased at the expense of pricing power and margins. Nonetheless, the management has a plan to improve the terms and conditions, and it shared some important strategic points during the bidding process. Let's take a look at them:

First The company will expose investments in new businesses and acquisitions and focus on fixing the companies they already have. Management will focus on improving the video games, collectibles and technology brands businesses. Only when these companies operate at a satisfactory level will the company explore further opportunities to drive shareholder growth. The lack of focus can certainly be a big problem, but it clearly shows that we should not expect any other external contributions to diversify the business, unlike what happened in the past few years when Tech Brands was a company diversification.

Second, we need to improve our value proposition with hardcore gamers to solidify this key demographics, though the company has no detailed plan of what they will actually do to achieve that goal.

Third Expanding the customer base to accommodate more mothers and families and occasional consumers. This is mainly due to an expansion of the product range such as exclusive collectibles, high-end e-sports accessories and other licensed goods, as well as an expansion of the benefits of the loyalty program, which can contribute to improving sales stability, but at the cost of margins.

Fourth, improve each customer's average transaction value, both in-store and online, by adding other relevant products and services. This is a double-edged sword. Like the strategic point above, this step can increase the total value of each transaction and revenue, but it can affect margins because the only way to build a bundle is to put it below the sum of its components.

Fifth reduces operating expenses in areas that do not generate revenue or operating profits, which we expect from virtually every store.

Margin Dilution

We saw that the business saw a significant margin decline and even a decline in adjusted dollar operating income (from $ 343.1 million in the fourth quarter of 2016 to $ 309.8 million in the fourth quarter of 2017), which shows that higher revenues do not contribute significantly to profit – which can only be the result of more intense promotional activity. The problem is that management has told us that margins will continue to decline to attract more customers. Consider, for example, the used business. In 2017, proprietary margins stood at 45.5%, down 80 basis points from 2016, reflecting more intense advertising activity in international markets. For the future, we expect the management to promote and promote more.



In the best case scenario, gross margin is expected to be flat, while it could drop a few hundred basis points at the bottom

Conclusion

The fourth quarter gave me no reason to look more favorably on GameStop's outlook. Adjusted operating income declined by double digits despite the strong positive impact of new consoles and successful AAA stocks, suggesting that the underlying problem is much larger than previously thought. In addition, efforts to attract more customers by increasing advertising activity will create further pressure on the bottom line. In other words, given the fact that GameStop's operating profit has declined sharply despite a 15% return on sales and without the impact of asset impairment, I see no reason to believe revenue will improve. Activity will be even more intense , Under these circumstances, I think that the value trap thesis is too strong to be ignored.

Disclosure: I / we have no positions in any of the stocks mentioned and no plans to initiate any positions within the next 72 hours. 19659028] I wrote this article myself and it expresses my own opinions. I do not receive any compensation for it (except from Alpha search). I have no business relationship with a company whose inventory is mentioned in this article.


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