3 Signs You Should Sell GameStop Stock

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.

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.

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.

That drop wouldn't be cause for alarm if the number stabilizes over time. But it would be a big issue if GameStop shoppers end up buying mostly low-margin hardware from the company while doing all of their software spending online.

New business lines fail

GameStop's plan is to milk its dominant market position in the video game business even as gamers move away from buying and trading physical game discs in favor of direct downloads. While managing the decline in this segment, management is focused on building up its new product lines of consumer technology, mobile phone services, and collectables. These segments should account for most of its profits by 2019.

That's why weak performances in one or more of these divisions would be cause for concern. The technology brands division, for example, recently posted a surprise profit drop that management blamed on the lack of availability of new Apple smartphones. GameStop can afford temporary challenges like that. But investors likely wouldn't put up with a string of disappointing results out of the business segments upon which the retailer has staked its future.

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Demitrios Kalogeropoulos owns shares of AAPL and GameStop. The Motley Fool owns shares of and recommends AAPL. The Motley Fool owns shares of GameStop and has the following options: long January 2020 $150 calls on AAPL, short January 2020 $155 calls on AAPL, and short January 2018 $19 calls on GameStop. The Motley Fool has a disclosure policy.