How GameStop Stock Can Regain Its Mojo After Last Year's 28% Slump

If you invested in video game stocks last year, you probably earned super-charged returns. All three of the biggest publishers trounced the market, led by Take-Two Interactive's 130% spike. Gaming hardware specialists like NVIDIA and Nintendo joined the party by roughly doubling, too.

Yet shareholders in the industry's dominant retailer didn't participate in that rally. Instead, GameStop (NYSE: GME) stock lost over a quarter of its value, compared to a 20% rise in the broader market. I recently highlighted a few reasons why investors might have been right to stay away from this business. Today, I'll look at some ways that GameStop shareholders could rebound from that brutal 2017 performance.

Low expectations

GameStop is expecting to earn about $3.25 per share in profits in fiscal 2017, which is the same prediction that management issued at the start of the year. Thus, with its earnings outlook unchanged, the stock's recent slump corresponds to an equivalent drop in valuation. Investors had been paying nearly seven times expected profits a year ago, which reflected the risks involved in owning a business that's attempting to pivot away from its core buy-sell-trade video game model into a broader specialty retailing approach. Now the stock can be bought for about five times earnings to yield an even bigger discount from the broader market's P/E of 19.

That fire-sale valuation makes sense for a business with no growth prospects, but that doesn't describe GameStop today. Sure, profitability has ticked lower recently thanks to weakness in both its core video game segment and its new technology brands division. However, the retailer just raised its holiday revenue forecast and now sees comparable-store sales rising in the low-to-mid single digits to mark a sharp turnaround from last year's 11% decrease. Wall Street bears are predicting that things will get worse before they get better for GameStop, but that pessimism just isn't supported by the latest operating trends.

A pleasant holiday surprise

GameStop earns about 40% of its sales and an even higher proportion of profits during the all-important holiday shopping quarter. That intense seasonality can make it a risky stock to own around this time of year, because even a small deviation from management's guidance can have a big impact on full-year results. Those misses are more likely right now, too, when the video game industry is being disrupted by a stampede toward digital spending.

It's possible that GameStop could surprise investors in the other direction, too. After all, it joined many other retailers in lifting its holiday outlook due to stronger customer traffic trends. Best Buy (NYSE: BBY) is probably the most comparable rival since it sells gaming software and hardware, along with a wider assortment of consumer tech. And there's growing optimism about a strong holiday for this retailing business thanks to a flood of innovative products in the market. GameStop, which is also a major retailer for the Apple iPhone lineup, stands to benefit from many of these same positive shopping trends.

Best-case scenario

A decent holiday season performance would support management's thesis that the business can build up its new product lines (consumer tech, mobile services, and collectibles) while milking GameStop's dominant position in the shrinking physical video game niche. It would also ensure that the generous dividend yield is well covered by earnings.

If GameStop takes another big step in the transition into a broader retailing profile -- without sacrificing much in sales or profits -- investors should reward the stock with a far less pessimistic valuation.

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Demitrios Kalogeropoulos owns shares of AAPL and GameStop. The Motley Fool owns shares of and recommends AAPL, NVDA, and TTWO. 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.