Will GameStop Ever Turn Things Around?

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GameStop (NYSE: GME) released its fourth-quarter earnings report on Tuesday afternoon, and its results and outlook were subpar, as expected. With video game makers increasingly relying on digital distribution, GameStop faces long-term headwinds in the new and pre-owned game segments of its business. Moreover, an effort to sell the company failed earlier this year.

These negative trends have caused GameStop shares to lose more than three-quarters of their value since late 2015. The video game specialist's poor earnings report caused the stock to plunge into single-digit territory in after-hours trading on Tuesday.

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That said, GameStop isn't necessarily doomed. However, investors will probably have to wait for the arrival of next-generation game consoles from Sony (NYSE: SNE) and Microsoft (NASDAQ: MSFT) to see if GameStop can stabilize its business.

Expecting another weak year in fiscal 2019

Back in late November, GameStop reported solid growth in comparable store sales and adjusted earnings for the third quarter of fiscal 2018. Nevertheless, it slashed its full-year earnings guidance, calling for adjusted earnings per share of $2.55 to $2.75 compared with a prior guidance range of $3 to $3.35. Management attributed the shortfall to a revenue mix shift toward lower-margin hardware and the underperformance of certain new game launches in the fall.

The results GameStop announced on Tuesday were consistent with that updated outlook. For the full year, adjusted EPS totaled $2.70. Comp sales rose for a second consecutive quarter, but still declined 0.3% on a full-year basis -- near the better end of GameStop's updated guidance range.

GameStop's forecast for the upcoming year was probably more concerning to investors. The company projected a steep 5% to 10% comp sales decline for fiscal 2019. Additionally, it expects to report a loss of up to $0.05 per share in the first quarter, compared to adjusted EPS of $0.38 a year ago. GameStop didn't provide full-year earnings guidance, because it is in the early stages of a cost-cutting project and just hired a new CEO.

But GameStop has a lot of cash -- and a lot of flexibility

While GameStop's guidance certainly was disappointing, the company's increased earnings volatility is partly attributable to the recent sale of its Spring Mobile division. This divestiture brought in more than $700 million in cash.

As a result, GameStop ended fiscal 2018 with more than $1.6 billion in cash on its balance sheet. This week, the company will use some of that cash to repay $350 million of debt that was set to mature in October. That will leave it with nearly $1.3 billion in cash, compared with less than $500 million of debt.

For comparison, GameStop's market cap fell below $1 billion in after-hours trading on Tuesday. In other words, investors are valuing GameStop at barely more than its net cash balance. The board recently approved a $300 million share repurchase program, which could allow the company to retire a substantial proportion of its shares using its excess cash.

GameStop also remains solidly cash flow positive, having generated $233 million of free cash flow in fiscal 2018. And while sales are under pressure, the company has plenty of room to cut costs, including through store closures. GameStop has more than 5,800 stores worldwide, and most of its leases expire within a few years. That will make it easy to close underperforming stores. It could also give the company leverage to negotiate lower rents for certain stores.

Can new game consoles turn things around?

Of course, a high cash balance is no guarantee that GameStop stock will rise over the long term. Even if GameStop returns a large chunk of its cash to shareholders, the stock could fall further if profitability continues plunging and the company starts to lose money.

However, while sales of new and used physical video games will likely continue to decline over the long term, some of the recent sales weakness is due to cyclical factors. Sony's PlayStation 4 and Microsoft's Xbox One were both launched in 2013. While Sony and Microsoft have released upgraded versions of these consoles in recent years, both platforms are nearing the end of their life cycles.

Neither manufacturer is likely to release a new video game console this year, but Sony and Microsoft are both likely to have new consoles on the market by 2021 at the latest. The launch of these next-generation consoles should drive a surge in software sales, temporarily offsetting the headwind from the ongoing shift toward digital delivery.

That's not a permanent solution to GameStop's problems. But it may buy enough time for the company to right-size its cost structure and shift its merchandise mix toward growth categories like video game accessories and collectibles, which together accounted for 20% of GameStop's sales in fiscal 2018.

Between its huge cash position and its flexibility to shrink, cut costs, and pivot to businesses with long-term growth potential, GameStop has plenty of upside potential for investors. That said, it is a risky investment because of the secular headwinds facing its core business. While I recently purchased some GameStop stock, I am keeping the investment a very small part of my portfolio. Other investors looking to bet on a GameStop turnaround should probably do the same.

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Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Adam Levine-Weinberg has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Microsoft. The Motley Fool owns shares of GameStop and is short April 2019 $13 calls on GameStop. The Motley Fool has a disclosure policy.