Today is a good day for the video game industry.
Take-Two Interactive's BioShock Infinite hits the market, and the dystopian adventure is garnering rave reviews. The first two releases in the franchise sold a combined 10 million copies, and Take-Two has cracked open the piggy bank in recent days for national TV ads.
Enjoy today, die-hard gamers. Take Wednesday off. Worry about Thursday.
GameStop reports on Thursday morning.
On the surface, everything's rosy at the leading stand-alone video game retailer. The shares are trading near December's 52-week high. Analysts see profitability per share climbing 21% to $2.09, and after coming off back-to-back quarters of beating Wall Street's forecasts on the bottom line, it would seem as if momentum is in GameStop's favor.
Well, it's not.
This new level gets harder
There are a few reasons to fret about the upcoming report.
Let's start with a snapshot of the industry. We already know that GameStop had a lousy Christmas.
GameStop's global sales during the holiday months of November and December fell 4.6% to $2.88 billion. Comps slipped 4.4% during the seasonally critical period. Analysts only see net sales at GameStop falling 3.5% for the quarter ending in January, and that's optimistic since January was another bad month for the industry.
Why would Wall Street be targeting a 21% pop in profitability on falling sales? It's not as if the market is holding out for margin expansion. GameStop's most lucrative business is the sale of preowned games and gear. It generates more than twice the gross profit percentage as new software sales. Forget about hardware sales, where GameStop can only afford a nominal markup. Well, the sale of secondhand gear is slipping at a faster rate than the new stuff -- and that's only going to get worse if new PS4 and Xbox 720 consoles prohibit the playing of hand-me-down titles as has been rumored.
The secret to buoyant earnings is GameStop deploying its greenbacks to buy back shares. Stock repurchases are good for the most part, but at this retailer it's masking the real demise in its business.
Just check back with the chain's fiscal third-quarter results. Adjusted net income declined by 12% even though it was nearly flat on a per-share basis. Swallowing down gobs of stock will do that, but it doesn't mean that the fundamentals aren't deteriorating.
Amnesia is a losing game
The market seems to forget that the gaming industry is deep into a three-year slide.
The two leading video game publishers -- Electronic Arts and Activision Blizzard -- hit fresh 52-week highs this month.
Why? This is an industry in decline. EA and Activision Blizzard have their marquee franchises holding up well, but everything else is falling apart at the seams. One can argue that EA and Activision Blizzard are in a better place than GameStop. They will cash in on the digital revolution and the lack of resale activity on downloads. GameStop -- despite having made some digital moves itself -- will never be able to compensate for the store-level decimation.
Investors bidding up GameStop may be enthralled by the still-profitable store model and the stock's generous dividend rate, but there's no reason to expect Thursday morning's news to be favorable.
Haven't they been paying attention? GameStop's been able to buy its way out of the bottom-line slump, but comps don't lie. GameStop has whacked away at its same-store sales guidance four times over the past year.
Comps for 2012
1% to 5%
(5%) to 0%
(10%) to (2%)
(9%) to (6%)
(9%) to (7.5%)
Source: GameStop quarterly reports.
Why is it going to get better?
Nintendo was supposed to provide the hardware spark during the holidays with November's introduction of the Wii U. Well, GameStop did manage to sell 320,000 of the more than 3 million Wii U units sold during the holidays, but hardware sales still fell nearly 3% at GameStop.
Nintendo has gone on to slash its target for Wii U units that it will sell in its fiscal year that ends this week.
Yes, Activision Blizzard's Call of Duty: Black Ops II set records with its November launch, but software sales at GameStop shrank 5% during the holiday period.
GameStop is doing its part to evolve, stocking the tablets and even smartphones with prepaid plans that have become the hot electronics. However, we've seen slumping consumer electronics retailers before. If GameStop's growth rests in the future of low-margin hardware sales, those chunky-model economics go right out the strip-mall window.
Investors may get a very flattering perspective of the future out of GameStop on Thursday morning, and the market may buy it. We'll have another year in which GameStop has to let air out of its tires every few months. Sooner or later, the market will not fall for this anymore. The bio is shocking, but forgiveness isn't infinite.
(See what I did there with Take-Two's new game?)
GameStop can't keep climbing as its prospects keep shrinking.
Another key player
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The article GameStop: It's All Downhill From Here originally appeared on Fool.com.
Longtime Fool contributor Rick Munarriz has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard, Nintendo, and Take-Two Interactive. The Motley Fool owns shares of Activision Blizzard and GameStop. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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