Why GameStop Can't Win (Unless It Totally Rewrites the Rules)

Last week was rough for GameStop (GME) investors. Shares of the leading video game retailer plunged 17 percent after it warned that holiday profits would be coming in well short of expectations.

GameStop's sales were strong during the holiday shopping period, fueled by brisk sales of Xbox One and PlayStation 4 consoles. The problem is that GameStop -- like most retailers -- sells the consoles at low markups. The real profit lies in selling the higher-margin games, and that's where customers just aren't coming around the way that they used to.

Despite seeing hardware sales nearly double, new software sales fell 22.5 percent during the nine-week holiday period. The end result is that GameStop now expects to have earned between $1.85 to $1.95 a share for the quarter. It earned $2.16 a share during the 2012 holiday quarter, and as recently as November it was telling investors to expect as much as $2.14 a share in profitability.

It's a miss, and it just may be the first of many more to come in 2014.

Getting Mauled at the Mall

GameStop has a model that would make many retailers envious. Its stores are small, with the kind of footprint that fits well in suburban strip malls where rent is cheaper than the major malls. It sells compact media in the form of games that go for as much as $60 a title. The larger hardware items sell for as much as $500 for the Xbox One and $400 for the PlayStation 4.

If generating a high volume of sales from a small store isn't enough, GameStop's most lucrative business actually has nothing to do with new games and systems. Diehard gamers know they can trade in the games they've beaten or the consoles they've grown tired of for store credit to buy the new stuff that they want. GameStop then refurbishes the trade-ins, selling them at higher percentage markups than it makes on new items.

Pre-owned sales are a major component of the GameStop business, and that's something that Amazon.com (AMZN) and Best Buy (BBY) have copied as a way to woo elusive gamers. However, for a vibrant pre-owned market to exist you have to have a vibrant marketplace for new items in the first place. That's not a problem on the hardware end where every few years sees a new generation of consoles. The rub for GameStop is that the future of software is anything but clear.

Counting Clouds

The digital revolution has changed the way we consume music, video, and books, and the pinch has been felt for sellers of CDs, DVDs, and hardcovers, respectively. Video games appear to be the next media where the physical form is fading in popularity.

%VIRTUAL-article-sponsoredlinks%GameStop investors hope that that won't be the case. They blame the 22.5 percent decline in new software sales on either cash-strapped gamers who were out of money after buying Xbox One and PS4 systems, or a lack of marquee releases.

Neither excuse holds up. We didn't see software sales plunge this badly when the Xbox 360, PlayStation 3, and Wii were introduced several years ago. We also had many big releases hit the market in time for the holidays.

The problem here is that the Xbox One and PS4 have rich self-contained ecosystems. You can download many games, or add-ons to existing games that extend their usefulness. This is bad news for GameStop, which needs folks to be buying new games more often.

Another issue with these digital downloads is that they can't be traded in and resold. Digital delivery has been great for the content creators in that they can reach directly to the end users with their music, movies, novels, and now games, but that comes at the expense of the middleman. And without new physical software, there is no pre-owned software to buy back and resell down the line.

GameStop saw this coming. It has made a couple of acquisitions that give it some skin in digital delivery. Unfortunately, they haven't been enough to move the needle for the chain.

The retailer will be around for a long time. It's still very profitable and it has a cash-rich balance sheet. However, the model itself will be challenged with every passing quarter. The game's changing, and GameStop needs to start dreaming up a new game to play before its earnings and money run out.

Motley Fool contributor Rick Munarriz has no position in any stocks mentioned. The Motley Fool recommends Amazon.com. The Motley Fool owns shares of Amazon.com and GameStop. Try any of our newsletter services free for 30 days.