After losing more than three-quarters of their value in less than a year, shares of GameStop (NYSE:GME) began to rally a few weeks ago, surging from a 52-week low of $3.15 to just above $5 prior to the company's recent earnings report.

However, investors were disappointed by the steep sales decline and big loss that GameStop reported for the second quarter. The company's weak full-year earnings guidance didn't help matters, either. As a result, GameStop stock plunged 10% on Wednesday, the day following the earnings release.

GME Chart

GameStop Stock Performance, data by YCharts.

Yet while GameStop's financial results look ugly right now, the company is still generating lots of cash flow relative to its valuation and has a rock-solid balance sheet. Management has laid out ambitious cost-cutting plans. Most importantly, some of the recent pressure on its sales stems from cyclical factors that will reverse next fall, when Sony (NYSE:SNE) and Microsoft (NASDAQ:MSFT) are expected to release their next-generation gaming consoles.

The second quarter by the numbers

Comparable-store sales plunged 10.3% at GameStop in the first quarter of fiscal 2019, and the company's sales trend worsened slightly last quarter. Comps fell 11.6%, while total sales declined 14.3% to $1.3 billion.

Hardware sales plunged 41.1%, driving more than half of GameStop's sales decline. The PlayStation 4 and the Xbox One family of gaming devices are quite old at this point, and Sony and Microsoft plan to debut next-generation consoles next fall. Naturally, with new consoles on the way, sales of the existing ones are plummeting. The end of the current console cycle is also weighing on sales of pre-owned hardware and software, which fell 17.5% last quarter. Sales of new software fell more modestly, but management expects bigger declines ahead.

A man, a woman, and a child playing a video game

Sales of video game hardware and software have been plunging due to cyclical factors. Image source: Getty Images.

GameStop's collectibles business remained the main bright spot for the company last quarter. Collectibles revenue totaled $171.8 million: up 21.2% year over year. That represented 13.4% of the company's overall sales mix.

GameStop's adjusted loss more than tripled year over year in the second quarter to $32 million, or $0.32 per share. The big drop in hardware sales didn't hurt much, because hardware sales carry very low margins. The pre-owned business is dramatically more profitable, and the sales decline in that category drove most of GameStop's profit erosion. Additionally, due to its plunging share price, GameStop had to take a big goodwill writedown last quarter. As a result, its GAAP loss ballooned to $415 million, or $4.15 per share.

GameStop expects similar trends for the second half

Whereas GameStop's initial sales forecast for fiscal 2019 called for comp sales to be down 5% to 10%, the company no longer expects sales trends to improve in the back half of the year. It is now calling for a "low-teens" comp sales decline on a full-year basis.

Management also introduced guidance for its fiscal 2019 earnings per share for the first time. The company should generate full-year adjusted EPS between $1.15 and $1.30. That would be less than half of the $2.70 it earned in fiscal 2018. This forecast also fell short of the average analyst estimate of $1.45.

On a brighter note, new CFO James Bell said that GameStop is on track to produce between $225 million and $250 million in free cash flow this year on a normalized basis. Reported free cash flow will be somewhat lower, though, due to the timing of certain inventory payments in early 2019, which pulled some cash flow from fiscal 2019 into fiscal 2018.

Cutting costs while awaiting a return to growth in late 2020

GameStop's new management team made it very clear during the recent earnings call that sales trends will remain weak over the next several quarters. However, the company is implementing a $200 million profit improvement plan, consisting of cost cuts and gross margin initiatives like inventory management improvements and pricing changes. This should lead to margin gains even before any potential sales recovery.

While the shift toward digital downloads of video games represents a major secular headwind, GameStop expects a meaningful rebound in sales after the next generation of consoles arrives in late 2020. Importantly, Sony and Microsoft have both confirmed that their new consoles will contain disk drives. (Some pundits thought one or both might move to downloads and streaming exclusively, which would have devastated GameStop's business model.) Moreover, GameStop CEO George Sherman highlighted the company's unique ability to drive sales for Sony, Microsoft, and video game publishers with its enthusiastic gaming-focused sales force.

GameStop does plan to shrink its massive fleet of more than 5,700 stores to better align with future sales trends. It will close between 180 and 200 stores later this year and management hinted that the number of store closures could accelerate over the next year or two. While very few of its stores lose money, closing profitable stores pre-emptively could boost GameStop's earnings if the company can recapture a large proportion of their sales in other locations.

Thus, while GameStop's sales and earnings plunged in Q2 and the near-term outlook calls for further declines, investors should be reassured by the company's aggressive plans to improve profitability. The new leadership team has also pledged to focus on the core business, avoiding the failed diversification efforts of the prior management team.

Finally, GameStop has paid down $400 million of debt over the past year, leaving it with slightly more cash than debt, and free cash flow remains quite strong. There's little doubt that GameStop will be a smaller company in the future. However, based on GameStop's current market cap of about $400 million, investors are probably underestimating its ability to remain profitable for many years to come.