Oct 13 2020 - GameStop: A Standoff Between Bulls And Bears

Summary

The solid free cash flow, the healthy balance sheet and the extremely low valuation are rather bullish arguments.

The horrible performance in the last few years and the fundamental threat to GameStop's business model are rather bearish arguments.

At this point, the stock can go in either direction.

Last week, I covered Bed Bath & Beyond (BBBY) and this week I will continue with GameStop (GME). Although both companies might seem quite different, they actually have a lot in common aside from the fact that both companies are specialty retailer. Both companies performed horrible in the last few years - since 2014 when the decline started both stocks lost more than 90% in value. But both stocks saw an impressive comeback during the last six months and could multiplicate the stock value. And I own both stocks and consider both investments as probably the worst investment decisions I made in the last few years, although I am holding on to both companies at this point.

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(Source: Pixabay)

When ignoring the dividend payments, which I received in 2018 and 2019, I am at a point again, where the investment in GameStop would be profitable and in the last few days I have been thinking quite hard about GameStop and if I should sell the stock or not. This article should basically help me to make up my mind and I will try to look at GameStop from many different perspectives to reach a decision what to do.

Arguments For Both Sides

I honestly don't know what to do as I can find solid arguments for the bull case as well as for the bear case. During the weekend, a SA news editor called it a "blockbuster bull vs. bear battle" and this statement is describing my opinion quite well. I can see the stock going in both ways. In my article I wrote in July 2017, I also didn't have a clear opinion about GameStop and although I invested in the meantime I am still struggling and don't know what to think about GameStop. To be honest, I consider the investment a big mistake, but the rally in the past few weeks is making me question my rather bearish opinion and wondering if there is something about GameStop I don't see.

And when looking at the sentiment of SA authors as well as Wall Street analysts, the opinions are also split. We have bulls, we have bears and people that are neutral although Seeking Alpha seems to be much more bullish right now than Wall Street.

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(Source: SEEKING ALPHA)

Mixed Quarterly Earnings

In the second quarter of 2020, which is including the months May, June and July of 2020, the company could report 2 million in revenue, which is reflecting a decline of 26.7% compared to the same quarter last year. Of course, we have to consider that COVID-19 was a negative impact and GameStop reported a 13% reduction in total store opening days. Comparable store sales declined 12.7% in the quarter.

The company also had to report an operating loss of .6 million, which was a huge improvement over the same quarter last year. In the second quarter of 2019, GameStop had to report an operating loss of 7 million (mostly due to huge goodwill impairment charges). GameStop also had to report a net loss of 1 million for the quarter, which is also an improvement over the same quarter last year in which the company had to report a loss of 5 million.

Although GameStop could reduce losses compared to the same quarter last year, these numbers were still not great. But while earnings per share were still negative (a diluted loss of .71 per share), the company could generate 1.9 million in free cash flow during the quarter.

Valuation

Usually, the intrinsic value calculation comes at the end of my articles, but I can take up the discussion of the huge difference between earnings per share and free cash flow at this point. And GameStop can still generate positive free cash flow - aside from one quarter in 2020, the free cash flow was still positive in all the other quarters. And when calculating the intrinsic value of a stock, I almost always focus on the free cash flow as it is much more important than net income.

When taking the free cash flow of the last four quarters, which was 0 million and assume GameStop will be able to generate a similar free cash flow in the years to come, this will lead to an intrinsic value of .23 for GameStop (using a 10% discount rate) and the stock would still be extremely undervalued. But even when being much more cautious and assuming free cash flow for the next fiscal year and only cautious improvements in 2022 and 2023 and a free cash flow of 0 million from 2024 going forward (half of the current free cash flow), we still get an intrinsic value of .29 for GameStop.

It basically comes down to the question if GameStop can survive and be profitable and generate still free cash flow at a very low level - if that is the case, then GameStop is undervalued. But if the business will continue to decline and eventually go bankrupt, the share price is certainly too high. In 2019, GameStop repurchased about 34.6 million shares, bringing the number of shares down about 34% during the year. When assuming that the share price was undervalued in 2019 (and it was undervalued if GameStop does not go bankrupt), this was a great move by management.

Financial Health

When we are staying with the positive arguments that speak for GameStop, we have to talk about the balance sheet. Despite the troubles the company was facing in the recent past with horrible earnings per share, the balance sheet can be described as more or less healthy. This is once again showing the difference between the income statement and cash flow statement. Although GameStop was not profitable, it could still generate positive free cash flow in most quarters.

After the massive goodwill impairment charges in 2019 and 2018, the company doesn't have any goodwill on its balance sheet. It still has 6 million in long-term debt on its balance sheet and 1 million in short-term debt. When comparing the company's total 7 million in debt on its balance sheet to the total stockholders' equity which was 2 million, we get a D/E ratio of 1.24, which is a little higher than I like to see, but still acceptable.

When talking about liquidity and solvency of GameStop, we have to mention 5 million in cash and cash equivalents on its balance sheet, which should provide enough liquidity to repay outstanding debt that is due within the next few quarters and still have enough cash to stay liquid. Overall, I would describe the company's balance sheet as healthy at this point.

Short Squeeze

About 105% of outstanding shares are sold short right now, which is an extremely high number. In case of BBBY, about 54% of outstanding shares are sold short and in case of Tesla (NASDAQ:TSLA), which was also considered a highly shorted stock, "only" 25% of outstanding shares were sold short. As a consequence, the theory of a potential short squeeze is quite prominent. But considering the fact that GameStop is probably one of the most shorted stocks, it seems not unlikely that many short sellers will be forced to buy back the stock as the price is moving higher and higher and actually leading to a short squeeze.

ChartData by YCharts

How such a short squeeze might look like in one of its most extreme forms was demonstrated in 2008 with Volkswagen. Within only a few trading days the share price increased from about 0 to 00 and then declined again.

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(Source: Wikipedia)

We can bet on a short squeeze, but that is neither solid investing nor is it my style of investing (or trading). I don't want to invest in a company and hope on a short squeeze, which is almost impossible to time and hardly knowable beforehand. But when looking at some examples from the recent past - like Hertz (HTZ) or also Tesla we can see what price movements are possible and how stocks driven by momentum can perform. In case of Hertz it was a short spike (as the company is bankrupt), in case of Tesla it is one of the most extreme bubbles I saw so far.

Horrible Performance

When turning away from a potential short squeeze that might take the share price to lofty highs and look at the numbers, we can't find so much reasons to be optimistic. At the beginning, we already mentioned the horrible performance in 2020 - especially in the last two quarters. And while we can ascribe the performance in the last few months to COVID-19, which had a negative effect on GameStop, the company was already struggling before the pandemic. We can also justify the negative earnings per share in 2018 and 2019, which were mostly the result of massive goodwill impairment charges (4 million in 2019 and 1 million in 2018). And without the goodwill impairment charges, GameStop would probably have reported a gain in 2018.

But not only earnings per share declined in the last few years. Sales and free cash flow also declined and especially 30% sales decline between 2015 and 2019 is not a good sign for GameStop.

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(Source: Author's work based on numbers from Morningstar)

The problem for GameStop is that we don't see any signs in the reported numbers that the turnaround might finally happen. Last week, I showed that Bed Bath & Beyond reported very strong quarterly results which could make us optimistic that a turnaround might happen. This is not the case for GameStop.

Long-Term Outlook

Aside from the performance in the last few years, the outlook for the next few years is especially worrisome. For starters, GameStop is continuing to suspend guidance. While many companies did not provide guidance during the first months of the pandemic, it is not a good sign that GameStop is still not providing any guidance.

And when looking at the market in which GameStop is operating and the trends we saw in the last few years, this is also not great. The gaming market is growing and many companies operating in this sector are performing very well, but this is not the case for GameStop. We can identify several problems for GameStop. First of all, from GameStop's perspective, the market is growing in the wrong direction. When looking at the sales by platform, we see that growth in the global video game market is especially stemming from mobile games while PC and console sales are rather stagnating. But especially in the mobile games market, it is rather difficult for GameStop to enter this business and profit from the overall market growth. And when looking at U.S. consumer spending, the growth also comes from spending on content and not so much on hardware and accessories, which is also rather negative for GameStop.

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(Source: theskyisrising)

GameStop is still mostly a brick-and-mortar retailer and its sales mostly stem from hardware, software and collectibles. And while there might be several reasons for people to buy hardware still at GameStop, the software sales will probably decline as there seems to be almost no reason to buy a video game at a store. If I may quote myself from July 2017:

The only difference between buying the product online or in a store is the consultation (which probably will be better in the store). In a store, I only can check the tangible part of the video games (the discs, the case, the booklet), but the intangible parts (the content) I can check neither online nor in a store, and hence, there seems to be hardly any reason to buy that particular product in a store. To make matters worse, I don't even have to buy video games online to get them delivered to me the next day. Instead, I can just download the content, and there seems to be no reason to go to GameStop at all.

And companies can react to that threat by increasing its e-commerce operations (as many retailers have done). But GameStop did not really react to that trend or did not react at the right time. In the last quarter online sales increased 800% which sounds great, but also shows how low the company's e-commerce sales are making such an increase possible in the first place.

The only ray of hope might be the collectible sales. In the last few years, GameStop has been moving into the collectibles business and it was quite successful so far. Between 2014, where GameStop had about million in sales from collectibles and 2019, GameStop could generate 7 million in sales.

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(Source: Author's work based on numbers from GameStop)

Compared to video games, which can easily be downloaded and purchased online, collectibles are probably rather bought in stores as I might want to look at these items before purchasing them. But as we can see in the last few quarters, collectibles sales are also not recession-proof and can also decline pretty steep. In the first two quarters of 2020, revenue from collectibles was only 5 million.

In the last few weeks, the stock price was quite news driven and especially Ryan Cohen taking an almost 10% stake in the company made people quite optimistic. The Microsoft (MSFT) deal that was announced last week led to a 44% increase for the stock in one single day. In both cases, I don't see the positive yet, although Justin Dopierala made a very convincing case on Monday that the deal between GameStop and Microsoft is actually a gamechanger. And finally, the all-new Xbox Series X and the PlayStation 5 will be released in November 2020 and should be a driver for GameStop sales. But overall, I am still a bit cautious if these aspects should really lead to a turnaround. I might be wrong, but with the information I have I don't see the turnaround yet.

Conclusion

GameStop is not the kind of stock (and company) I would buy anymore. If you don't own GameStop, you should probably move on and rather look for high-quality investments somewhere else by searching for companies with a durable business model and a wide economic moat surrounding the business. For me, it comes down to the decision between holding and selling the stock. On the one side we have the healthy balance sheet, the still positive free cash flow and especially the very low valuation. But on the other side, we have a business model that is under threat and GameStop is only undervalued if the business does not face bankruptcy in the foreseeable future. And so far, I also can't detect much reasons why the Microsoft deal or the investment of Ryan Cohen is extremely bullish. Overall, I would rate GameStop as neutral at this point as I can see the stock go in both ways. But GameStop is a speculative bet and not the kind of company I would buy any more.

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