GameStop Corp. (GME, Financial) is considered the king of meme stocks and most of the investing literature that can be found around the stock revolves around its meme feature.
The purpose of this discussion is to present an analysis of the company's fundamentals beyond its fading meme feature. Indeed, GameStop is a business with shrinking sales and a falling investor base. At a current price-earnings ratio of above 1,000, the potential meme premium in its valuation is unsustainable in the absence of the retail investors' euphoria that existed in 2021. The business continues to decline and the possibility for the stock to become unlisted at some point in the future is real. Furthermore, the meme feature of the stock is becoming obsolete and focusing on fundamentals is increasingly important when engaging in the trading of GameStop shares.
The rally is unlikely to be sustained as the meme feature is fading
GameStop became one of the most famous stocks during the Covid-19 pandemic, together with other meme stocks such as AMC Entertainment Holdings Inc. (AMC, Financial) or BlackBerry Ltd. (BB, Financial). It did not gain its fame from its core business, games and other entertainment products, despite the accumulated savings of a quarantined digital youth providing the best possible environment for it. The company also did not manage to break through with its digital asset wallet and NFT business, despite the crypto mania at that time. As a matter of fact, the company remained financially troubled, closing stores and recording tumbling share prices. The sales decline continues today, and its online sales segment is the only one keeping it afloat.
The fame of the stock actually originates from the worsening of its fundamentals: the stock was an easy short for hedge funds - too easy, according to Reddit users on r/wallstreetbets, a stock trading discussion subreddit. The now famous influencer Keith Gill (also known as DFV and Roaring Kitty), published an analysis that became one of the catalysts of the 2021 short squeeze that caused major financial damage to hedge funds and other short sellers.
Gill, who is better known as Roaring Kitty, published a series of social media posts during the second weekend of May 2024. Only this time, the stock did not soar because of the retail traders' fervor. It is estimated that around 70% of the trading activity on Monday, May 13 (the first trading day after the posts) was institutional and algorithmic.
The algo-driven rally is, therefore, not sustainable in the absence of the same individual investors that jumped in the meme euphoria back in 2021 and provides an argument that the stock price will likely return to its early May level. The disappearance of the meme feature, as demonstrated by reduced retail activity, may be linked to the fact that hyped memes are usually short-lived and gain their temporary hype from their originality. A hype never occurs twice in such a short period.
Poor fundamentals do not justify an expensive valuation
GameStop is clearly a declining business. Revenue has been trending lower for years now, as stores continue to close and layoffs accelerate.
Revenue has declined by almost 40% since the pandemic even began and Ebitda has turned negative since then. The stock rallied in 2021 not only due to social media hype, but because of hopes that the company would benefit from the quarantine environment. GameStop was, in theory, well positioned as one of the leaders of the gaming and entertainment segments. As people were quarantined and mostly remotely working, it was assumed the consumption for home entertainment, games and digital products (such as crypto wallets and NFTs, where the company is also trying to be active) would be strong tailwinds favoring growth. However, the company's poor ability to quickly and fully transition its business model into a lower-cost gaming e-commerce platform with fast deliveries caused the business to struggle, sales to decline, stores to close and layoffs to accelerate.
The earnings forecast released on May 17 caused a sell-off of 19.73%. GameStop expected first-quarter 2024 net sales of $872 million to $892 million, a decline of approximately 27% in one year and significantly lower than the expected $1.05 billion. Free cash flow is negative at -$238.6 million for 2023 and trending lower since the start of the pandemic in 2020. GameStop also announced it will sell up to 45 million shares in an at-the-market offering. This is usually the sign of a struggling company with poor growth and profitability perspectives.
Another aspect investors like to analyze is ratios, particularly return on assets, return on capital and return on equity. Essentially, when these ratios are positive, it means that every dollar invested generates more than a dollar of revenue. When these ratios are positive and growing, there is an increased likelihood that the business is efficiently managed and may indicate free cash flow is likely to grow, hence triggering a virtuous cycle of reinvestments, growth, share buybacks and dividend payments to shareholders.
Although these ratios have been trending higher, they are still in the red and an improving trend cannot be confirmed at this stage.
Therefore, the fundamentals cannot justify the expensive valuation the stock is subject to. The stock is currently trading at a last 12 months price-earnings ratio of over 1,000 and at next 12 months earnings multiple of over 2,000. Further, the stock had been trading in a range of 0.15 to 0.50 times revenue from 2008 to 2020. By close on May 17, even after the poor earnings forecast release and the shares sale by the company, the stock was trading at 1.37 times revenue. This puts the fair value of the stock much lower than the $22.21 per share of last week's close at best at around $6 to $8 to be in line with historical valuations of the stock when the business was still profitable and growing.
Risk factors to my case
GameStop has visibly been on a downtrend since 2015-16 when it reached its peak. Any bullish case is complicated to make at this point in time. However, we will now look at potential factors that could invalidate the strong sell case Wall Street and this discussion make.
The company is in a difficult situation and only a significant overhaul of the business model could put it back on a profitability path. The company has been closing physical stores, which is a necessary move to reduce costs while it tries to find new sources of revenue to tap. Cutting costs can only help it gain some time until its obligations start mounting up. One of the possibilities GameStop's management is pursuing is the transition to a digital business model. In theory, it is the most viable solution as costs are lower and a wider customer base could be reached with an active e-commerce platform. However, this transition may be coming too late. The online space is heavily crowded with large, well implemented and fast shipping service e-commerce companies. Therefore, the way out from the decline could be a strategic sale to a large retail company such as Walmart Inc. (WMT, Financial) or Amazon Inc. (AMZN, Financial).
Bottom line
GameStop is given hereby a strong sell rating. Its fading meme feature and hype potential have been confirmed during last week's rally where retail traders stayed on the sideline after Roaring Kitty's tweets, in sharp contrast with 2021. The fundamentals are clearly worsening since 2015-16 with an acceleration of the decline since the start of the pandemic.
While many businesses suffered from the early Covid environment, most recovered. And even though the pandemic era was by itself a large tailwind to the gaming and entertainment segments, the company failed to recover and benefit from a growing demand in those segments. GameStop has reached a point where it is selling its own shares. It is, therefore, complicated to make the case as to why investors would buy them; the stock deserves, therefore, to be rated a sell and risk-averse investors should stay away.
