As I write this on Feb. 25, GameStop’s ready to open higher, up more than $74 to $166, perhaps more. That’s on top of a $46.74 gain the day before.
There’s a saying that you have to be good to be lucky. There’s another saying that luck is what happens when preparation meets opportunity.
Whatever’s been going on here, you can be certain of one thing: neither of these sayings applies to the people making money on GME.
Examining Past Losses
One of the things that successful investors do is study their past mistakes to understand where they might have gone wrong. History tends to help you not make the same mistakes twice.
A Wealth of Common Sense blogger and financial planner Ben Carlson has a post from June 2018 that discusses six things he learned from big mistakes. Carlson uses Michael Batnick’s book Big Mistakes: The Best Investors and Their Worst Investments as the backdrop for his post.
Carlson’s fifth mistake: “Recognizing your mistakes is one of the best ways to learn from them.”
He’s especially turned off by a money management practice of moving the goalposts to make yourself look better. An example would be if your portfolio underperformed the S&P 500 over five years but outperformed the MSCI ACWI over the same period.
He then quotes Batnick’s chapter about Warren Buffett:
“[O]ne of Buffett’s strengths is in recognizing that mistakes are part of the game. Buffett has included the word “mistake” 163 times in his annual letters. He, like everybody else who has ever put a dollar into the market, is no stranger to lousy investments.”
If you have made money on GameStop. Congrats. But don’t for a second think that this makes you or r/WallStreetBets superhero Keith Gill a good investor. Not by a longshot.
The Valuation of GME Stock
I think it’s fair to say that GME is overextended at $145. With annual free cash flow (FCF) of $320 million (GameStop’s best FCF effort in the past three years) and an enterprise value of $12.3 billion ($145 multiplied by 69.75 million shares plus debt of $1.2 billion minus $450 million in cash) equals an FCF yield of 2.6%.
And that’s being generous with its free cash. In the trailing 12 months, its FCF was just $150 million and $490 million in 2020. Further, as my InvestorPlace colleague points out, GameStop first needs a plan before we can talk seriously about a triple-digit stock price for an extended period of time.
As I said in January, former Chewy (NYSE:CHWY) co-founder Ryan Cohen still has a lot to prove when rescuing GameStop. His online pet food business is still not making money on a GAAP basis after a decade in operation.
Back to my colleague.
Markoch points out that the company’s serious reduction in physical locations underway isn’t going to solve its long-term issues. It will save a lot of cash, but it won’t replace the revenue lost from those stores.
In the first nine months of 2020, GameStop’s revenues fell 31% to $3 billion. That’s a $1.3 billion drop. Year-to-date, it’s closed 462 stores. Simultaneously, e-commerce sales increased 257% year-over-year and accounted for close to 25% of sales, or $750 million.
So, the positive from this is that e-commerce is generating 25% of overall sales. This time last year, it didn’t mention e-commerce in its Q3 2019 press release. Not once. Sure, digital got 17 mentions, but nothing to write home about.
I’ve got two negatives.
First, the percentage of e-commerce sales in the third quarter of 2020 was 18%. This means that the trend toward e-commerce is slowing. Secondly, the addition of e-commerce sales in the first nine months only made up for 58% of GameStop’s lost revenue in the period.
If it continues to close 75-100 stores per quarter while experiencing an even slower pace of e-commerce sales, the revenue gap will only increase. In the short-term, it might result in non-GAAP profits, but ultimately, this is akin to plugging the hole in the Titanic’s hull.
It’s not going to work.
The Bottom Line
Josh Enomoto is one of the few InvestorPlace contributors to write about GameStop in recent weeks, which actually owns GME stock. He believes that GameStop’s ace in the hole is a return to normalcy, which bodes well for the sale of secondhand games.
The man has nerves of steel; I’ll give him that.
However, for the rest of us mere mortals, making money on GameStop should never be confused with successful investing. It’s the mistakes you make and learn from that define what type of investor you become, not the lucky bets you made along the way.
On the date of publication, Will Ashworth did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia. At the time of this writing Will Ashworth did not hold a position in any of the aforementioned securities.