Having followed GameStop (NYSE:GME) for almost a decade now, who could have imagined what would transpire with GME stock over the last three months. Whether GME stock remains the poster child for excessive stock market speculation in 2021 remains to be seen, but Gamestop remains a very misunderstood company.
Back in the mid 2000s — I’m guessing 2004-2006 — I attended GameStop’s annual investor day for both buyside and sellside analysts. To start the meeting at 9 a.m., the GME executives demonstrated how long it would take to download a full 60 GB video game over the internet. Internet infrastructure wasn’t quite up to producing the speeds we’re used to now, particularly in the Dallas hotel conference room where the meeting was held.
A real-time set-up was displayed throughout the day, with the point being it would take perhaps half a day or all day for the download. Alternatively, they suggested, one could just drive to a GameStop store. The company claimed a unit existed 15 minutes away from 90% of all American households.
It was an interesting point at the time, but internet speed upgrades largely made that argument invalid over the years, and for the first time in 2020 digital game downloads were higher than physical disc sales. Despite the secular shift to digital downloads, GameStop still has a few things going for it.
GME Stock: The Latest Console Cycle Helps
One current issue that is helping GME is the latest console cycle, which started in 2020 and will likely last throughout this year. Microsoft (NASDAQ:MSFT) released the Xbox Series X and Sony (NYSE:SNE) debuted the PlayStation 5. In 2017, Nintendo (OTCMKTS:NTDOY) tried to break the lumpy console cycle by releasing the Switch platform in an off year. There has been a widespread shortage of these consoles, largely due to Covid-19 supply chain disruptions. This scarcity issue may keep the GameStop name at the forefront of buyers minds for quite some time.
Although game consoles are much lower margin items than software (games), they traditionally bring in above-average store traffic where customers also buy collectibles or the latest games in disc form. The fourth-quarter holiday time frame for GME was actually quite good, with same-store sales increasing 6.5%.
Raising Capital Through Inflated Stock Price
Don’t look a gift horse in the mouth, as the saying goes. In GameStop’s recent 10-K filing, the company stated they may increase the size of their ATM Program throughout 2021. This is a program to sell stock at current market prices, or an at-the-market offering. Their team of internal and external lawyers who must opine whether this is legal, feasible and within SEC guidelines have been no doubt working overtime.
Just a 5% dilutive offering could raise over $600 million at current levels which would absorb quite a bit of losses in the next few years as the company pivots to a comprehensive omni-channel technology provider.
What is GME Stock Worth
There is of course no reasonable or sensible justification for GME’s current stock price from a fundamental perspective. If GME returns to historical operating margins next year (it won’t even come close), then they would earn approximately $3 per share. This would give them roughly a 60x P/E ratio for a company that is secularly challenged, faces tough competition, and whose high margin business may eventually be completely disintermediated.
Operating losses and negative free cash flow are expected in 2021 and will likely bleed into 2022. There is an enormous amount of uncertainty in the GameStop business model and prospective path to historical margins. If they can achieve positive operating margins and return to the 6% level over the next 5 years, then the company may be worth in the $40-$50 range over that time frame, at best.
There is no scenario in which GME stock are a reasonable investment at these levels from a fundamental perspective, and it remains a speculative trading stock.
Value investing legend Seth Klarman told a wonderful story about sardine trading in his classic 1991 book Margin of Safety (which can be had for $1,000 on Amazon) that may be apropos for the GME situation:
“There is an old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, “You don’t understand. These are not eating sardines, they are trading sardines.”
GME stock are trading sardines.
On the date of publication Tom Kerr did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Kerr, CFA is an experienced investment manager and business writer who has worked in the investment and securities business since 1994.