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GameStop Stock is Wound Tighter Than a Magnetic Coil

GameStop (NYSE:GME) stock will be remembered in financial history as the stock that triggered a war between hedge funds and the Reddit army. And it seems like an extended conflict is on the horizon as GME stock remains significantly volatile with nearly 45% of float still shorted.

GME Stock On a Mobile Phone

Source: Shutterstock / mundissima

GME stock will be remembered for surging over 2,400% in a matter of one month. In the following month, the stock then also declined by 91%. Clearly, the stock is not for the fainthearted.

If I had a predict the price-action in the foreseeable future, I would be inclined to avoid GME stock at current levels. Recently, the company announced that it will offer 3.5 million shares time to time through an “at-the-market” equity offering program. With dilution on the cards, the stock is likely to trend lower.

From the management perspective, at-the-market offering seems like a good step. At current valuations, it makes sense to boost the cash buffer. The important part is the utilization of cash proceeds in the coming years.

Dilution is not my only concern. At some point in time, the markets will move beyond the GME stock euphoria. The worry is that core business fundamentals might not match with valuations, even with the company undertaking a business transformation strategy.

Let’s Talk About Fundamentals

Beyond the talk of speculative positions, let’s discuss the fundamentals of a company that trades at a market capitalization of $12 billion.

For fiscal year 2020, the company reported sales of $5.1 billion, which was lower by about 22% on a year-over-year (YoY) basis. Importantly, even at these revenue levels, the company reported operating loss of $238 million.

The company has talked about complete business revamp. As an example, the company is winding down operations in Denmark, Finland, Norway and Sweden. Last year, the company said it will have closed 1,000 stores by the end of FY20. This will help in cost reduction, but it’s too early to believe that a major transformation is underway.

It’s important to mention that I am not painting a doomsday scenario for the company. There are positives to talk about. The company’s e-commerce sales for FY2020 increased by 191% on a YoY basis, which constitutes 30% of total sales. The company having omni-channel capabilities is a positive.

However, like the volatility in the stock, I would swing back to talking about the concerns.

For FY2020, the company reported gross margin of 24.7% and margin contracted by 480 basis points. According to the management, the margin contraction is due to an, “expected mix shift toward lower margin console sales in response to the launch of generation 9 consoles.”

In addition, “increased freight and credit card fees associated with the shift to E-Commerce sales and a broader promotional stance” also compressed margins.

These reasons will continue to have an impact on the company’s margin. Therefore, benefit from store closure might be offset by these cost factors. If GameStop continues to report operating level losses, there is a strong case for GME stock trending lower from current levels.

Concluding Analysis

If online sales continue to accelerate, there is a case for the company achieving operating level profitability in the future. However, a shift towards low margin products (hardware products) would imply that operating cash flows remain relatively low. Ultimately, a business is valued on the basis of its potential to deliver free cash flows. I am not very optimistic on that front.

Coming back to investor sentiment, GME stock is likely to see sharp reaction to any positive or negative news. In general, the views on the stock are on the extremes.

Even if I had to take a trading bet, I would be cautious. Equity dilution is one reason for this view. Furthermore, the company’s preliminary sales results have not impressed the markets. It therefore makes sense to wait for some correction before initiating any short-term positions.

On the date of publication, Faisal Humayun did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.

Faisal Humayun is a senior research analyst with 12 years of industry experience in the field of credit research, equity research and financial modeling. Faisal has authored over 1,500 stock specific articles with focus on the technology, energy and commodities sector.

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