GameStop (NYSE:GME) completed an at-the-market equity offering after issuing five million shares to raise about $1.126 billion on Tuesday. GME stock jumped 9% premarket and has gained 1,053% year-to-date.
The Reddit Army will eventually have to accept that GameStop’s excessive valuation does not make any sense. But if the recent weeks are any indicator, there will be wild swings in the interim.
Despite the video game retailer reporting weaker-than-expected earnings and sales in a secular downward spiral, GME stock continues to trend upward.
You have to give credit where it’s due. The meme stock frenzy is changing how people think about companies. But it will only have a short-term impact. No one wants to pay 17x price-to-book for an unprofitable company.
As Stacey Cunningham, the New York Stock Exchange president, said in an interview with Axios on HBO, “The markets are not a casino. They are highly regulated and they’re highly overseen.”
So, even though the short-term movements may cause fear and anxiety, markets reward companies with solid underlying fundamentals in the long run.
Against this backdrop, a clear divide is emerging. One section of retail investors is looking toward Reddit to make short-term profits. The other group is either cashing in its investment or staying away from the whole phenomenon.
Now, it depends on which type of investment strategy do you want to follow.
GME Stock Is Divorced From Fundamentals
GameStop’s poor Q1 results signal that a significant turnaround is not on the horizon. The recent decline suggests the recent squeeze has finally run its course. Bottom line? It is time to take profits and look elsewhere.
In the last year, shares of GameStop have skyrocketed nearly 4,400%. As a result, the embattled video game retailer’s stock-market value has surged to $15.3 billion from $1.31 billion at the end of 2020.
GameStop is a short-seller target, with more than 16% of its shares being sold short. However, this is one of the main reasons why Redditors have taken an interest in the stock. This is ironic since a high short interest ratio (SIR) is associated with stocks falling or stocks that appear to be overvalued.
What is normally an Achilles heel has become a source of strength in the world of meme stocks. But putting the hype aside, GameStop’s valuation can’t be justified under any circumstances.
Although the pandemic created a unique crisis for retailers like GameStop, they were in trouble long before the current crisis emerged.
Since 2018, GameStop has closed down more than 1,000 locations due to increased margin pressure. The long-term sales trend is down. GameStop’s competitive position in the gaming merchandise market has been on the wane for several years.
Despite GameStop’s net sales increasing 25.1% to $1.3 billion in Q1 2021, the gross margin declined from 27.7% to 25.9%. Moreover, the net loss of $66.8 million is a clear indicator that despite decreasing its global store base by 12% year-over-year due to “strategic de-densification efforts,” the bottom line is not getting healthier.
Where Do We Go From Here?
GameStop’s Q1 earnings report highlight how the company continues to struggle to achieve growth in one of the best periods in video gaming history. The only positive is that Q1 revenue of $1.28 billion was up 25.05% year-over-year. But we need to put things into context.
The jump is not impressive when you realize most GameStop stores were closed in Q1 2020 due to the pandemic. If we use the Q1 2019 figure of approximately $1.55 billion, sales are actually down 17.42%.
In addition, the increase in the first quarter was driven by hardware sales, which jumped to $703.5 million from $513.1 million in the year-ago period. You can chalk that down to the launch of the next generation of consoles from Sony (OTCPK:SNEJF) and Microsoft (NASDAQ:MSFT) in late 2020. However, this is not enough to sustain sales momentum for several quarters more.
Eventually, the console upgrade supercycle will fade away. Video game retailers will have to rely on selling out software rather than hardware. On that note, software sales in Q1 decreased to $397.9 million from $417 million a year ago, especially worrying since GameStop’s main focus as of late is transforming into a digital enterprise.
The retailer has named Matt Furlong as its new chief executive and Mike Recupero as chief financial officer. Furlong and Recupero are each leaving Amazon (NASDAQ:AMZN) to assume their responsibilities at GameStop.
From the looks of it, they have their work cut out.
Fun While It Lasted
GameStop’s new leadership could successfully execute a turnaround. But the chances are slim. Revenues are not growing fast enough, and margins are declining.
The short percent of the float is still high, 29.3%. But I don’t believe it is significant enough to lead to a short squeeze.
Since public investors own most of GME stock, you will still see wild price swings in the short term. But in the long run, the valuation will come down to earth. So you have to decide if you want to be there holding the bag when it does.
On the date of publication, Faizan Farooque did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
Faizan Farooque is a contributing author for InvestorPlace.com and numerous other financial sites. Faizan has several years of experience in analyzing the stock market and was a former data journalist at S&P Global Market Intelligence. His passion is to help the average investor make more informed decisions regarding their portfolio. Faizan does not directly own the securities mentioned above.