There’s an old joke about two explorers who encounter a lion. One of the explorers starts putting on running shoes while the other asks, “Are you really planning on outrunning that lion?”
“No,” answers the first explorer, “I only need to outrun you.”
This quip has become an apt metaphor for meme stocks like AMC Entertainment (NYSE:AMC) that survive in terrible industries. By raising enough capital at inflated valuations, these firms stay solvent while their competitors collapse. The best run of these survivors will eventually consolidate the market and turn lousy businesses into profit-spinning ones.
So, what about GameStop (NYSE:GME)? A company that has managed to raise $1.7 billion from investors in its meme-fueled rally?
At first glance, the popular stock has every element of an explorer outrunning their friends. GameStop emerged from the Covid-19 shutdowns with a stronger balance sheet by raising capital at meme-level prices. No pure-play competitor remains standing.
But a closer examination shows that the lion is now coming for GameStop itself. The Texas-based video-game retailer has failed to turn its consolidated industry into meaningful profits. Meanwhile, the company’s efforts to diversify into e-commerce, Web3 and non-fungible tokens (NFTs) have essentially failed.
There’s a good reason why, last November, I suggested that GameStop needed Elon Musk to buy it. Unless something drastic happens, shares of GME stock could be worth $11 by 2025… and far less as time goes on.
GME Stock: The Current State of GameStop
From a financial standpoint, GameStop is a well-capitalized but underperforming company. In 2022, the retailer generated only $52 million in free cash flow from $5.9 billion of sales. Dividing by its $1.69 billion invested capital brings us to a 3.1% cash return on capital invested, less than half of its cost of capital.
A closer examination reveals that even these weak figures aren’t sustainable. In 2022, GameStop inflated its cash flows by doing the following:
- Cutting back inventory. GameStop generated $230 million by cutting its inventories. It now only averages 64 days of inventory, down from 76 days in 2019.
- Underspending on store upkeep. The company now only spends $12,700 annually per store in capital expenditure, down from an average of $22,200 between 2010 and 2019.
- Prepaying fewer taxes. Lower profitability means that GameStop generated $172 million in cash from not having to prepay income taxes.
That means GameStop is expected to post at least a $152 million cash outflow this year and $156 million the next, reducing its total liquidity to $1.08 billion by 2025.
Assuming free cash flow begins to normalize after that, a 3-stage DCF model shows GameStop’s justified value in 2025 at roughly $4.30, an 80% downside.
GameStop Has No ‘Clean’ Valuation
Several issues stand in the way of this “clean” 2025 valuation.
Firstly, GameStop is quickly turning into the next Blockbuster. Same-store sales are stagnant, even as the firm shuts down its less productive locations. Digitalization, e-commerce and gaming subscriptions are to blame. Microsoft’s (NASDAQ:MSFT) Xbox Series S already comes with no disc drive and future generations of consoles may eventually follow suit. The assumption that free cash flow will normalize after 2025 is a massive leap of faith.
Second, the range of possible outcomes is still fairly large, thanks to GameStop Chairman Ryan Cohen. In late 2020, the founder of e-commerce website Chewy (NYSE:CHWY) took an activist stake in the video-game retailer with plans to “pivot from a brick-and-mortar mindset to a technology-driven vision.” Although initial attempts at revamping the firm’s digital sales have fallen flat, a turnaround is still not out of the question.
Finally, retail investors still like GME stock. Shares trade at 0.99X price to sales as of this writing, higher than Walmart (NYSE:WMT) and nearly three times more than Best Buy (NYSE:BBY). By the time 2025 rolls around, it’s unclear how this wild card will play out.
That means the possibilities for GameStop vary greatly. In a bearish case, the firm continues down its cash-burning path, fails to pivot to a digital model and losses accelerate as customers abandon physical games. In this case, shares should trade under cash value since investors should believe losses will continue. (It’s why 175 biotech companies trade for less than their cash on hand). In this case, GME stock could trade for as little as a $500 million market capitalization by 2025, or $1.64 per share.
Meanwhile, a GME stock bull might assume that the firm eventually happens upon a profitable niche, say e-sports or virtual reality (VR) gaming. GameStop then turns into the next Twitch and institutional investors join in on sending shares into the $40 to $50 range. Assigning a 50% probability of this outcome is the only way its justified value can reach $20 today.
The problem with this, however, is that it involves GameStop exploring these niches, which it’s not doing. The company stopped reporting e-commerce sales separately and has reportedly laid off staff in e-commerce, engineering and blockchain.
It also involves committing millions of dollars to research & development (R&D). GameStop is not doing that, either. Overheads came down in 2022 on cost cuts.
That means my best valuation for GameStop only considers its cash-on-hand, working capital, net physical assets, intangibles and actual liabilities. Assuming that these figures come to $1.08 billion, $984 million, $650 million, $250 million (i.e. the value of the GameStop brand) and $400 million respectively, the roughly $3.4 billion market capitalization equates to a value of about $11 for 2025.
GameStop: The Problem With a High Share Price
In 2014, GameStop reversed its high-growth acquisition strategy to focus on winding itself down. Its high-profile acquisitions of gaming firms and digital distributors had proved too difficult to manage.
This less-interesting way of doing business is a surprisingly profitable strategy. Companies like Coinstar have long-used this tactic to milk a dying business for cash before shutting things down once nothing’s left. Shareholders are rewarded with handsome dividends.
Indeed, between 2014 to 2020, GameStop returned about $2 billion to shareholders through dividends and share buybacks. It was a perfect example of profitably winding down a firm.
Today, the retailer has no such luxury. GameStop’s $20 price means its enterprise value now sits at around $4.5 billion, far more than any wind-down value could produce. And retail investors would reject that plan anyway. They bought because they wanted GME stock to “go to the moon,” not a 38-cent dividend.
That’s bad news for shareholders. CEO Matt Furlong is trying to stem losses and turn cash flow around. But we’ve seen this story at Blockbuster and other retailers selling things people no longer need. Unless GameStop changes its path, it will face the same eventual outcome.
As of this writing, Tom Yeung did not hold (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.
