Last Wednesday, shares of GameStop (NYSE:GME) fell 20% after Chairman Ryan Cohen unceremoniously fired his handpicked CEO Matt Furlong and replaced him with GameStop’s former general counsel.
Ordinarily, elevating a company’s top lawyer to the CEO role indicates an upcoming bankruptcy… or at least an asset fire-sale. Utility firm PG&E (NYSE:PCG) did the same with its general counsel in 2017 to ease the firm into Chapter 11 following the California wildfires.
But GameStop is no regular business. Despite burning through $112 million last quarter and missing revenue estimates by 9%, the company still has an enormous amount of cash in the bank. A timely capital raise in 2021 means the firm could theoretically survive another three years at the current rate of cash outflow.
That means the video game retailer now has no choice but to forge ahead. It’s an ugly problem. But GameStop’s financial position leaves Cohen only to throw more money at a declining business.
GME Stock: Go Big or Go Home
Dying companies can sometimes be surprisingly attractive investments. If an investor buys shares of a value stock for $5, corporate management only has to return $5.01 per share (after taxes and discount factors) to declare victory.
Many of these beaten-down stocks have significant hidden assets. Factories, machinery and even the company’s land can get sold to willing buyers. Armstrong Flooring (OTCMKTS:AFIIQ) extracted $107 million in assets for stakeholders in 2022 despite generating no profits for the previous five years. An entire “vulture capitalist” industry exists solely to make these deals happen.
Dying firms can also generate high cash flows by avoiding reinvestment. DVD rental firm RedBox allowed their kiosks to degrade while milking every last cent from them. And before Ryan Cohen became an activist investor, GameStop was doing the same with its stores. Between 2011 and 2019, GameStop cut its capital expenditures by over 50% and shrank its store count by 13%. Customers might not like stepping into stores with moldy carpets, but it’s a strategy that worked. Over the same period, the firm returned $2.8 billion to shareholders in the form of dividends and share buybacks — an excellent performance for a firm worth just $3.3 billion in 2011.
But GameStop’s meme popularity has created a problem:
Shares of GME stock are now too expensive to wind down profitably.
Rather than milking $5.01 from $5 shares, GameStop’s new management is faced with turning $25 shares into $25-plus profits. And the only way to do that is to go big.
The Ugly Choice
To do that, GameStop’s Ryan Cohen will have to throw good money after bad and hope that something magical happens.
That’s because GameStop finds itself in a terrible business. Selling physical copies of video games has become impossibly hard in an age where 90% of all games are sold digitally. GameStop also struggles to make any money from selling consoles and accessories — the lifeblood of its remaining revenues. In 2022, the company generated only 23% in gross profits, down from 31% in 2017.
That means the firm will have to find a new source of profits in an industry that’s generally devoid of them. E-sports company FaZe Holdings (NASDAQ:FAZE) lost $168 million last year on $70 million in revenues. And according to industry insiders, Microsoft (NASDAQ:MSFT) “loses as much as $200 on every Xbox it sells.” Large game developers are the only players that mint money — and even profits in that sector aren’t guaranteed.
Last year, I suggested that Elon Musk should seriously consider running the company. Changing a corporate DNA is hard and often only happens when the clock is ticking. In February, InvestorPlace contributor Will Ashworth made a similar quip by suggesting that GameStop close all its stores to help speed the conversion to e-commerce.
The reality is that Ryan Cohen will need to find a business outside of video game retailing. And replacing Matt Furlong was the first painful step in the right direction.
The Timid Management
As GameStop’s CEO, Matt Furlong did the opposite of what markets needed. The ex Amazon (NASDAQ:AMZN) executive spent a year (and relatively little effort) building out the company’s Web3 Gaming and non-fungible token (NFT) divisions, only to backtrack after failing to see immediate results. According to its career site, the Texas-based firm has only five tech positions open. None have to do with blockchain technologies.
GameStop has also failed to promote its e-commerce business. In 2022, the firm spent only $75 million — or 1.2% of revenues — on advertising. Chewy (NYSE:CHWY) spends closer to 6.4%.
At its core, these are the signs of overly timid management. In fiscal 2022, the company spent so little on research and development that its accountants saw no reason to break out the figures in its annual report. The firm has also avoided reinvesting in its physical store footprint, leaving its employees underpaid and stores falling apart.
To be fair, cutting back on capital investment was an attractive choice from an accounting standpoint. GameStop earns -18% return on capital invested (ROIC), meaning that every dollar put into the company can be expected to lose 18 cents. It’s usually better to return cash to shareholders instead.
But as outlined earlier, GameStop’s high share price makes that option unattractive. Once you deduct cash and debt, GameStop’s enterprise value stands at around $5.6 billion — roughly 4X greater than all inventory and physical assets the company has on its balance sheet. Furlong’s strategy would have only ended in disappointment.
What Should Investors Do With GameStop?
GameStop’s revamped management faces the same daunting task that Furlong did two years ago. The video game retailing industry is no better today than when the former CEO started.
True GME stock believers will hang onto their shares. To these brave investors, GameStop represents more than a dying video game retailer — it’s both a source of entertainment and a middle finger to the Wall Street establishment.
But from an investment standpoint, there are plenty of better bets. GameStop scores a below-average “C” grade on my quantitative Profit & Protection system for its lack of growth, poor quality and negative momentum. History tells us that these low-grade companies tend to underperform over the next 12 months. And if returns are all you’re looking for, it’s best to stay away from GME’s high price until new management can prove they can make the ugly choices required by GameStop’s $25 share price.
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.
