GameStop: My short position is increasing

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Justin Sullivan

Game Stop (NYSE:GME) has been one of my longest short positions, held in any form on and off, since late 2015 when the company faced the reality of people turning away from in-store shopping various gaming devices and services. Since then, they’ve seen the stock price surge in the name of the meme trading frenzy and then slide back into a more realistic range.

While all of this was happening, the company took advantage of the higher stock price to shed a large portion of its debt, but failed to turn a dent in other parts of its businesses to reverse course of declining earnings or higher costs of those earnings to justify a continued higher share price.

Let’s examine these 1 positives to 99 negatives to see where we stand.

The 1 Positive: Debt & Interest Expense

In 2018, the company held a record amount of long-term debt at just over $818 million, on which it paid nearly $57 million annually in interest expense. In 2020, as interest rates plummeted to near zero, the company’s stock price went through the frenzy of meme stock trading and alongside refinancing some of its high-yield debt — it issued a slew of stocks to pay off its existing debt.

They continued to pay their debts over the following years as follows:

2018 2019 2020 2021 2022 now
LT Debt $818 million $472 million $420 million $216 million $41M $32M

(Source: Corporate Balance Sheet – Seeking Alpha)

Not only does this help their valuation by deleveraging the company, but it also serves as a cash saver due to the lower interest expense they will be paying over the long term, especially as interest rates soar as the Federal Reserve tries to fight global inflation thereafter the COVID-19 pandemic.

As a result of deleveraging, the company has saved millions of dollars in interest expenses each year, which it can use to boost parts of its business.

2018 2019 2020 2021 2022 now
ie $57M $57M $27M $32M $27M $2.1M

(Source: Company Income Statement) (IE = Interest Expense)

Comparing these two charts shows how sensitive the company is to rate hikes. While they cut their long-term debt in half from $420 million to $216 million, their interest expense increased from $27 million to $32 million. That means that if they hadn’t repaid their long-term debt, they would likely be paying tens of millions more in interest expenses annually, which would cripple any growth opportunity they might have in the future by not allowing for physical investment.

But even with this somewhat rosy development, there are still negatives.

The many negatives

There are negative factors that, in my opinion, far outweigh the positive ones.

Number 1: Revenue

The company’s revenue continues to decline as it sees lower demand for its devices and services, which face stiff competitive pressures from other online e-commerce stores like Amazon (AMZN) and others. After seeing a small increase in sales here and there each quarter, using heavy promotions to get goods out the door, they mostly continued their downtrend.

2018 2019 2020 2021 2022 TTM
sale $8.5 billion $8.3 billion $6.5 billion $5.1 billion $6.0 billion $6.1 billion

(Source: Company Income Statement – Seeking Alpha)

The pandemic has seen their personal sales plummet, as have many other retail outlets, and as they have regained some of those sales it’s still hard to see them returning to their former glory days at 2019 levels as consumer behavior is likely on switched to online shopping, which gives GameStop little advantage over almost every other player in the industry. This is mainly due to the higher price of these devices and services, which drives current and potential users to look for the best deals, meaning they often look elsewhere and show very little brand loyalty to GameStop.

As a result, revenue growth from that point forward will require low-single-digit growth, which is expected to decline. I continue to believe that given the market dynamics in the gaming industry, the company will most likely miss or report accordingly on these expectations.

2023 2024
sale $6.27 billion $6.48 billion
growth +4.27% +3.41%

(Source: GME Sales – Analyst Forecasts – Seeking Alpha Aggregator)

Number 2: Gross margins

Not only do I believe the company is likely only to meet, or possibly miss, its sales guidance, but also that the cost of goods is pretty high and rising. That means that by not being able to adequately compete with other online retailers and simply raising prices to combat those rising costs, the company is likely to face falling gross profit margins in the years to come.

Though the company is seeing some margin expansion with the online shift, the fact that its merchants and suppliers are raising prices for them while they have very few ways to raise prices is concerning.

Moreover, after some decline in their operating costs for a few years, they are back on the rise as the company has more or less done whatever it takes to close underperforming stores while also having to cope with the increase in labor costs for minimum-wage workers in their stores and others Investments they need to make to attract people to their online sales platforms.

Both of these problems cause very limited growth potential for the company’s bottom line, even if they end up growing their sales by the rates mentioned above. That means, I think, that even if they’re growing sales in the low single digits, chances are their net income isn’t growing much at all, if at all.

valuation report

After several years of reporting a loss per share due to significantly higher expenses and other factors, the company is expected to report a nearly 21% decline in earnings per share to a loss of $(1.37) per share. This implies a net loss of more than $415 million, which I think is a conservative forecast.

While this may not be the best comparison given the company’s profitability and earnings per share growth, a company like Big Lots (BIG) has a similar physical footprint to GameStop and is expected to grow revenue at about a third of GameStop’s rate but is traded at a multiple of 0.1 times the futures turnover. Forecasting a highly optimistic 0.5x revenue multiple for GameStop means its fair value is around $4 billion in market cap.

GameStop’s current market cap is just under $8 billion.

Risk assessment gives cause for concern

The main risk associated with being short on GameStop is that once they have had a hand in becoming the target of meme stock traders who drove the company’s stock price so high, it can certainly happen again . This means that if you were short, you could wake up one day like it happened before and the company’s stock would go up several hundred percent and you would owe that much.

One way to get around this is to use longer-term CALL options, which can catch that move and provide a nice cushion for any move against you. I’ll explain what my options are at the end of the article, but since I’m not a financial advisor and everyone has different risk tolerances, you should consult with a financial professional and GameStop in particular before going short in general.

The other risk associated with shorting the company’s stock is that it’s somewhat vulnerable to a takeover by an e-commerce company. Their brand awareness and sales channels can potentially be a major boom for a company looking to enter or expand their presence in the gaming hardware and software business. I won’t speculate on who that might be, but it’s certainly not out of the realm of possibility given the company’s integration with an e-commerce platform and the closure of 90% of its physical locations at a net positive or a Sum of positive results -all parts benefit.

There are other minor risks associated with GameStop, like getting an unforeseen tailwind from an increased interest in games or a sudden launch of a best-selling game that can skyrocket their sales. Still, I don’t think these are enough to overcome its natural decline, but investors or potential investors in GameStop can make their own arguments.

Conclusion of the thesis

With the above factors, even with debt and interest expense reduced to near zero, the company faces too much headwind to justify any type of position in its current state. Additionally, the fact that they’re trading at around 1.3 times the forward sales multiple by current expectations means they’re overvalued by as much as 50% in my view, even if they maintain their current sales growth trajectory.

Given that they are likely to miss those expectations, there is little reason for me not to double my current short position and build it back up to its previously held size.

I hold a short position through equity and will add to it later. I’m holding some long-dated CALL options to mitigate potential risks should GameStop get wind of meme traders. I’m currently holding calls in June 2023 with a $50 and $60 strike just in case I don’t blow my account.

I remain very pessimistic about the company’s long-term prospects.

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