The stonk meme craze found its genesis with beleaguered video game retailer GameStop (NYSE: GME) about a year and a half ago, and it’s been a battleground ever since. The stock is making huge moves in both directions, which makes it great from a business perspective. However, with Q2 results last night, I don’t see much reason to want to own this one longer term.
I will be clear and say up front that the short squeeze happened in early 2021 and will not happen again. GME then had short interest levels above 100% of free float and the shorts were burned dramatically. Short-term interest today is around 20%, which is nowhere near enough for the type of movement we saw earlier. Given this, anyone looking for the second round of “MOASS” will be perpetually disappointed.
What we have with GME is a retailer that I think is struggling to generate cash flow because at the end of the day its business is still a relic of the past. The second quarter earnings report did not change that view, and indeed, I think it highlights some of the key challenges facing the company.
GME is due for an oversold bounce, but that’s probably all
Let’s start with the table to get an idea of the terrain from a technical point of view. We can see the stock has halved from the early August high to the earnings report, a dramatic drop in the space of about four weeks. You would expect it to be oversold after such a move, and it is.
The PPO has fallen to -9 as the histogram continues to accelerate downward. The good news is that this is the level at which the stock has bounced in the past. We see the same type of behavior with the RSIs, with the 14 days at -25 and the 5 days at -5. Those are very oversold readings for all three momentum indicators, showing that over all three timeframes (short, middle and longer), the stock is oversold. Even the 10-day rate of change is at -28%, again, where it has bounced in the past. These readings collectively greatly increase the odds of a bounce here.
It also means that the chances of a sustained rally are quite low. Stocks in bullish patterns do not become as oversold. It’s just a fact and although oversold stocks tend to bounce back, I see no reason why we should expect GME to rally significantly from here. The stock is well up in the pre-market, but keep in mind where it’s come from over the past four weeks. The odds of a rebound were pretty good, but in my opinion, I don’t think it will be anything other than a rebound. There has been far too much damage to this stock indicating that the bears are in strong control.
GameStop fundamentals are murky at best
The second-quarter report showed a year-over-year revenue contraction of 4% to $1.14 billion. This is obviously not the direction investors should want earnings to move, and it is a departure from the results of the past two years. GME has done a tremendous amount of work over the past two or three years trying to diversify away from selling physical games, which has been its bread and butter for many years. To be clear, he has no choice but to do so, and he is trying to increase income from collectibles, for example, to help him diversify. The revenue share of this segment was almost 20% in the second quarter, compared to 15% a year ago. That’s fine, but the fact that collectibles take up a bigger slice of a shrinking cake doesn’t give me the warmth and fuzziness. In other words, this segment is still far too small to stem the tide of declines elsewhere, so the total continues to fall. At some point, collectibles may be large enough to impact the total, but the question for investors is, how big will the revenue be if/when that happens?
The revenue outlook is decent, with mid-single-digit growth expected, but the second quarter results, in my opinion, do not support this level of optimism. The second quarter is not as critical to earnings as the third and fourth quarters, so we will have to wait and see how those play out due to the significant seasonality of the business. But so far, I’m not impressed.
The second thing that worries me, and even more so than sales, is that the company is failing to pull itself together from a margin standpoint. Here is some historical data that shows gross margins and operating margins as a percentage of revenue, on a twelve month basis.
This is ugly as we continue to see quarter after quarter lower margins. Operating margins have not been positive on a TTM basis since 2019. This is partly because gross margins have fallen and show no signs of slowing down. Part of that is because general and administrative costs aren’t going down at the same rate, so we’re seeing compression on both sides; decline in sales profitability and increase in relative costs. Stork or not, GME needs to show investors that it can operate sustainably, and the harsh reality is that it hasn’t.
So did we see any progress on that front in Q2? Uh, no, definitely not.
Gross profit fell about 12% while general and administrative expenses increased about 2%. It’s a massive deleveraging of general and administrative costs and it’s the exact opposite of what GME needs to show investors. I’m really concerned about the margin situation, and that has other implications as well, like on the balance sheet.
GME has issued a bunch of shares since the short squeeze happened, and honestly, I don’t know why it hasn’t issued more. The stock was incredibly overvalued for months last year, which is exactly when you would want to issue stock.
The number of shares has increased by about 40 million in total, which means that if GME can once again achieve profitability, it will be that much harder to move the needle per share. However, from what I see, that may never be a problem. In other words, I don’t see much reason to think this business will be profitable again.
The good news is that the sharp rise in shares cleaned up GME’s balance sheet, and it ended the second quarter with $909 million in cash and almost no long-term debt. That’s fantastic, and it means the business should be able to run for a long time, even if it’s not profitable (which it is).
Here’s the problem; perpetually weak earnings are impacting cash flow, and that’s what got me thinking about GME’s ability to try and turn the tide. He’s bought himself time (literally) with his stock offerings, but he’s also burning that money at an alarming rate.
Below is TTM’s free cash flow in millions, and it’s not pretty either.
The TTM FCF has been falling for several quarters, and Q2 comes out at -$123.9m (-$103.4m in operating cash flow and $20.5m in capex). It’s been tough for GME, and in case the perma-bulls consider it unimportant given that we still have Q3 and Q4 left, I’ll note that last year’s Q2 FCF was a loss of 25 million dollars. This represents a deterioration of approximately $100 million year over year for a directly comparable period. There’s no way to sugarcoat that.
Let’s enjoy this thing
GME’s valuation was not a concern for many months of 2021, as the stock traded more on technicals and headlines. However, those days are over and as I said GME has to start delivering real results at some point. Given that, I’m of the opinion that we can assess it based on more traditional methods at this point. Let’s start with the price/sales ratio, since we can’t use any kind of revenue metric because there is no revenue.
GME was trading at an extremely low fraction of pre-squeeze sales in early 2021, so I’ve chosen to plot post-squeeze valuations only, which still span about a year and a half. The average valuation was ~2X forward sales, and we finished yesterday at 1.1X. This is roughly the bottom that we have seen two other times, so much like the technical indicators on the price chart, this would seem to imply that we are expecting a rebound in the stock price. To be clear, I don’t think we’ll see 3X forward selling again, and honestly, I’d be surprised if we see 2X selling again. The factors driving these valuations have come and gone, so those expecting a bounce back to past highs in the P/S ratio are likely to be disappointed.
We can also value GME based on its enterprise value versus gross profit, and this shows that investors also seem willing to take less valuation risk on the stock.
The average has been over 8 times gross profit since the start of 2021, but most of 2022 has been about half that value. On this metric, I see GME as more overvalued (or less attractive) than P/S. This makes sense given that the stock price has not hit new lows, but gross profit continues to fall. There will be a calculation about it, I believe, and it will not be with an increase in gross profit to reach the share price.
The factors that drove GME’s incomprehensible rise last year, which hit a bunch of millionaires in the process, are dead and gone. Some people continue to cling to the idea that GME will tighten further, but there is simply no basis in reality for this line of thinking. This company is struggling in a variety of critical operating metrics, and I see no way forward. Moreover, short-term interest is nowhere near high enough to generate another massive pressure.
The valuation is correct and the chart suggests that we will have an oversold bounce. But if we do, I would see it as an opportunity to sell. Shorting GME is a dangerous game, obviously, and not for the risk-averse. However, in the long run, this company is burning way too much cash and at some point it will have to raise capital again. It has virtually no long-term debt, so that’s an option, but given its steadily declining profitability, I’m not sure who would lend to GME. That means further dilution is the way to go, which only compounds the problems for the stock and its valuation.
The bottom line here is that any bounce we get from this earnings report is a chance to get out, and if we get to the downside of the 20-day exponential moving average, which is currently around $31, I’ll be looking to take a short position at that time.