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Better Buy: Amazon vs. GameStop

By Leo Sun – Aug 18, 2020 at 11:00AM

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Should you pay a discount for the underdog or a premium for the champion?

Amazon (AMZN 0.58%) and GameStop (GME -3.36%) went in opposite directions over the past five years. Amazon's stock surged nearly 500% on the strength of its e-commerce and cloud businesses, but GameStop's stock plunged 90% as sluggish mall traffic, competition from bigger retailers, and the rise of digital downloads gutted its business.

The COVID-19 crisis amplified those differences, with Amazon fulfilling orders throughout the pandemic as GameStop closed its brick-and-mortar stores. At first glance, the choice between these two stocks seems simple: Amazon offers long-term growth, while GameStop is headed off a cliff.

A group of young shoppers holding shopping bags.

Image source: Getty Images.

However, contrarian investors might claim Amazon's stock is overvalued while GameStop's stock is undervalued. Over the past year, several activist investors -- including Scion Asset Management's Michael Burry -- placed bullish bets on GameStop's recovery. Do those investments suggest GameStop's battered stock has more upside potential than Amazon's beloved stock? Or is it smarter to stick with the e-commerce leader?

Amazon is firing on all cylinders

Amazon's revenue and earnings grew 20% and 14%,respectively, in 2019. In the first half of 2020, its revenue jumped 34% as its earnings rose 24%.

Amazon's online marketplaces generated brisk sales throughout the pandemic, but their margins stayed slim. The North American unit's operating profit declined annually in the first half, mainly due to higher COVID-19 expenses, and its international unit remained unprofitable.

However, Amazon Web Services (AWS) grew its operating profit 48% annually and accounted for 65% of its operating income. The growth of that cloud infrastructure platform -- the world's largest by annual revenue -- easily offset the lower margins of its e-commerce business. That balance enables Amazon to consistently sell products at low prices, and to expand its e-commerce ecosystem with low margin and loss-leading strategies.

Amazon expects that momentum to continue with 24% to 33% annual revenue growth in the third quarter. It expects its operating profit to only rise 9% at the midpoint, due to over $2 billion in COVID-19 costs, but that would mark a sequential decline from over $4 billion in related costs in the second quarter. Analysts expect Amazon's revenue and earnings to rise 31% and 38%,respectively, this year.

GameStop is grasping at straws

GameStop's activist investors expect the upcoming launches of the PS5 and Xbox One to boost traffic at its stores and demand for physical games. They also likely believed its previous turnaround plans-- which include shuttering weaker stores, reducing its inventories, expanding its e-commerce platform, turning its stores into social hubs for gamers, and securing exclusive deals with companies -- would bolster its sales and earnings.

Two people shop for video games at a store.

Image source: Getty Images.

Unfortunately, the COVID-19 crisis derailed those wobbly efforts. GameStop's revenue declined 22% in fiscal 2019, with a 19% dropin comparable store sales, and its adjusted EPS plummeted 91%. It also suspended its dividend last year.

In the first quarter of 2020, its revenue dropped 34%year over year, and its comps declined 17% after excluding all the stores closed throughout the pandemic. Including those stores, its total comps plunged 30%. It also posted a steep loss compared to a slim profit a year earlier.

GameStop didn't provide any guidance for the full year,but Wall Street expects its revenue to decline 11% and for its earnings to stay in the red. Michael Burry also notably reduced his stake in GameStop from 5.3% to 4.3% in May-- which is lower than the 5% threshold required for future public disclosures. That retreat doesn't bode well for GameStop's future.

The valuations and verdict

Amazon's stock trades at over 100 times forward earnings, but its robust growth, wide moat, and dominance of the e-commerce and cloud markets all justify that premium.

GameStop's stock looks cheap at less than one times its annual sales, but the odds are stacked against it. Gamers are downloading more games instead of buying physical copies, they're visiting fewer malls, and bigger retailers (including Amazon) carry the same consoles, hardware, and collectibles. GameStop's plans to turn its stores into social hubs also seems ill-advised (especially during a pandemic), since other "gaming hubs" -- like arcades and internet cafes -- have largely failed.

Amazon might look expensive right now, but it's smarter to pay a premium for the winner instead of a steep discount for the loser. I told investors to give up on GameStop last June, and I'm sticking by that call regardless of how badly activist investors want to save this sinking ship.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon and recommends the following options: long January 2022 $1920 calls on Amazon and short January 2022 $1940 calls on Amazon. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Amazon Stock Quote
Amazon
AMZN
$93.95 (0.58%) $0.54
GameStop Stock Quote
GameStop
GME
$25.29 (-3.36%) $0.88

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