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After Gamestop's 368% Rally, Is This as Good as It Gets?

By Rich Duprey – Oct 12, 2020 at 9:00AM

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The video game retailer is going to be hard-pressed to keep the good times rolling.

GameStop (GME 7.70%) has come back strong after its dismal fourth-quarter earnings report in late March led the stock all the way to a low of $2.57 per share. The pandemic, it turns out, was a saving grace for the video game retailer.

With everyone locked down at home with nothing to do, playing video games was a key form of entertainment, and GameStop's e-commerce platform showed it just might be able to survive in a digital and online gaming world.

Friends playing video game

Image source: Getty Images.

And the retailer has benefited from the mania over the looming gaming console upgrade cycle as both Microsoft and Sony prepare to launch the latest versions of the Xbox and PlayStation, respectively.

Yet with a stock that has well more than quadrupled in value since hitting bottom earlier this year, investors need to question whether this is as good as it gets. I think they should tread carefully here.

A growth spurt

I've previously said the console upgrade cycle is a very short-term cash infusion for the company, and it will need to devise a plan to survive in a future where the market for physical games and brick-and-mortar stores just isn't all that relevant anymore.

The lifecycle of consoles is growing, meaning GameStop likely won't survive if all it does is hope to ride the current upgrades until the next cycle bubbles up. With new systems lasting seven years or more on average, GameStop needs to do something now if it wants to be around then.

To an extent, it is -- the pandemic showed the retailer how to leverage its online presence and physical footprint to grow revenue. E-commerce sales jumped 800% in the second quarter after having been up as much as 1,000% during a six-week period in the first.

GameStop has hired a new chief digital officer to focus on how it confronts the challenge. It has also redesigned its mobile app, which it claims will make a gamer's experience more meaningful, whether he or she is in the store or outside it. 

Management noted e-commerce sales are on track to be a $1 billion business this year, yet they have only achieved 20% penetration, suggesting there remains significant growth in the years ahead. Coupled with arguably one of GameStop's most important developments, the just-announced 10-year agreement with Microsoft to modernize the retailer's back-end operations and expand its digital and physical game options, there is hope for the company's future.

Off on a tangent

Yet it also highlights the considerable drag GameStop's physical store footprint is going to continue to have on its finances.

While new activist investor, Chewy.com founder Ryan Cohen, wants to use those assets to GameStop's advantage, it will also radically remake the company. The plan to transform the video game retailer into a rival of Amazon by vastly expanding the types of merchandise it sells is reminiscent of the resources GameStop wasted when it acquired Simply Mac and Spring Mobile. 

The company needs to avoid the fate of video rental giant Blockbuster, which failed to confront the challenge Netflix posed, but this aggressive strategy promises to derail the more strategic shift CEO George Sherman is attempting to engineer.

Getting big as it goes small

Broadening the range of merchandise beyond video games and its Funko collectibles and being able to ship them more quickly to customers is a seismic shift in logistics that plenty of businesses with deeper pockets and more experience have tried and failed.

GameStop will be hard-pressed to compete with Amazon in any area, whether it be selection, price, or delivery speed. The e-commerce giant has a vast well of financial resources it can draw from to support its operations, whereas GameStop is relying on the one-off event of the game console upgrade cycle to keep it from falling into the abyss.

While the video game retailer's physical footprint gives it a geographic advantage, its stores also tend to be located in strip malls and shopping malls, which are suffering from declining consumer traffic.

Revenue-generating capabilities beyond new console sales looks iffy, yet GameStop has debt of $472 million on its balance sheet, offset by by $735 million in cash and equivalents.

GameStop did generate $182 million in free cash flow in its latest quarter, even though it recorded negative adjusted earnings before interest, taxes, depreciation, and amortization, so it's not going to go bankrupt anytime soon, but its ability to finance this new transformation seems limited.

Nice while it lasted

Even with the gains made in online sales, overall revenue still fell significantly during the preceding quarters, and GameStop is trying to become profitable as a smaller operation. At the same time, it may radically alter the business that requires it to expand.

There is a lot that can go wrong with GameStop after its big rally, and it needs to execute perfectly to succeed. That suggests the video game retailer has reached its peak -- and investors are likely better off on the sidelines.

 

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool’s board of directors. Rich Duprey has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon, Microsoft, and Netflix. The Motley Fool recommends Chewy, Inc. and GameStop and recommends the following options: long January 2021 $85 calls on Microsoft, short January 2021 $115 calls on Microsoft, short January 2022 $1940 calls on Amazon, and long January 2022 $1920 calls on Amazon. The Motley Fool has a disclosure policy.

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Stocks Mentioned

GameStop Corp. Stock Quote
GameStop Corp.
GME
$27.34 (7.70%) $1.96
Netflix, Inc. Stock Quote
Netflix, Inc.
NFLX
$237.20 (-0.77%) $-1.84
Microsoft Corporation Stock Quote
Microsoft Corporation
MSFT
$247.52 (2.82%) $6.78
Amazon.com, Inc. Stock Quote
Amazon.com, Inc.
AMZN
$121.09 (4.50%) $5.21
Sony Corporation Stock Quote
Sony Corporation
SONY
$67.69 (2.31%) $1.53
Funko, Inc. Stock Quote
Funko, Inc.
FNKO
$21.06 (1.35%) $0.28
Chewy, Inc. Stock Quote
Chewy, Inc.
CHWY
$32.40 (3.78%) $1.18

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