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GameStop Stock Has Climbed Too High

By Adam Levine-Weinberg – Oct 14, 2020 at 10:15AM

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GameStop stock has rallied this year, but not for any good reason.

Investors left GameStop (GME -1.52%) for dead in the early days of the COVID-19 pandemic. However, shares of the gaming retail specialist have sparkled in recent months, rallying from a 52-week low of $2.57 to around $10 by the end of September.

GameStop stock then soared 44% last Thursday , after the company announced a new partnership with Microsoft (MSFT -0.97%). The shares have roughly doubled year to date.

GME Chart

Data source: YCharts.

It wasn't entirely clear why the Microsoft announcement drove such a furious rally in GameStop stock, as the partnership mainly consists of GameStop adopting various Microsoft technology solutions. Yet even before last week, the stock price had become detached from GameStop's rather poor fundamentals.

GameStop's business has collapsed

GameStop's financial results have been deteriorating for several years because of a combination of cyclical and secular factors. A lack of new Sony and Microsoft consoles and weak game release slates have weighed on sales. On top of that, GameStop has been hurt by falling retail traffic and growing consumer adoption of game downloads (which allow game publishers and console makers to avoid retail middlemen like GameStop).

What started as moderate sales and earnings pressure turned into a rout last year, as consumers began to delay purchases ahead of the expected late-2020 releases of new PlayStation and Xbox gaming consoles. Comparable sales plunged 19.6% in fiscal 2019, with big declines in both hardware and software. As a result, adjusted net income cratered 91% year over year to $19.1 million.

The pandemic made a bad situation worse. Sales plunged 34% in the first quarter and 27% in the second quarter. That led to an adjusted net loss of $195.1 million ($3.01 per share) for the first half of fiscal 2020.

Management tried to accentuate the positive, pointing to an 800% surge in e-commerce sales last quarter and solidly positive free cash flow. However, the e-commerce growth came off an extremely low base, and GameStop's total sales still plunged. Furthermore, the positive free cash flow was driven by a 50% year-over-year reduction in inventory: something that can't be repeated.

A family playing a video game

Image source: Getty Images.

The Microsoft deal is overblown

As bad as GameStop's results have been in 2020, they still managed to get investors more excited about GameStop stock. The Microsoft announcement last week was the icing on the cake.

Yet as many retail analysts noted, the deal mainly consists of GameStop buying Microsoft technology. Employees will be equipped with Surface tablets and will begin using Dynamics 365, Microsoft 365, and Microsoft Teams. Buying some technology solutions hardly amounts to a legitimate positive catalyst.

The one substantive way in which the two companies are partnering is that GameStop will begin selling Xbox All Access. This is a bundle of a console and a 24-month subscription to Xbox Game Pass Ultimate -- which provides access to over 100 games, along with other perks -- for no upfront cost. GameStop will get a share of the customer's monthly payments toward the console and the Xbox Game Pass Ultimate service. Essentially, it will be selling the subscription on commission.

It's certainly a good thing that GameStop will get a share of the revenue from this subscription offering. But once someone pays for subscription access to over 100 games, it's reasonable to expect that customer to buy fewer physical games in the future. Thus, GameStop is probably cannibalizing its own future sales.

GameStop has no future

While the upcoming PlayStation and Xbox console launches will help GameStop, the pandemic will almost certainly reduce the retailer's near-term share of console and game sales. In fact, analysts expect GameStop to run around breakeven in fiscal 2021 -- which ought to be a cyclically strong year -- with sales volumes well below the retailer's weak 2019 results.

Meanwhile, book value no longer provides a margin of safety for shareholders. Entering this year, GameStop stock traded at a 59% discount to book value. Now, the stock trades for more than twice the company's book value.

GameStop has been a business in decline for years. The COVID-19 pandemic has accelerated this process, such that the company may only break even or post small profits in good years while suffering huge losses in bad years. The company has plenty of cash, so bankruptcy isn't a near-term risk, but it's not clear how more time could enable GameStop to turn itself around. The recent surge in GameStop stock looks like a bubble that's bound to pop sooner or later.

Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Adam Levine-Weinberg has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Microsoft. The Motley Fool recommends GameStop and recommends the following options: long January 2021 $85 calls on Microsoft and short January 2021 $115 calls on Microsoft. The Motley Fool has a disclosure policy.

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Stocks Mentioned

GameStop Corp. Stock Quote
GameStop Corp.
GME
$25.99 (-1.52%) $0.40
Microsoft Corporation Stock Quote
Microsoft Corporation
MSFT
$246.79 (-0.97%) $-2.41

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