GameStop (GME -2.26%) took shareholders on a wild ride last year, as investors tried to make sense of conflicting trends that could either lift it to new heights or crush its business entirely. GameStop stock began the year around $6, but plunged in the early days of the COVID-19 pandemic, bottoming out below $3 in early April. However, shares of the video game specialist rallied beginning last summer, driven by the arrival of a new generation of gaming consoles, activist investor involvement, and anticipation of the economic reopening to come.
GameStop stock ended 2020 at $18.84. It proceeded to double earlier this week, soaring from a closing price of $19.95 on Tuesday to $39.91 by the end of the day on Thursday. The stock rose further in after-hours trading on Thursday, pointing to the potential for further gains.
A short squeeze likely drove the bulk of GameStop's gains this week. Alas, GameStop's fundamental outlook can't come close to justifying its current valuation.
Three pieces of news
GameStop made two major announcements last week. First, it revealed that comparable sales grew 4.8% during the two-month holiday period, following a string of double-digit declines. This wasn't particularly good news, though. Total sales still fell 3.1% year over year in the November-December period due to store closures and supply constraints. Moreover, GameStop had previously reported that comp sales rose 16.5% in November. This implies that comps were probably negative in December.
Second, GameStop appointed Chewy founder Ryan Cohen and two of his associates to its board of directors. Cohen's RC Ventures built up a big stake in the company last year and has been pushing it to pivot toward e-commerce and other digital initiatives. Given Chewy's incredible success, GameStop shareholders are understandably happy to see Cohen and two other former Chewy executives joining the board.
Third, one of the largest hedge funds dedicated to short selling is reportedly scaling back many of its positions. Shares of many heavily shorted companies -- led by GameStop -- have rallied in response. As of the end of December, the video game retailer had 71 million shares shorted, slightly greater than its total share count of 70 million.
GameStop's huge pop this week looks like a classic short squeeze. As the stock rallied, losses piled up for investors who had shorted it. Some may have been forced to put up more capital or cover their positions by buying the stock. The rush of short-sellers buying GameStop stock drove it even higher, forcing other short-sellers to cover their positions. (Rinse and repeat.)
Short squeezes are frequently associated with high trading volume. Sure enough, more than 230 million shares traded hands on Wednesday and Thursday combined, compared to an average of fewer than 7 million per day during the prior week.
Secular challenges remain
GameStop's revenue has plunged over the past two years, falling from $8.3 billion in fiscal 2018 to a little over $5 billion in fiscal 2020. As a result, the company was barely profitable in fiscal 2019 (excluding special items) and is on track to ring up a big loss for fiscal 2020. While analysts expect revenue to recover somewhat in fiscal 2021, they don't expect GameStop to return to profitability (on average).
The fundamental problem is that the growth of digital game downloads is disrupting GameStop's core business. In fiscal 2018, the company derived more than half of its revenue and nearly two-thirds of its gross profit from software sales. Yet consumers are increasingly buying games online and downloading them directly to their consoles, completely bypassing retailers.
Some enthusiasts still prefer physical games, which can be lent to friends or traded in at video game retailers like GameStop. But digital downloads tend to be cheaper and hassle-free. They're also more profitable for console makers. Sony and Microsoft are both selling cheaper all-digital versions of their new consoles to promote the growth of their digital-download businesses. Thus, the market for physical video games -- GameStop's bread and butter -- is in secular decline.
A bubble bound to pop
New board member Ryan Cohen believes GameStop can return to strong growth by reinventing itself as a digital-first retailer, like Chewy. If that were true, GameStop stock's recent surge could continue. After all, the company still trades for around 0.5 times sales.
However, the gaming market and pet supply markets are quite different. GameStop doesn't serve much of a purpose anymore. For the most part, console makers, game publishers, and consumers are better off using digital distribution to cut out the middleman.
GameStop's results will likely improve over the next couple of years as it benefits from the console upgrade cycle, cost cuts, and economic reopening. But it won't make that much money compared to its now-lofty share price. Within a few years, sales and earnings will likely fall into terminal decline. All signs point to GameStop stock plunging back to earth before long.