GameStop (GME 2.56%) shares rocketed higher in January, driven by an epic short squeeze. At its peak in late January, GameStop stock had jumped 25-fold from its price at the beginning of 2021.
But while a short squeeze can drive a stock to incredible heights, the gains don't tend to last long. Sooner or later -- usually sooner -- the stock price reverts to a level more in line with the company's fundamental prospects. GameStop bulls learned that lesson the hard way last week, as GameStop stock plunged by about 80%, surrendering most (though not all) of its January gains.
GameStop stock year-to-date performance, data by YCharts.
Some investors who have seen their gains evaporate in recent days think that GameStop's fourth-quarter earnings report -- due out in late March -- could reinvigorate GameStop stock. That looks like a bad bet, though. GameStop's subpar holiday sales update points to weak Q4 results ahead.
Sales momentum fades quickly
A new generation of PlayStation and Xbox consoles hit the market last fall. GameStop viewed this as a key turning point for its business. In recent years, slumping demand for the prior generation of consoles -- combined with secular headwinds from greater consumer adoption of mobile gaming and digital downloads -- caused the gaming retailer's revenue to erode rapidly.
The new consoles launched in November, giving GameStop an immediate boost. Comparable sales jumped 16.5% that month, compared to a 24.6% decline in the third quarter (which ended on Oct. 31).
This momentum didn't last, though. Last month, GameStop reported that comparable sales rose just 4.8% for the nine-week holiday period that ended on Jan. 2. Total sales fell 3.1% year over year. These results imply that comparable sales declined in December. Management blamed the sales slowdown on temporary store closures and an industrywide decline in foot traffic as COVID-19 cases spiked in December.
The pandemic remained quite severe for most of January, so it's doubtful that sales trends improved in the final month of GameStop's fourth fiscal quarter. Total sales likely declined year over year for the full quarter.
Earnings are likely to fall again
In conjunction with GameStop's Q3 earnings report, management predicted that sales and profitability would return to growth in the fourth quarter. However, that was before sales trends slowed abruptly in December. Right now, the analyst consensus still calls for adjusted earnings per share to reach $1.35, up from $1.27 a year ago. That doesn't seem realistic, though.
Together, Sony and Microsoft shipped about 8 million consoles last quarter, similar to late 2013, when they introduced the PS4 and Xbox One. In the quarter that those consoles launched, GameStop's new video game hardware sales jumped 88%. That provided a 15% sales lift (largely offset by a double-digit decline in GameStop's non-hardware revenue). Hardware sales have grown as a percentage of GameStop's total revenue in recent years, so if anything, hardware sales may have provided an even bigger sales lift for GameStop last quarter.
Yet we know that GameStop's total revenue fell during the holiday season. Lower sales of other products must have outweighed the increase in console revenue. That's not very surprising. Weak foot traffic hurts GameStop's high-margin used software business. Software was the biggest driver of GameStop's sales declines in the first three quarters of fiscal 2020. Alas, hardware sales come at very low gross margins -- typically around 10% for GameStop, compared to more than 30% for the rest of its business. Thus, the mix shift toward hardware will weigh heavily on GameStop's profitability.
Image source: Getty Images.
In its holiday update, GameStop said it expected comparable sales and profitability to be positive for Q4 as a whole. That guidance isn't very inspiring. Considering the profitability headwinds it faces, earnings could easily fall by 50% or more year over year.
An uncertain future
As the pandemic fades and console supply grows, GameStop's sales and earnings trends should improve. That's not saying much, though. The company posted an adjusted operating loss of $267 million for the first nine months of fiscal 2020. Even the most bullish analyst on Wall Street projects that GameStop will earn less than $1 per share this year and $1.57 per share in fiscal 2022.
Even after last week's plunge, GameStop stock trades for more than 40 times this "bullish" estimate for fiscal 2022. That represents a premium to the market and a huge premium to other retail turnaround prospects. (For example, Kohl's stock trades for less than 11 times the most bullish analyst estimate for fiscal 2022.)
This doesn't make much sense. Physical disc sales for console games -- the linchpin of GameStop's business -- continue to lose share to digital downloads. The combination of weak long-term prospects and a high valuation makes GameStop stock likely to fall further in the months and years ahead.
This article represents the opinion of the writer, who may disagree with the "official" recommendation position of a Motley Fool premium advisory service. We're motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.
