Last year, stock market volatility reared its head in a manner never before witnessed by investors. The coronavirus pandemic sent equities skidding lower and ultimately cost the benchmark S&P 500 more than a third of its value in about a month.
This year, it's not the broad-based indexes that are being whipsawed. Rather, it's an obscure basket of a few dozen stocks that retail investors have latched onto.
In simple terms, retail investors (mostly young and/or novice investors) on Reddit's WallStreetBets (WSB) chatroom are banding together to buy shares and out-of-the-money call options in stocks with high levels of short interest. Short-sellers are investors who make money when the share price of a stock goes down.
The goal of the WSB community is to create a short squeeze. That's where short-sellers run for the exit at the same time. Since short-sellers have to purchase stock to cover (i.e., exit) their positions, it can exacerbate an already explosive upside move in a heavily short-sold stock.
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The key thing Reddit investors are overlooking with their favorite stocks
Over the past two months, Reddit's retail investors have taken a particular liking to three companies:
Back in mid-to-late January, when this Reddit frenzy began, video game and accessories retailer GameStop was the most shorted stock in the entire market, relative to its float (i.e., all shares available for trade). Meanwhile, movie-theater chain AMC and Canadian marijuana stock Sundial were both heavily sold short relative to their floats and were also penny stocks. This acted as a secondary lure for young retail investors.
On a year-to-date basis, retail investors have helped to drive shares of AMC, GameStop, and Sundial "to the moon," as retail investors like to proclaim. Through the closing bell on March 23, AMC was up 395%, GameStop a cool 792%, and Sundial 153% on a year-to-date basis.
But there's a key performance factor that retail investors are overlooking for all three companies, and it's not something that can be swept under the rug for a long period of time. Specifically, it's that operating earnings always matter.
Although some combination of euphoria, emotions, and technical analysis have driven short-term gains in these stocks, long-term share-price appreciation is always going to be derived from operating performance. A quick look at all three companies shows that Reddit investors are in deep trouble.
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Can AMC survive?
Without question, AMC Entertainment struggled mightily in 2020. The vast majority of its theaters were closed for brief periods of time, while many are still contending with varied degrees of restrictions, such as social distancing requirements and mask mandates. Between purposefully reduced capacity and potential consumer safety concerns, AMC isn't operating with anywhere close to a full deck.
Though the company recently announced that 99% of its theaters would be open, as of today, March 26, AMC doesn't have clean bill of health. It narrowly avoided filing for bankruptcy less than three months ago and only managed to keep the lights on by selling nearly 165 million shares of stock and issuing more than $400 million in debt capital.
Based on Wall Street's projected losses for the company over the next two years, AMC doesn't have enough cash to survive. This implies that management will continue diluting its shareholders or issuing even more debt to raise capital.
AMC's operating model also looks to be broken, or at best, severely damaged. Select streaming companies are choosing to release films on their platforms the same day they'll hit theaters in 2021. This hurts AMC's chances for a rebound this year, and calls into question its film exclusivity going forward.
If you need even more evidence that AMC is in trouble, look at its debt. Most of the debt issued by AMC in 2020 carries an interest rate north of 10%, with a $100 million tranche issued in January 2021 carrying a 15% to 17% variable interest rate. In 2019, prior to the pandemic, AMC only generated $359 million in adjusted free cash flow -- and that was when things were good. The company paid close to $357 million in interest expenses last year, and things are only going to get worse.
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GameStop's reshuffle is a work in progress
If there's a concession I'll offer with GameStop, it's that the company's future isn't in question. With $635 million in cash and just shy of $363 million in debt, the company shouldn't have an issue continuing to operate (which is more than I can say for AMC).
However, blindly following other investors into GameStop based on euphoria, technical analysis, or high hopes would be a big mistake, especially if you took a gander at the company's fourth-quarter and full-year operating results.
Despite a 191% increase in e-commerce sales last year, net sales declined to $5.09 billion from $6.47 billion in the prior-year period, with comparable-store sales falling nearly 10%. GameStop blamed the closure of 12% of its store base, the impact of coronavirus closures, and a shift toward lower-margin console sales as reasons for its poor performance. On an adjusted basis, the company lost $138.8 million for the full year.
The issue for GameStop is the company waited too long to shuffle its operating model to support digital gaming. GameStop was built as a brick-and-mortar model, so transforming it to focus on digital gaming is a multiyear project. For 2021, it'll likely translate into another annual loss.
As the icing on the cake, the company noted that it might raise capital by selling its stock to fund its transformation. I don't want to sound like a broken record, but that'll mean existing investors will see their shares diluted.
Image source: Getty Images.
Sundial is bringing up the caboose in cannabis
Finally, there's marijuana stock Sundial Growers, which is operating in one of the fastest-growing industries in North America.
New Frontier Data believes U.S. pot sales will grow by 21% on an annualized basis through 2025, with BDSA forecasting a more-than-doubling in Canadian weed sales to $6.4 billion by 2026. Yet Sundial delivered net sales that declined 4% in 2020.
Sundial blames the poor performance on its shift away from low-margin wholesale cannabis, as well as supply-chain disruption caused by the pandemic. Interestingly, the vast majority of North American pot stocks grew their net sales last year.
What's more, Sundial's forward-year growth is nothing to write home about. While most U.S. multistate operators are generating sales growth of 30% to 150%, and even Canadian licensed producers are piling on the green, Wall Street is counting on Sundial to grow sales annually by the low- to mid-10% range. It's effectively bringing up the caboose in one of the fastest growing industries.
Sundial has also proved to be a serial diluter. If you thought AMC's share-based dilution was awful over the past year, take a gander at what Sundial has done since the end of September. Its share count has ballooned from 509 million to 1.66 billion, and the company recently filed a prospectus to sell up to $800 million in additional shares via at-the-market offerings from time to time. Sundial's outstanding share count could easily top 2 billion, which would make it all but impossible for this company to generate a meaningful profit or escape penny stock territory.
No matter how much euphoria is built into these Reddit stocks, operating earnings always matter.
