Shares of GameStop (NYSE:GME) have pulled back dramatically from the all-time high of $483 they reached in late January in the midst of an epic short squeeze. Nevertheless, the stock is up more than 700% year to date. This reflects some investors' optimism about GameStop's ability to remake itself as a gaming e-commerce powerhouse (and perhaps lingering hopes for another short squeeze).
GameStop stock gained another 6% on Monday, after the company announced that CEO George Sherman will step down later this year. Clearly, investors are excited about the prospect of a new visionary leader changing the retailer's fortunes. However, the business case for GameStop -- both in the short term and the long term -- continues to be dubious at best.
Weak fourth-quarter results
Early in the fourth quarter, GameStop's management and shareholders were optimistic that the arrival of a new generation of gaming consoles in November would drive a long-awaited financial turnaround. Yet while the company posted solid sales results that month, its sales momentum didn't last.
Indeed, GameStop reported last month that total sales fell 3% in the fourth quarter. And as expected, the sales mix shifted aggressively toward hardware, which carries low margins. Sales of software and collectibles -- more profitable items -- plummeted 22% year over year.
As a result, GameStop's gross margin sank to 21.1% from 27.2% a year earlier. GameStop still reported year-over-year earnings growth for the quarter, but that was driven entirely by a one-time tax benefit. Excluding asset impairment charges, operating profit (which is a pre-tax metric) plunged more than 65% to just $29.5 million.
The Q1 outlook
GameStop's sales trends have improved over the past few months. In early April, GameStop disclosed that total sales rose 11% year over year in the first nine weeks of fiscal 2021, including an 18% gain during the five-week period ending on April 4.
Investors shouldn't get too excited. Even if sales were to rise 18% for the full quarter -- implying that year-over-year growth accelerates in April -- GameStop would generate around $1.2 billion of quarterly revenue. For comparison, GameStop generated over $1.5 billion of revenue in Q1 2019 and nearly $1.8 billion of revenue in Q1 2018.
GameStop's current sales trajectory is unimpressive in light of the tailwind from having new Sony and Microsoft consoles on the market. Moreover, the company will likely suffer another drop in gross margin due to higher hardware sales. That's why every single Wall Street analyst following the company expects GameStop to lose money this quarter.
E-commerce is a strategic long shot
In short, GameStop remains a loss-making retailer for now. And while sales will likely return to growth this year after an awful fiscal 2020, revenue won't get anywhere close to the $8 billion-plus GameStop routinely generated as recently as three years ago.
Chewy co-founder and incoming GameStop chairman Ryan Cohen is convinced that the video game specialist can turn itself into an e-commerce powerhouse. Yet there is little cause for long-term optimism.
First, mobile gaming accounts for the bulk of the gaming market's growth. It would be very difficult for any retailer to tap into that market in a meaningful way. (In theory, GameStop could create its own Android app store, but it would face an uphill battle to get customers to use it.)
Second, digital downloads recently surpassed 50% of console game sales, compared to less than 10% a decade ago. GameStop doesn't bring much to the table with respect to selling digital downloads: Console makers and game publishers can go directly to consumers. And while physical game sales won't disappear anytime soon, GameStop's core market is likely to continue shrinking. Improved e-commerce capabilities won't be able to drive rapid growth when the total market is in terminal decline.
GameStop bulls might point out that the company's e-commerce sales nearly tripled last year. But that growth didn't represent incremental revenue. Instead, customers who otherwise would have made in-store purchases at GameStop shifted spending online. Indeed, total sales still plunged by more than 20%.
The GameStop stock rally has bought some time
The one piece of good news for GameStop shareholders is that the stock's surge is allowing the company to shore up its balance sheet. Earlier this month, GameStop announced an at-the-market offering to sell up to 3.5 million shares (worth more than $500 million at current prices). GameStop is using some of that cash to pay off its remaining long-term debt.
With plenty of cash and no debt, GameStop will have plenty of financial flexibility as the next CEO prepares to implement a new strategy. However, I'm skeptical that the retailer will be able to find a profitable niche in the gaming market of the 2020s. And with GameStop currently carrying an $11 billion market cap, this is one stock I wouldn't touch with a 10-foot pole.