Why Is Everyone Talking About GameStop?

GameStop's (GME 0.10%) stock surged 15% on July 7 after its board of directors approved a 4-for-1 stock split. The split will occur after the market closes on July 21, and shares will start trading on a split-adjusted basis on July 22.

The stock split won't change GameStop's market value or its valuation, but the decision still turned it into one of the hottest topics on Reddit's WallStreetBets subreddit again. But will that short-term buzz set a floor under its stock, which is still trading about 60% below its all-time high set in January 2021?

Image source: Getty Images.

Has its business fundamentally improved?

Prior to GameStop's Reddit-fueled rally last year, its days seemed numbered. Digital downloads, which generated much higher-margin revenue for video game publishers, had permanently disrupted its sales of physical games. It had also overexpanded its brick-and-mortar presence over the years with big acquisitions and new store openings.

GameStop's main turnaround strategy was to diversify its business away from physical games by selling more hardware, collectibles, and toys. It also closed down its weaker stores, renovated other ones, and expanded its e-commerce marketplace. Here's how that strategy panned out over the past five years.

Data source: GameStop. *Did not disclose comparable-store sales growth.

Last year, GameStop's revenue rose 18% to $6.01 billion against an easy comparison to its pandemic-related store closures in 2020, but still came in 7% lower than its $6.47 billion in revenue in 2019. It also stopped disclosing its comparable-store sales growth last year, which makes it impossible to gauge the performance of its remaining fleet of brick-and-mortar stores.

The margins tell an even gloomier story. Between fiscal 2017 and 2021, GameStop's gross margin declined from 33% to 22.4%. Its operating margin also tumbled from 1.5% to negative 6.1%.

Analysts expect GameStop's revenue to increase 8% this year, but they also project its operating and net losses will widen. However, that forecast could still be too optimistic because the broader video game market has stalled out. Video game spending fell to its lowest levels in more than two years in the U.S. this May, according to the NPD Group, and the research firm expects a full-year decline in 2022 as supply chain issues and inflationary headwinds curb the market's appetite for new games.

The red flags are easy to spot

GameStop's business hasn't fundamentally improved, but its stock jumped from the single digits to the triple digits last year because investors realized that over 100% of its shares were being shorted. That ratio indicated that many of the shares were being sold naked, or without being properly borrowed before initiating a short position.

When retail investors realized the shorts had gotten too greedy, they teamed up on Reddit and other social networks and aggressively bought the stock to trigger a massive short squeeze. GameStop capitalized on those gains by raising $1.68 billion through two new stock offerings last year.

That was a shrewd strategy for GameStop, but it should have also been a red flag for its investors, since it indicated the company was eager to sell its shares at inflated prices before the "meme stock" frenzy inevitably ended.

More red flags subsequently appeared. In addition to obfuscating its comps growth, GameStop started to pivot toward cryptocurrencies and non-fungible tokens (NFTs). Earlier this year, it announced it would seek out crypto partnerships and build an NFT marketplace for video game publishers. The crypto and NFT markets more broadly both collapsed this year as rising interest rates drove investors away from speculative investments, but GameStop reiterated its commitment to those two volatile markets during its latest conference call in June.

GameStop's decision to split its stock while its share price was in the $130s also seems like a desperate attempt to jump on the stock-split bandwagon. But while it made sense for Alphabet (GOOG 0.37%) (GOOGL 0.35%) and Amazon (AMZN -1.14%) to split their shares because their stock prices had risen into the thousands, GameStop's split merely seems aimed at generating some fresh buzz among retail investors. 

Meanwhile, GameStop's core business is still in trouble. Shortly after the stock split announcement, GameStop abruptly fired its CFO, Michael Recupero, and said it would lay off an undisclosed number of employees.

Still now a viable investment

GameStop currently trades at about 1.6 times this year's sales. That might initially seem cheap, but other struggling brick-and-mortar retailers -- like Bed Bath & Beyond (BBBY) and Kohl's (KSS 4.53%) -- are trading at less than one times their forward sales.

If we strip away the meme stock, crypto, NFT, and stock-split noise, we'll notice that GameStop still has a lot in common with those dying retailers. Its stock might generate some short-term returns for nimble traders, but it's clearly not a viable long-term investment. About a fifth of GameStop's shares are still being shorted today, but it definitely won't replicate its dramatic gains from last year.