Despite dropping 33% year to date, GameStop (GME 1.12%) stock is still up by a jaw-dropping 2,400% from the roughly $1.00 per share it was worth in early 2020. The company is flying high after the meme stock rally jacked up prices of heavily shorted equities.
But despite its lofty price tag, GameStop's fundamentals still leave much to be desired. Long-term investors should stay far away. Here's why.
A business in terminal decline?
Founded in 1984, GameStop has its roots as a brick-and-motor retail chain focused on new and used video game software. But like many companies that started in that period, its core business model became outdated with the rise of e-commerce, streaming, and digital downloads. And while GameStop has lasted much longer than other 80s babies like Blockbuster Video (which went bankrupt in 2010), the future looks bleak.
GameStop's revenue has fallen 37% (from $9.55 billion to $6.01 billion) between 2012 and 2021. And the company has seen its market eroded by direct-to-consumer rivals like Valve Corporation's Steam, which allows users to download content directly from its platform.
GameStop still has an economic moat as a place to buy and sell used games, but it is unclear if that niche will be enough to keep the company afloat. Forays into new businesses, such as non-fungible tokens (a form of digital collectibles), are yet to materially impact financial statements. And management's cryptocurrency efforts look more like a way to maintain hype for the stock than actually turn the business around, although time will tell.
Second-quarter earnings were not impressive
GameStop's second-quarter earnings were lackluster. Net sales dropped 4% year over year to $1.14 billion because of a decline in software and hardware sales. And operating losses expanded from $58 million to $107.8 million in the period. That said, with $908.9 million in cash and just $32.1 million in long-term debt, the company has a healthy balance sheet.
Instead of funding itself through cash flow and bond offerings, GameStop sells more shares of its (arguably) overpriced stock. This is the right thing to do from a business perspective, but it can harm shareholders by diluting their claim to future earnings, which lessens the fundamental value of their shares.
As of the second quarter, GameStop's outstanding shares totaled 304 million compared to just 66 million in early 2020. Investors should expect this number to continue growing because of the company's operational losses.
The valuation is simply too high
With a price-to-sales (P/S) ratio of 1.4, GameStop's stock doesn't look super overvalued compared to the S&P 500's average of 2.3. But those numbers don't tell the full story. The company operates in what appears to be a dying industry, with revenue eroding over the long term; plus, it isn't profitable and funds itself through equity dilution.
GameStop's valuation should be much lower in light of its many challenges. And investors should avoid the stock because of continued risk to the downside.