GameStop: No Good News, Exit Now

Dec. 11, 2019 11:35 AM ETGameStop Corp. (GME)89 Comments2 Likes

Summary

  • Guidance turns very sour.
  • Cash is unwisely deployed for share repurchases.
  • Investors are still able to exit the stock before it gets even worse.
  • Looking for a helping hand in the market? Members of Deep Value Returns get exclusive ideas and guidance to navigate any climate. Get started today »

Investment Thesis

At the start of September 2019 I noted in an article titled Stay On The Side:

[...] having a long position, despite its allure of investing in a fallen angel is just too speculative and not worthwhile investing in.

And to be clear, this is absolutely not a ''I told you so" article. What I believe this article delivers is a wonderful case study, that a drop in price does not mean undervalued.

This stock is best avoided. Here's why:

No Good News Out of GameStop

Nothing from GameStop's Q3 2019 results was positive.

And if you have read my work before, you will hopefully know that I specialize in cheaply valued, contrarian stocks, so this is exactly the type of investment I seek.

But the trick in this sort of strategy is selectivity. Just because something has fallen in price, and is facing a grim outlook, this does not immediately imply the stock is a bargain opportunity.

For investors, the easy option here is to point blame on management's poor execution, naivety, or inexperience, or even a combination of all the above. But in investing there's no place for emotion. What actually matters is the consideration of what is the risk-reward available at this valuation?

Consider this, if during its Q2 2019 results (last quarter) GameStop was guiding for fiscal 2019 comparable sales to be down in the low teens, and now just 90 days later GameStop is pointing for fiscal 2019 comparable sales to be a decline in the high teens, this ultimately speaks of the poor control over the company's trajectory.

Conversely, during the earnings call, the recently-appointed GameStop CEO George Sherman declared:

[...] we do not believe these results are indicative of what we would expect for the business in the long term.

In other words, the narrative coming out of GameStop is now a jam tomorrow story. Will investors be believers in this turnaround?

Questionable Capital Allocation Strategy

Investors will be questioning whether the close to $180 million deployed toward share repurchases during the trailing nine months was a wise move or not. If the business survives, of course, it will appear to have been wise.

Having said that, in reality, without any hindsight bias from the share price movement, just from common sense, capital used to fully pay down debt would have been a much wiser allocation strategy.

Specifically, we know that GameStop's Q3 2019 ended with a net debt position of $140 million. If GameStop had used the approximate $180 million toward paying down, it might have succeeded in ending fiscal 2019 with a strong net cash balance sheet - thus, for now, its strong balance sheet appears to be unlikely.

Valuation - Not Cheap Enough

The return from investing in a stock has a lot to do with the multiple investors are willing to pay for a stock. If a company executes well on its strategy, with positive guidance, investors are all too happy to pay a huge multiple for the stock.

And the reverse takes place when the company poorly executes and offers dismal guidance. Investors adopt a ''show me'' first approach. Hence, this compresses the multiple investors will be willing to pay for the stock even lower.

Further compounding troubles for investors, GameStop is an ''almost too-easy story'' to be negative about. GameStop faces secular headwinds, with a questionable value proposition, also it's a brick-and-mortar retailer, with declining revenues, as well as, a leveraged balance sheet.

There's simply no aspect of this story which makes for a compelling investment.

The Bottom Line

For as long as the stock was rising, as it had done the past three months, shareholders were becoming hopeful and not willing to ask the fundamentally-challenging questions.

But given its poor outlook, many bargain hunters are likely to reconsider their position in this stock. I fail to see a compelling reason for shareholders to remain invested at approximately $550 million.

Looking For Rewarding Returns?

Even though GameStop is terrific, numerous studies have shown that it is difficult to beat the market with widely followed richly-priced popular names.

Meanwhile, by being extremely selective and investing in smaller contrarian stocks, your chances substantially improve.

Investment strategy inspired by Buffett, Pabrai, and Greenblatt.

Contrarian investing: never easy, but often rewarding. 

Sign up for your two-week free trial with Deep Value Returns today!

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This article was written by

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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