One Year Later: GameStop Shows Investors Are Ignoring Fundamental Research (GME)

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A year after meme stocks’ reckless rally in late January 2021, valuations for some of the most popular meme stocks, particularly GameStop (GME) and AMC Entertainment (AMC), remain detached from reality. Looking back, here are the key takeaways:

  • Even stock trading is making less headlines than a year ago, but it still affects the stock market today.
  • Investing in meme stocks involves reckless and unnecessary risk, which puts an investor’s portfolio at risk of potentially devastating declines.
  • We have no problem paying a premium for a company that generates big profits, but that’s not the case with meme stocks.
  • Investors need reliable fundamental research more than ever to gauge corporate earnings, as the market moves away from high-flying growth names toward more stable cash generators.
  • The stock market’s decline so far in 2022 suggests that investors are paying much more attention to earnings valuations than they did in 2021.
  • The narrowing gap between valuations and fundamentals is not good news for investors in similar stocks, who tend to ignore due diligence altogether.
  • Meme stocks like GameStop and AMC Entertainment remain dangerously overvalued and aren’t generating the earnings needed to justify their current valuations.

Below, we highlight how, despite falling significantly from its 2021 peak, GME remains a dangerous stock. We do the math to show how the business needs to operate to justify its current price. We also look at more realistic scenarios, which show that GME could have more than 59% downside.

The Meme-Stock rally has stalled and has yet to fall

Meme traders (or self-styled “monkeys”) threw caution to the wind and crowded GameStop in January 2021, sending the stock soaring as high as $347/share (based on closing prices). Even after falling 68% from that peak, GME is still trading almost 500% higher than at the end of 2020, according to Figure 1.

Figure 1: GME remains 500% above the 2020 closing price

GME Awards since end of 2020

GME Awards since end of 2020

New Constructions, LLC

GME has yet to trade in line with its actual trading fundamentals. This phenomenon remains in place for other popular meme stocks, such as AMC Entertainment and Express (EXPR). Even Koss Inc. (KOSS), which is trading 85% below its stock peak, is still nearly 200% above its 2020 closing price.

Given that these stocks are still trading much higher than their fundamentals warrant, it is clear that investors and monkeys continue to ignore fundamental research and take unnecessary risks with their investments.

Changes didn’t fix a broken business

Despite boardroom and management changes, GameStop remains a lagging brick-and-mortar retailer in an increasingly online world. While the stock has been on the rise recently following reports of it entering the NFT and crypto market (a playbook similar to the AMC meme-stock companion), these stocks hardly change the fundamentals under assets of the company.

In fiscal 2020 (fiscal year ended 02/01/20), prior to the stock run, the company’s net operating profit after tax (NOPAT) margin was 1% and its invested capital is running , a measure of balance sheet efficiency, sat at 1.5, resulting in a return on invested capital (ROIC) of just 1%. Over the past twelve months (TTM), GameStop’s NOPAT margin has fallen to -2% while its ROIC has fallen to -3% TTM.

Base revenue, a more accurate measure than reported revenue, fell from $19 million in fiscal 2020 to -$141 million in TTM. Despite the sharp deterioration in business, GameStop’s stock price continues to trade as if fundamentals never matter.

Figure 2: GameStop fundamentals before and after the Meme-Stock rally

GME Fundamentals Pre and Post Meme Stock Rally

GME Fundamentals Pre and Post Meme Stock Rally

New Constructs, LLC and Company Filings

Quality research helps measure risk more clearly

While shorting GME may be a losing proposition, we believe it is important to understand the high risk of owning the stock by quantifying future cash flow expectations in the current market price. action.

It’s clear that meme traders have ignored this due diligence, but we’re making it easy for them.

GME is priced to generate 150% of Activision Blizzard’s revenue

We use our Inverse Discounted Cash Flow (DCF) model to analyze future earnings growth expectations implied by GameStop’s share price. In doing so, we see that at $109/share, GameStop is priced as if it would immediately reverse declining margins and grow revenue at an unrealistic rate for an extended period.

Concretely, to justify its current price GameStop must:

  • improve its NOPAT margin to 3% (i.e. its three-year average before COVID-19, compared to -2% TTM) and
  • increase revenue by 15% per year through FY2028 (1.5 times the projected growth of the video game industry until 2027).

In this scenario, GameStop generates more than $13.5 billion in revenue in fiscal 2028, representing 150% of Activision Blizzard’s (ATVI) trailing twelve-month revenue and 168% of the hybrid brick-and-mortar retailer’s revenue and Williams-Sonoma Electronic Commerce (WSM). For reference, GameStop’s revenue fell 1% annually between FY2009 and FY2019.

There is a 31%+ downside if the consensus is right:

In this scenario, GameStop:

  • NOPAT margin improves to 3%,
  • revenue grows at consensus rates in fiscal years 2022, 2023 and 2024, and
  • revenue grows 10% per year from FY2025 to FY2028 (equal to projected industry growth rate through 2027), then

the stock is worth only $76/share today – a decrease of 31% compared to the current price. If GameStop’s growth continues to slow or its turnaround comes to a complete halt, the downside risk for the stock is even higher, as we show below.

There is a 59% plus downside if growth slows to attainable rates:

In this scenario, GameStop

  • NOPAT margin improves to 2% (5-year average),
  • revenue grows at consensus rates in fiscal years 2022, 2023 and 2024, and
  • revenue grows by 4.4% per year from fiscal year 2025 to fiscal year 2028 (continuation of the consensus of fiscal year 2024), then

the stock is worth only $45/share today – a decrease of 59% compared to the current price.

Figure 3 compares the company’s historical revenue and implied revenue for the three scenarios we’ve presented to illustrate how high GameStop’s stock price expectations remain. For reference, we also include TTM revenue from Activision Blizzard and Williams-Sonoma.

Figure 3: GameStop Historical Revenues vs. DCF Implied Revenues

Implicit income GME DCF

Implicit income GME DCF

New Constructs, LLC and Company Filings

Fundamentals Bring Clarity to Sparkling Markets

Wall Street is not in the business of warning investors of the dangers of risky stocks because they make too much money from their trading volume and from underwriting debt and selling stocks.

With a better understanding of fundamentals, investors have a better idea of ​​when to buy and sell – and know what risk they are taking when holding a stock at certain levels. Without reliable fundamental research, investors have no way of assessing whether a stock is expensive or cheap. Without a reliable measure of valuation, investors have no choice but to gamble if they want to own stocks.

This article was originally published on January 20, 2022.

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