With 138% Short Interest, Board Change Sends GameStop Stock Soaring
Financial theory says that the price of a stock instantly reflects all the available information about the current value of its future cash flows. The recent stock price behavior of GameStop GME shows the cracks in that theory.
GameStop — which sells video games mostly through physical stores — enjoyed a 57% pop in its stock price on January 13, according to the Wall Street Journal.
This rise happened despite a 30% decline in revenues for the most recent quarter, negative free cash flow and no forecast for the future, according to GameStop’s third quarter earnings conference call transcript.
Does this price spike reflect a sudden reassessment of the current value of its future cash flows? I think it does not. Instead, it reflects a buying panic resulting from news about changes on GameStop’s board of directors.
GameStop’s Phenomenal Stock Price Spike
GameStop shares have enjoyed a huge rise in the last 12 months — the stock was up 583% in the last year — from $4.60 in January 13, 2020 to $31.40 this Wednesday.
Much of that increase was triggered by news that pet supplier Chewy’s “co-founder Ryan Cohen [— who owns 13% of GameStop’s stock —] and two of his former colleagues” are joining GameStop’s board, noted the Journal.
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Why should that make GameStop 57% more valuable than it was the day before? It helps to understand how short selling works. That is what happens when someone bets that a stock will drop by borrowing shares from a broker, selling them in the open market, and hoping to repay the stock loan by buying them back later at a lower price.
A short-squeeze occurs when the short seller’s bet goes bad. Instead of the stock’s price dropping below the level at which the short seller sold, the price goes up. When that happens the broker who lent the shares to the short seller demands that the loan be repaid right away.
This leads to a buying panic as short sellers go into the market to buy the shares. The more such short sellers are buying, the faster the price rises — and the higher the price, the bigger the short seller’s losses.
GameStop is one of the most heavily shorted stocks. According to the Journal, at the end of December more than 138% of its shares available for trading were sold short. That is possible because “traders are able to borrow shares from other investors, and those shares can be loaned more than once.”
What drove up GameStop’s shares was a short-squeeze on steroids.
GameStop’s Miserable Performance And Prospects
It does not take a genius to realize that when videogames can distributed digitally there is far less need for the retail store network built to distribute them via physical media (like CDs in boxes).
Cohen has been urging GameStop to respond to this reality by closing physical stores and distributing games digitally. That is what GameStop was doing throughout 2020. In December 2020, GameStop said it had “closed more than 460 stores during the first three quarters of its fiscal year and reported stronger demand across its e-commerce unit,” noted the Journal.
In short, Cohen’s proposal is what GameStop has been doing. And the results have been quite poor.
GameStop revenue has plunged, it lost money, and burned cash. As CFO Jim Bell said in the company’s third quarter earnings conference call, net sales of $1 billion were 30.2% lower than the year before. GameStop lost $18.8 million in the quarter and burned through $200 million in free cash flow — leaving it with $450 million in cash on its balance sheet, according to Morningstar.
GameStop suspended guidance for the fourth quarter but excitedly touted a 352% increase in its e-commerce sales — sadly the revenues are not reported separately which I interpret to mean that the amounts are not significant. Meanwhile, Bell proudly pointed out that since the end of 2018, GameStop has closed 1,020 stores.
Should You Buy GameStop Stock?
There are some who are bullish on GameStop’s fundamentals. Wedbush Securities analyst Michael Pachter told the Journal that short sellers are overlooking demand for GameStop’s used items which it sells in its roughly 5,000 stores.
Ihor Dusaniwsky, the head of predictive analytics at financial technology and analytics firm S3 Partners, told Dow Jones that he thinks the stock is being driven up by its board shakeup and stronger holiday sales.
I would consider buying these shares if the company had real prospects for top-line growth and positive free cash flow. Even though I see more pain ahead for short-sellers I will stay away from GameStop.