GameStop Won’t Be Able To Cut Its Way To Success

Summary:

• Ryan Cohen has become CEO of GameStop, calling for extreme frugality and cost-cutting measures at the company.
• The company has shown some improvement in its Q2 results, but its results are still not good enough to justify its current valuation.
• However, GameStop continues to burn a significant amount of cash, and its core business is unlikely to be profitable and sustainable in the long term.

Back in April, I wrote that GameStop (NYSE:GME) was facing numerous headwinds and that the valuation didn’t make much sense, placing a “Sell” rating on the name. With the stock down over -20% since then and down -35% since I reiterated my “Sell” rating, let’s catch-up on the video game retailer.

Company Profile

As refresher, GME is a video game retailer that operates stores and e-commerce platforms under the GameStop, EB Games, and Micromania brands. The company sells both new and used video games, and customers can trade-in pre-owned games for cash or credit. It also sells related video game and pop cultural merchandise at its stores, and also owns the Zing Pop Culture brand in Australia and Europe.

Through the first six months of the year, 55% of GME’s sales were hardware and accessories, nearly 31% was software, and the rest collectibles. The U.S. accounted for about 66% of revenue, while Europe was 18%, Australia 10%, and Canada 5%.

Cohen Becomes CEO

The last time I looked at GME, I noted that its CEO had been fired and that large shareholder Ryan Cohen had been elected as Executive Chairman. Since then, Cohen has taken on the role of CEO effective September 27th.

Cohen is best known as the founder and former CEO of online pet store Chewy (CHWY), but more recently he has been entangled in investing in down and out stocks, including the now bankrupt Bed Bath & Beyond. Cohen has become a controversial figure, as his firm RC Venture took a nearly 10% stake in Bed Bath & Beyond only to sell out of its few months later, while he and the company’s former CFO Gustavo Arnal were accused of a pump and dump scheme before Arnal jumped off a skyscraper.

Shortly after taking over as CEO, Cohen sent a memo to employees calling for extreme frugality at the company. In the memo, the new CEO wrote:

“Our job is to make sure GameStop is here for decades to come. Extreme frugality is required. Every expense at the company must be scrutinized under a microscope and all waste eliminated. The company has no use for delegators and money wasters. I expect everyone to treat company money like their own and lead by example.”

Cohen called out that the company must avoid using leverage, as well as buying bad inventory and running expenses too high. He also noted that he was not taking a paycheck.

While Cohen’s stance is understandable, his calls for extreme frugality is unlikely to create a good working environment or to attract talent. This is also usually needed for a business to be successful, so you have to question the tone he setting out of the gate. It’s not a good first impression in my view.

GME had already been focusing on cutting costs before Cohen took over, and it continued to show progress when it reported it Q2 results. SG&A expenses fell to $305.9 million, or 27.7% of net sales, versus $387.5 million, or 34.1% of net sales, a year ago, and were down from $345.7 million, or 27.9% of net sales in Q1.

Meanwhile, gross margins improved 160 basis points to 24.7% from 23.1%, despite the decline in its generally higher margin collectibles business.

Overall, GME saw revenue rise 1.8% to $1.16 billion, topping the consensus of $1.14 billion. The company saw strength in software, with sales up nearly 26% to $397 million. Hardware sales edged up to $597.0 million, while collectible revenue sank -24% to $169.8 million.

The company was able to post adjusted EBITDA of $1 million compared to a -$78.1 million loss a year ago. Operating cash flow, however, worsened to -$109.1 million from -$103.4 million a year ago, while free cash flow only improved slightly from -$123.9 million a year ago to -$119.2 million.

The company still has a ton of cash, with $1.2 billion in cash and marketable securities and minimal debt. This is due to the company issuing a lot of equity at high prices during its meme stock run.

While the quarter showed some nice improvement with sales up and strong cost controls leading to positive EBITDA, the company still continues to burn a significant amount of cash. The company hasn’t hosted a conference call the past two quarters, so it hasn’t given any insight into when it might be able to stem this cash outflow.

Now the company has raised a lot of cash, so bankruptcy is not on the table anytime soon. However, there doesn’t appear much opportunity to turn the company’s current core business around into something sustainable and long lasting. It had gotten a boost by going into higher-margin pop culture collectibles, but that once fast growing business has become a drag more recently.

Conclusion

GME’s market cap has gone from $7 billion, with a $6.4 billion enterprise value, last time I looked at it to around a $4.6 billion market cap and $4.0 billion enterprise value. That values the company at around $1 million per store, which continues to seem way overvalued. It’s tough to see a scenario were the current business is solidly profitable and worth anything close to $4 billion in its current form.

There has been a big shift to video game subscriptions and digital downloads than physical games, which will continue to be a cyclical headwind for the company. At the same time, the video console cycle has been lengthening, with the next generation of consoles not expected until about 2028. Those factors are all working against GME, and with its push into collectibles now stalling, there doesn’t appear to be much more it can do with its current concept.

As such, I continue to think Cohen may try to use the cash to make an acquisition and get into another business. Making an acquisition and shifting businesses can be a desperate move, but it is likely the best option for the company given its outlook and current cash position.

Given its current valuation and with macro uncertainty picking up, I continue to rate GME a “Sell.” The biggest risk to upside gains would be for the company to make an attractive acquisition in my view, or for the stock to go on another meme inspired run, but the latter seems pretty unlikely at this point.

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