Why shorting GameStop remains high risk

GameStop Corp. (GME, Financial), once a symbol of the retail sector's woes, has undergone a turnaround that defies conventional expectations. Led by an unorthodox CEO and largest shareholder, the company now boasts a balance sheet bolstered by cash and minimal debt. This remarkable transformation was fueled by what may be one of the most significant capital raisings in the history of the stock market.

In this analysis, I'll dive deeper into GameStop's transition from pandemic-related turmoil to a robust financial position and examine why it may still be precarious to bet against this stock now.

GameStop defies the logic of retail today, where a company that doesn't grow often can't survive. That's because with competition as fierce as ever, increasing profits and expanding operations simply means remaining competitive, not collapsing.

If we look at GameStop's business, its annual revenues have been in free fall since 2018 (with a brief exception in 2022 when the trend briefly corrected). But perhaps GameStop is the only company in the world that has increased its cash by more than 50% while reducing its revenue by about 40% over the past decade, as shown in the chart below.

GME data from GuruFocus

How was that possible? Through what was probably the largest fundraising campaign in stock market history.

In 2020, marked by the chaos of the Covid-19 pandemic, markets experienced one of the biggest crashes in their history. During the height of the pandemic, the S&P 500 (SPY, Financial) suffered one of the fastest and steepest declines. Between February 19 and March 23, 2020, the index fell by around 34%. Retail stocks in particular reacted mixedly afterward. E-commerce companies such as Amazon (AMZN, Financial), for example, saw a significant increase in their shares, reflecting increased demand for online shopping and delivery services.

Companies with strong brick-and-mortar presence such as Macy's (M, Financial), JC Penney (JCPNQ, Financial) and Gap (GPS, Financial) initially suffered from sales slumps and lockdowns, leading to sharp share price declines. However, major retailers such as Walmart (WMT, Financial) and Target (TGT, Financial), which already had robust e-commerce channels, were able to adapt quickly.

GameStop, which doesn't have a robust e-commerce channel and is a brick-and-mortar store, took the biggest hit. But the truth is that the stock has been in shambles since 2018. As a result, bears betting heavily against the stock will eventually push the company's short interest above 100% (possibly given that the shares have been borrowed and sold repeatedly).

In 2019, for example, the negative pressure on GameStop was so strong that even the famous trader Michael Burry (Trades, Portfolio) bought a sizable position after considering the high short interest in the stock and realizing that the company was undervalued. Burry even sent letters to GameStop management recommending the repurchase of $238 million worth of shares.

At this point, some time later, an unknown trader named Keith Gill (aka Roaring Kitty), who was just another YouTuber sharing his content, began to point out a thesis similar to Burry's. Shortly thereafter, former CEO and founder of Chewy (CHWY, Finance), Ryan Cohen, bought around 10% of the company's shares, becoming its largest shareholder. In parallel, at a time of pandemic, when trillion-dollar stimulus packages were being pumped into the economy and an entire global population was locked in their homes, a flood of new retail investors flooded into the market.

Driven by commission-free brokers like Robinhood (HOOD, Financial), investing and trading were democratized, and social media platforms like Reddit (RDDT, Financial) served as the stage for a kind of orchestrated trade to pressure GameStop short sellers. The result was that GameStop shares rose by four digits in a matter of days in early 2021, along with some other stocks, particularly those with a similar profile to GameStop, a legacy company that has struggled as the industry modernizes.

What happened next was what any struggling company would do when its stock price skyrockets: sell stock. GameStop raised about $1.67 billion worth of stock and used that amount to pay down its debt and strengthen its balance sheet.

Over time, Cohen proved himself to be the activist investor he is. He rose to become GameStop's CEO, shaking up management and choosing leaders he trusted. After several years of volatility, attempts to turn the company around, and speculation about his future plans, he became the company's CEO and, through drastic cost-cutting measures, led it to profitability for the first time since 2018.

But from its peak in January 2021 to April 2024, GameStop shares had lost more than 87% of their value. It turns out that there was a new twist in 2024, just when people thought the story had gone too far and the natural tendency of short sellers was to bet against the company until it became a penny stock again.

Gill, the same man who originally sparked the GameStop hype, re-emerged from obscurity after more than three years and announced a huge bet on the video game retailer – around 5 million GameStop shares and 120,000 call options. The result? Another short squeeze, but this time on a smaller scale, with shares rising nearly 400% in a matter of weeks.

This was the perfect opportunity for Cohen and his team to sell shares and strengthen the company's balance sheet once and for all. In May, GameStop sold 45 million shares and raised $933 million in cash. And that wasn't all.

On June 7, after another massive surge, GameStop sold another 75 million shares, raising another $2.10 billion. Combined with the company's cash holdings, GameStop now has around $4 billion on its balance sheet and is virtually debt-free.

GameStop's unconventional management has so far revealed little about its future plans, but the funds raised from the sale of shares could be used to convert the company into a holding company.

According to quarterly filings, GameStop announced that its board of directors has adopted a new investment policy. This policy gives the CEO and largest individual shareholder, Cohen, the authority to invest in stocks and other financial instruments. In other words, it seems that the strategy is to invest outside of the core business, which makes sense given the declining sales over the past five years.

However, the success of this strategy is uncertain. It requires Cohen and his team to have a strong investment vision, similar to Warren Buffet (Trades, Portfolio)'s approach. Until more details about these new investment opportunities emerge, the company's management appears to be focused on operating efficiently, reducing costs and pursuing profitability, even if it is only at breakeven.

While this plan may sound unconventional, it is not impossible to make a convincing case for it. The biggest obstacle is that investors are currently paying an incredible 257 times enterprise value/Ebitda for this bet, which seems far from reality.

Currently, 10.70% of GameStop shares are shorted, which is significantly less than in recent years. This suggests two things: short sellers have learned from the past, and the likelihood of a short squeeze is much lower.

Also, the narrative around GameStop could shift from “betting against” to “transformational and growth potential.” This could attract a different type of investor – one more focused on fundamentals and long-term strategies.

Since the Roaring Kitty mystery is mostly solved (and has already been addressed this year), I don't think it will significantly impact the stock price again. The most likely cause of volatility would be Cohen's efforts to turn GameStop into a holding company, which seems pretty dubious in my view.

But most importantly, it's hard to bet against a stock with such a volatile history, a strong balance sheet (especially with all those stock sales), no debt, and a company that doesn't lose money. This makes the idea of ​​betting against GameStop based on extremely high valuations seem shaky, especially since valuations have played little role in the investment thesis in recent years.

GameStop's transformation from a struggling retailer to a financially strong competitor is simply remarkable.

The company has cleverly used share sales to bolster its balance sheet and positioned itself with solid cash reserves and minimal debt. While Cohen is steering GameStop toward a holding company, the future is a mix of uncertainty and potential. With short interest at a modest 10.70% (considering history) and the stock's volatility associated with strategic changes, betting against it now seems like a risky gamble. The stock's strong financial base and near-profitability make it a difficult target for short sellers, making any bearish bets even more complex.