On Monday, GameStop (NYSE:GME) stock nosedived 10% after the firm announced a 3.5 million share shelf registration. But as Reddit’s r/WallStreetBets machine sprang to life, share prices started to climb back. Within hours, GME stock had regained virtually all lost ground.
Ordinarily, markets should shudder at an offering of that size; GameStop’s program could potentially raise up to $1 billion in fresh capital – equivalent to the firm’s net profits since 2010. But GameStop is no ordinary beast. With so much retail demand for GME stock, investors should give GameStop’s management a free pass on this offering. They deserve it.
GME Stock: A Primer on Stock Offerings
Like a homebuyer getting a mortgage, struggling companies often need to borrow money for major purchases. Between 2016 and 2020, AMC Entertainment (NYSE:AMC) borrowed $2.7 billion to turn their 1,000 cinemas into luxurious megaplexes with reclining seats and other fancy additions.
Conversely, companies flush with investor goodwill can instead turn to equity financing. Rather than borrowing cash, these high-flying firms can issue new shares and sell them to investors. Telsa’s (NASDAQ:TSLA) “Master of Coin” CFO Zach Kirkhorn has expertly raised billions for the electric vehicle company going this route.
With GameStop stock at $190, its shareholder sentiment looks much like Tesla’s. GME’s high valuations means that a 3.5 million share issuance will only dilute shareholders by 5%, far lower than its original 10% planned last December. And retail investor demand looks unsatiable – a necessity for selling more shares into an already saturated market.
More Money, More Problems? Not Anymore.
GameStop’s capital raise signals a stunning U-turn in strategy. For years, the firm’s caretaker management squeezed out cash from the videogame retailer like water from a stone. Rather than reinvest in store upkeep, management spent lavishly on dividends and stock buybacks instead. Only $100 million went to capital expenditure annually, while $150 million to $400 million went back to shareholders.
But then GME stock went wild. And GameStop is getting a second chance to capitalize on the mania.
Today, GameStop’s $190 share price is far beyond the $30 average price that its management bought back shares. Just like investors, company management wants to buy low, sell high. The firm also needs the money. With a re-energized board and company mission, the firm’s new chief growth officer and COO will need plenty of cash to turn its 4,000 stores into profit-making centers. (Perhaps Zumba studios or Bitcoin mining centers, tongue-in-cheek investors might imagine)
Reddit Gives GameStop a Free Pass
Much of the excitement is warranted. Chewy.com (NYSE:CHWY) co-founder Ryan Cohen has rekindled a fire at the 37-year-old videogame retailer, from making personal customer calls to disgruntled customers to reforming the company’s entire board. Its management team now look more like a list of Chewy.com alumni than a group of caretakers. Share prices could top $500 by year-end if Cohen manages to prove a new business case for the mall-based retailer.
Retail demand for GameStop stock has also remained stubbornly strong. The story continues to get featured daily on Reddit’s r/WallStreetBets, with investors still buying with a target price of “the moon.” Monday’s sudden recovery after its 3.5 million share offering announcement should surprise no one.
But does that make GME stock a buy?
What’s GME Stock Worth?
Those buying GameStop stock today are doing so on faith alone. Current generations of game consoles now offer digital-only versions, and even owners of regular consoles are increasingly turning to online purchases. In 2020, online game sales overtook sales of physical copies. Meanwhile, GameStop’s physical stores continue to burn cash. The company has $867 million in FY2021 contractual obligations and has 1,848 store leases up for renewal. Its current hoard of cash will last shorter than most investors realize.
That makes GME’s current $190 price unfathomable by traditional valuation metrics. Even using highly profitable Best Buy’s (NYSE:BBY) 0.6x EV-to-revenue multiple as a baseline, GameStop’s value comes to just $7.6 billion, or $115 per share.
But none of that matters to Reddit investors. In their minds, Cohen has already planted the seeds that will turn GameStop into the next generation of tech-based videogame companies. To them, Chewy’s 5.1x EV-to-revenue multiple makes far more sense – a valuation that would push GME stock to $1,040.
Investors looking to profit from GameStop madness might buy in at $190 – the firm looks set to enter the high-growth online gaming industry. But those looking to profit from retail investors might also consider the options market.
Today, the mad rush for GME options has pushed spreads and open interest to unprecedented levels. Put option sellers stand to earn $100 per contract if GME stays above $120 for just four days. Call sellers can make the same amount if GME stays below $300.
Profiting from Reddit might be a day trader’s game. But regular investors don’t have to miss out either.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.
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