Why Is GameStop Stock Surging! Short Squeeze Explained

We saw GameStop stock price skyrocketed by about 144% on Monday 25 Jan 2021. It reached a high of $158, before retreating back. And finally ending off the session with a 18% gain from the previous trading day.

There was a total of US$16.7 billion worth of GameStop shares that were traded on a single day. And that amount is more than 3 times the company’s market cap of around $5 billion. Can you imagine that?

Let’s take a look at what is causing such insane volatility. Why is the videogame retailer’s share price climbing higher and higher even though it is making losses at the moment. And finally, we will see how it will pan out eventually for the company. Let’s go!

What Does GameStop Do

GameStop Stock Sales Breakdown

Source: GameStop Presentations – Creating Value for All Stockholders

First, let’s take a quick look at what business and market is GameStop in.

You may not know, GameStop Corp is a Fortune 500 company. It is a video game retailer, operating across 4 key geographical locations – United States, Canada, Australia and Europe. It offers games and entertainment products through its 5000 physical stores and online e-commerce platform.

Key segments of business include hardware and accessories, software and collectibles. Hardware consists of new or pre-owned video game platforms and consoles such as the well known Sony Playstation, Microsoft Xbox and Nintendo Switch. Software ranges from full-game downloads to in-game digital currency that the company sells. As for the collectibles segment, it consists of license merchandise related mainly to video game, television and movies industries and pop-culture themes.

Business Performance

Before we can head into the discussion of the wild trading session of GameStop stock that we saw on monday, we need to have a quick overview of its business performance.

First, understand that GameStop has been losing money in recent years. Moreover, we expect this to continue this year and possibly even the next.

GameStop Stock Revenue And Net Income Trend

Source: Stockrow / GameStop Corp Revenue and Net Income Snapshots

You can see from the chart above, the company registered a negative net income of US$673 million in 2019. Although result for full year 2020 is not out, the first 9 months registered a net loss of US$296 million. Therefore, we expect the full year net loss to be around the US$400 million range.

The economics have changed, gamers no longer need to go to physical stores to purchase new game titles. In fact, the company’s increasing focus on its ecommerce platform to deal with growing competition online is met with challenges as well. The reason being gamers can now download new titles directly from their computers or even directly from the consoles nowadays.

Why GameStop GME Stock Is Climbing Higher

So what is pushing up GameStop share prices recently? A group of loyal investors who continue to support the company’s stock even though Wall Street has classified it as overvalued.


Another key news that has poured positive sentiment on its future is related to the company’s announcement earlier this month. Ryan Cohen, founder of online pet supply store Chewy, has come on GameStop’s board. Also, two other former Chewy executives has joined him as well. According to a press release, these three new directors are expected to bring to the table deep expertise in e-commerce, online marketing, finance and strategic planning to GameStop.

Therefore, since early January this year, GameStop’s share price has been climbing steadily upwards.

What Is Causing The Surge of GameStop GME Stock

However, all these positivity built into the stock price are speculative in nature as the company is still making losses. Coming out of the red requires successful execution to transform the company into a more digitally focused business.

As a result, a large pool of investors have made a bet against GameStop by shorting its shares. So just for your understanding, shorting is equivalent to selling the shares that you don’t own. Meaning investors are borrowing shares and selling them, hoping to repurchase the stock at a lower price. So that they can profit from the price decline eventually if it does happen.

Short Squeeze Effect of GameStop Stock

GameStop Stock Price 5 Day Chart 27 Jan 2021

Source: Yahoo Finance / GameStop Corp (GME) 5-Day Price Chart – 27 Jan 2021

However, a short position can be very risky in nature as the downside is unlimited. Why, because when the stock price goes up, short sellers’ losses become bigger if they don’t buy back or cover their position soon enough. This creates what we call a short squeeze.

What happens is that eventually, the short sellers can no longer hold on, but have to cover their positions. When the group of short sellers try to cover their positions at the same time as the share price climbs higher and higher, it creates an excess demand for GameStop shares in a low supply environment.

Thus, resulting in a rapid increase in the share price of GameStop. This is what we call a short squeeze that we saw during the Monday trading session, sending the stock price up by 144%. But the market did ease off eventually and settle on a 18% one-day gain.

So, this huge volatility that we saw is nothing more than the frenzy buying and selling caused by the speculation happening in the market.

Possible Turnaround

We do see some positive updates in the 3rd quarter 2020, when the company updated certain improvements achieved so far:

  • Closed about 800 stores worldwide, and expected to reach over 1000 by fiscal year 2020. But of course this will affect the company’s revenue, and may not necessarily translate to eventual success online.
  • Reduced over $440 million in SG&A expenses since the middle of 2019, where approximately 67% will be a permanent reduction.
  • More disciplined inventory management leading to increasing inventory turns from 4X to 4.7X in just over a year. This led to more than $350 million improvements in working capital.
  • For the first 9 months of 2020, e-commerce contributed 25% of total sales, up from a mid-single digit percentage historically. There was also a 257% increase in e-commerce sales, in Q3 2020, fueled by elevated omni-channel capabilities.

Execution Risk

Well these are some positive updates of the company trying to transform itself. But i think that GameStop’s share price may have gone a bit too far, given its current status. The expected potential and profitability of the turnaround seems to be built into the stock price currently.

Yet, there’s so much uncertainty to be able to confidently assess that at this point in time. Anyone in business will know that growing a business by 20% can already be very challenging. Not to say a turnaround, which can be an uphill task.

Conclusion

So, at this point in time, an in-depth analysis can shed some light on the strength of the company’s strength. But based on these preliminary findings, we will say to hold on at the sideline first. We need to see if the rapid growth in the company’s online channel is sustainable.

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