Investing in the stock market can be quite the adventure. Last year, the volatility brought about by the coronavirus pandemic led to the quickest decline of more than 30% in the S&P 500‘s storied history, as well as the fastest rebound back to all-time highs.
In 2021, an unexpected catalyst has taken over as a key market driver: retail investors.
The important question retail investors should be asking about AMC and GameStop
Beginning in mid-January, retail investors from Reddit’s WallStreetBets chat room began banding together to buy shares and out-of-the-money call options in companies with high levels of short interest (i.e., stocks where a lot of investors are betting on a share price decline). Both video game and accessories retailer GameStop (NYSE:GME) and movie theater chain AMC Entertainment (NYSE:AMC) fit the bill. GameStop was the most short-sold stock of any publicly traded company, with AMC also heavily short-sold and sporting a penny stock share price (which is itself a major lure for young retail investors).
Without getting too far into the weeds, the goal of these retail investors was to effect a short squeeze and put a hurting on the so-called big money. Institutional investors and hedge funds are the primary holders of short positions. By creating a short squeeze, retail investors sent pessimists fleeing for the exit, further vaulting companies like GameStop and AMC to the upside.
But tenured investors are also keenly aware that a company’s operating performance matters far more than any short-term euphoria. With short-squeezes highly unlikely to support GameStop’s or AMC’s market valuations over the long run, the question becomes this: When will these turnaround candidates be profitable?
Let’s take a closer look.
GameStop’s multiyear transformation is a work in progress
To get the obvious out of the way, GameStop endured a rough 2020 because of the pandemic. Some of its stores were closed, with others seeing dramatically reduced foot traffic. This did not help an already struggling company.
The problem for GameStop is that it’s a victim of its own success. Over two decades, it became one of the dominant retailers of new and used video games, consoles, and accessories. The used game market, which allowed the company to repurchase and resell physical games, was an especially lucrative venture for the company. With things going so well for so long, management continued down the same path.
However, this success came to an abrupt halt a few years ago. With gamers steadily shifting to digital platforms, GameStop’s brick-and-mortar empire quickly transformed from an asset to a liability. Despite its best efforts to promote digital gaming — GameStop’s e-commerce sales in 2020 grew by 191% — total revenue last year declined by 21%, with the company shuttering 12% of its stores.
In order for GameStop to get back into the profit column, it needs to continue to reinvest in digital growth initiatives, while at the same time curbing its spending by closing underperforming stores. Essentially, GameStop is going to back its way into the profit column. Full-year sales will remain relatively stagnant, but the higher margins associated with digital gaming, coupled with lower costs from a smaller store base, should eventually bring GameStop back to profitability.
When might this happen? According to Wall Street’s consensus estimates from FactSet, it’ll be three more years before GameStop is back in the profit column. If there is a positive here, it’s that earnings before interest, taxes, depreciation, and amortization (EBITDA) is expected to be positive this year, but EBITDA isn’t the same as profitability.
Considering how far GameStop has run, waiting three more years for an estimated $1.25 per share in profit is a tall order.
AMC’s future is murky, at best
Compared to AMC Entertainment, GameStop had a cakewalk in 2020. The pandemic shuttered many of AMC’s theaters, and most of those that have reopened have capacity-limiting social distancing mandates in place.
To get back to its glory days, AMC’s game plan is to focus on harnessing film exclusivity in its theaters, reducing its debt load, and emphasizing high-margin alternative channels, such as its video on demand service. AMC also needs the pandemic to wrap up in 2021, at least in the United States. The quicker its theaters can return to full capacity, the faster the company can address its most-pressing concerns.
But the issues with AMC look far less fixable than what GameStop is contending with. AT&T subsidiary WarnerMedia announced plans to release all of its films on HBO Max the same day they’ll hit theaters in 2021. Walt Disney will do the same on its Disney+ streaming platform for a small number of movies. Losing exclusivity on film releases, or having its exclusivity window cut in any meaningful way, would prove devastating to AMC’s chances of a successful turnaround.
Making matters worse, the company has been forced to leverage itself to the hilt in order to survive. It ended 2020 with $5.7 billion in corporate borrowings, and has been paying north of a 10% interest rate on most of its debt issuances over the past year. Considering how favorable lending rates are for most businesses, a double-digit interest rate shows how distressed AMC’s operating model is viewed.
As for when AMC will be profitable, it remains a mystery. Despite an expected doubling of sales in 2021 and 2022, Wall Street’s consensus is for AMC to lose $3.25 per share in 2021, lose another $0.97 per share in 2022, and shrink to a per-share loss of $0.60 in 2023. This implies it’ll be at least another four years before the company has a shot at becoming profitable.
My suspicion is AMC’s debt is too much of a crippling factor for this company to succeed. Simply servicing its debt is going to eat up a lot of operating cash flow. Plus, without an influx of new capital via dilutive share offerings or debt issuances, AMC likely doesn’t have enough cash to cover its losses over the next two years.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.