A Post-Mortem Analysis: GameStop (GME)
Stock Price Manipulation, Wall Street Greed, Misplaced Risk, and the Beauty of Wall Street Bets
Contrary to popular belief, the recent price action of GameStop was not an out of the blue unexpected occurrence. Although few could have anticipated that Wall Street Bets would be the straw that broke the camel’s back, the writing has been on the wall for over a year now.
What ended up transpiring was a perfect storm of events layered one on top of the other unfolding over the course of a year and a half. In the end, what resulted was exposing the horrible risk management that many so called “smart money” hedge funds employed to take advantage of retail investors.
In my opinion, market inefficiencies exist on a grand scale and the story of GameStop should give retail investors hope to extract these opportunities into profitable trades.
How so? A backstory:
In the Beginning
On August 16th, 2019 Michael Burry – the protagonist from the popular film, The Big Short – wrote an open letter to GameStop urging the Board of Directors to aggressively buy back shares in the open market. At that time, Burry had accumulated a roughly 3.3% stake in the fledgling retailer and felt the overall capital allocation management had employed over the years had destroyed shareholder value.
GameStop had roughly $480MM in cash on hand and a market capitalization of only $200MM. To say investors had little faith in current management – despite having plenty of cash – is an understatement. Roughly 60% of the 90MM share outstanding were being shorted by investors. Ultimately, despite having a net cash position – i.e. more cash than debt - they were betting the company would end up going bankrupt.
However, they were completely wrong.
Although GameStop stock gravitated from $3 to $6 on news of Michael Burry’s involvement, the large hedge funds maintained their relentless short position throughout. Although, the short trade was a good trade over the past five years as GameStop fell from $50 to $3, the nearly 100% gain was not enough – hedge funds wanted to see the company go bankrupt.
Despite poor capital allocation, suspending their dividend, and standing idly by in an increasingly evolving digital gaming ecosystem, GameStop was actually in an okay financial position. However, despite a number of catalysts unfolding right before investors’ eyes, the shorting persisted.
For starters, GameStop heeded to Burry’s advice and executed a massive share repurchase.
Share repurchases are a fantastic and tax efficient way for companies to return cash to shareholders. GameStop gobbled up 1/3 of all outstanding float – or 30MM shares – at around $5/share.
This spelled trouble for short sellers.
Buying back shares is great for shareholders because it gives them ownership of a larger piece of the overall company. In GameStop’s case, if someone owns 9MM shares out of 90MM total shares outstanding, they own 10% of the company. After the 30MM buyback, however, they would own 9MM shares out of 65MM shares – or appx. 14% of the company. Doing a buyback is a great way for management to show confidence in the company’s future while simultaneously giving investors a bigger slice of the pie.
Remarkably, though, those betting against the stock did not let down. Now that the tradable float decreased from 90MM shares to 60MM shares, the total shares shorted increased from 66.67% of shares outstanding to a whopping 100% of shares outstanding.
Quite frankly, any short interest above 10% is considered to be relatively risky, but making a bearish bet on a company where total shares shorted is 100% of the float is downright foolish – especially for a company with multiple positive catalyst developing.
So, what were these catalysts?
Over the next 12 months a number of events transpired that made it even more apparent how foolish this bearish bet was.
In March, April, and May, Hestia and Permit, two hedge funds collectively owning approximately 7.2% of shares outstanding, filed a proxy statement indicating their interest to place two independent directors onto the Board of Directors. They felt, over the many years they’ve owned GameStop stock, management had continuously eroded shareholder value. By running for two board seats, they felt they would provide a shareholder-oriented voice to help management steer GameStop in the right direction.
In June, shareholders casted their votes and it was announced Hestia and Permit won the requisite number of votes to occupy two seats on the board. Their nominees, Paul Evans and Kurtis Wolf, are two financially savvy investors and corporate re-structuring experts whose voice on the board would undoubtedly prove to be a net positive for shareholders.
Shortly thereafter, GameStop announced they would seek approval from bond holders to extend 50% of their $400MM in debt out two years – maturing in 2023 instead of 2021. Now, with a cash hoard of over $500MM, GameStop had only $200MM of debt due in March 2021 and another $200MM due in March 2023.
At this point, not only did GameStop have two activists advocating on behalf of shareholders on the Board of Directors, its debt exchange made it virtually impossible for the company to go bankrupt within the next 2-3 years.
However, despite all this, hedge funds continued to short the stock in excess of 100% of shares outstanding.
Later, to add insult to injury, GameStop announced a $90MM sale leaseback of its portfolio of properties located in Australia and Texas. By selling off its global headquarters and fulfillment centers and leasing them back from the seller, GameStop was able to bolster its cash balance to prepare for the next generation of gaming consoles.
Now, GameStop had a cash hoard of nearly $800MM with $200MM in debt due in 2021 and $200MM in debt due in 2023.
But what about cash flow?
Although having cash is nice, were they expected to continue losing money? What about future business prospects?
In 2013, as a way to get involved in the mobile accessories industry, GameStop purchased Spring Mobile from AT&T. Later in 2018, after the business hit a wall, GameStop sold the division to Prime Communications for $700MM – far less than they paid for it a few years prior.
As a result, in 2019 GameStop wrote-off an astonishing $406.5MM as an impairment to goodwill. This write-off drastically decreased GameStop’s reported income despite it being a non-cash driven expense item.
Essentially, GameStop overpaid for Spring Mobile and had to accurately depict on the balance sheet the acquisition’s adverse impact to the company’s financial statements. However, this impairment didn’t mean $406.5MM went out the door in one fell swoop. For some reason, short sellers didn’t quite understand this.
After all, GameStop has made numerous indications that their stores are 90% cash flow positive and they would continue to de-densify their store fleet count to better maintain profitability leading into the biggest console refresh in gaming history.
Play Station 5 and X Box Series X Hit the Market
In November 2020, Sony and Microsoft launched their highly anticipated Play Station 5 and X Box Series X gaming consoles.
For the longest time, the premise for the short bet against the company was based on the digitalization of the gaming community and how GameStop simply could not adapt. Although over the years gamers started migrating away from disks towards downloadable content – putting pressure on GameStop’s core pre-owned, tradable, and new software disk sales business – the shift was slower than people thought.
The new consoles were being launched with optical drives built into the system. Meaning, disks were going to be around for at least another 7+ years. And, even if downloadable content was going to take away GameStop’s market share, a rising tide lifts all boats. Surely the biggest gaming retailer would gain additional store traffic for holding the highly coveted new gaming hardware.
Again, short sellers dismissed this reality.
Based on prevailing data, prior console releases underwhelmed and didn’t result in a growth in console units being sold year over year. This generation of gaming hardware was going to be very different. Counterintuitively, the majority of gamers were flocking to the consoles with the optical drive instead of the digital only versions – debunking any thesis that digital gaming would destroy disk drives in the near-term.
This proved GameStop was not a secularly declining brick and mortar failure, but rather a cyclical business at the cusp of a massive value unlocking event unduly priced at impending bankruptcy levels.
However, the short position was actually even more risky than reported. Here’s why:
Who Owns GameStop?
Over the course of the year, numerous funds stepped in and realized how valuable the stock was at dirt cheap levels. Out of the 65MM shares outstanding, Burry owned roughly 3%, Muss Asset Management came in and bought 5%, Donald Foss bought 5%, Senvest Capital bought 5%, and Hestia and Permit owned their 7% stake.
What this means is that not only was essentially every single share shorted, but large funds owned a tremendous amount of stock, taking their owned shares out of the day-to-day tradable float.
These funds, including other passive indexes such as Black Rock, Fidelity, Vanguard, and Dimensional Fund Advisors, had the ability to recall their lent out shares back from short sellers. This, at any moment, could have caused over exposed short sellers to close out their position without warning – forcing an exodus of short sellers to purchase stock in the open market at any price owners would offer.
Since such a large amount of stock was owned by a handful of individuals, it’s quite possible only 25MM – 30MM shares were in the tradable universe, not the reported 65MM shares outstanding. Meaning, shares shorted as a percentage of total tradable float could have been as high as 200%.
Ryan Cohen, The Savior
Then came Ryan Cohen, billionaire founder of successful pet e-commerce company, Chewy.
Ryan Cohen first became a shareholder in GameStop in spring of 2019. Later, in August he disclosed a 9% stake in the retailer. This filing was unique in two distinct ways.
Investors are required to disclose a position in a company after exceeding a 5% stake in a public company. The fact that Cohen went from <5% ownership to 9% in a matter of days showed that he was looking to accumulate a large number of shares before anyone realized what he was doing. Second, he used a lawyer by the name of Christopher Davis, an attorney specializing in activist shareholder activity, to file his ownership stake.
Cohen meant business and was likely going to influence the company in some capacity.
As expected, over the next few months, Cohen continued purchasing more shares of GameStop and, in the process, blasted management for being asleep at the wheel. He argued GameStop continued to lose market sure despite the surrounding gaming industry exploding due to stay-at-home orders and other ramifications brought on by the pandemic.
However, despite active funds like Muss, Burry, Foss, Hestia, Permit, and Senvest owning approximately 25% of shares outstanding and Cohen owning another 13% with intentions to go activist, shorts doubled down.
With such a thin tradable float and short sellers relentlessly doubling down their investment to increase shares shorted to 75MM shares, bears began to short shares that didn’t actually exist.
Threshold Security List
Short sellers operate by borrowing shares from an owner, selling those shares on the open market, and buying them back at a lower price to make a profit before handing them back to the lender.
Time and time again GameStop found itself on the NYSE SHO Threshold Security List. Meaning, brokers were letting funds short shares that didn’t actually exist with the hope of locating those shares to deliver them back to the short sellers at a later time.
If at least 10,000 shares or 0.5% of shares outstanding were unable to be located for five consecutive trading days – i.e. brokers could not find enough owners to lend out their shares to short sellers in exchange for a fee – brokers would be forced to close out the short’s position.
However, it can take up to 13 days for a broker to close out a shorts position after not being able to find any shares to borrow. Worst of all, even after the position is closed out after 13 days, nothing is stopping other brokers and short sellers from continuously participating in the same process of shorting shares that don’t exist.
This issue continued to persist week after week for numerous months at a time. Despite their persistent inability to locate shares to deliver to short sellers, brokers continued to allow funds to participate in this overcrowded risky trade, hoping to find shares for them at a later date.
This blatant stock manipulation of shorting shares that are never delivered continued to press the stock lower and lower despite the fundamental improvements going on beneath the hood.
Melvin Capital, Maplelane, and many other funds continued to do this manipulative tactic so their large put positions on the stock – an investment that profits if a stock stays below a certain price by a certain future date in time – would make money.
Their manipulative plan actually worked for many years, but after numerous catalysts began to emerge, it finally blew up in their faces.
We have Wall Street Bets to thank for that.
Wall Street Bets
Wall Street Bets is a community on Reddit that promotes high risk, high reward trades. As Ryan Cohen began buying shares and subsequently posted cryptic memes and emojis on Twitter, Wall Street Bets began to develop this immense affinity towards Ryan Cohen, The Savior.
As a result, thousands of Wall Street Bet users – led by one user, u/DeepF*****gValue - began buying deep out of the money call options on GameStop.
A call option is a contract that allows the investor the right to purchase an underlying stock at a future price at a later point in time. Purchasing a call option is a high risk, high reward investment that can prove to be extremely lucrative if the underlying stock rises above the option contract’s strike price. As more people began posting about GameStop, the unsustainable short interest, Cohen’s involvement, and the upcoming gaming console, more people bought out of the money call options.
What’s unique about call options is that it can prove to be a self-fulfilling prophecy.
When an investor purchases a call option, the market maker selling the option is forced to buy the underlying stock to hedge against any risks associated with the stock moving up.
This is known as delta hedging.
When investors purchase an obscene amount of call options on a stock that already has a small tradable float, market makers are forced to buy a lot of underlying stock all at once. This causes a gamma squeeze – or the massive share appreciation we saw in GameStop.
However, because the stock was so shorted, the gamma squeeze caused short sellers to close out their position as the stock rose to astronomical heights – far above the limit brokers would allow short sellers to risk in their accounts. This is known as a short squeeze.
Putting It All Together
The Wall Street Bets community divulged a tremendous vulnerability in GameStop’s public float structure. Hedge funds such as Maplelane and Melvin Capital had an over exposed position in a company that was very far away from every going bankrupt. Their greediness and unwavering conviction to maintain an incredibly large short position in a company already so heavily shorted and hated caused them to simply miss the forest for the trees.
Reddit did not cause any form of market manipulation in the slightest. If anything, the hedge funds on the short side caused the manipulation by shorting a stock they didn’t own in perpetuity in an overcrowded trade with numerous upcoming catalysts.
What happened over the past two weeks was inevitable. If it wasn’t Reddit, it would have been any number of other causes. Regardless, it was greed and foolishness that blew up these short hedge funds, not any retail-driven democratization vendetta.