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A Famous Investor Bets Big on GameStop -- but Will It Pay Off?

Leo Sun, The Motley Fool

GameStop (NYSE: GME) lost 90% of its market value over the past three years as mall traffic dried up and digital downloads torpedoed sales of physical games -- which led to fewer trade-ins and sales of preowned games.

The bears claimed that GameStop was the "next Blockbuster," and its ongoing declines supported that thesis. Its revenue fell 13% last quarter (its fourth straight quarter of declining sales), its comps tumbled 10%, and its net income plunged 63%.

GameStop expects its comps to decline 5%-10% for the full year, while analysts expect its earnings to drop 45%. Those declines scared away most of the bulls, but one major investor -- Scion Asset Management's Michael Burry -- is betting big on its recovery.

A child holds a blackboard with "buy" and "sell" signs drawn on it.

Image source: Getty Images.

The "Big Short" investor goes long

Burry, who was portrayed by Christian Bale in the film version of Michael Lewis' book The Big Short, was famously one of the few investors who bet against subprime mortgages before the 2008 financial crisis.

Burry recently revealed that Scion had purchased a 3% stake in GameStop, three million shares, for $10.6 million. Speaking to Barron's, Burry stated that GameStop's "balance sheet is actually in very good shape," and that sales of new disc-based consoles next year would "extend GameStop's life significantly."

Burry also dismissed the notion that cloud gaming services like Alphabet's (NASDAQ: GOOG) (NASDAQ: GOOGL) Google Stadia would kill traditional consoles, claiming that the situation "looks worse than it really is."

Scion recently sent a letter to GameStop's board, urging the company to repurchase nearly $240 million in shares with its cash on hand. GameStop previously authorized a $300 million buyback plan in April but bought back only about $62.4 million in shares so far.

Does Burry's thesis make sense?

GameStop's balance sheet looks decent, but that's mainly because it sold its Spring Mobile stores to AT&T for $700 million, suspended its dividend to save $157 million per year, slowed down its buybacks, laid off staff, and shuttered stores.

As a result, GameStop reduced its long-term debt by 43% annually to $469 million last quarter, and its cash and equivalents rose 124% annually to $543 million -- which actually exceeds its market cap of about $370 million. GameStop's other valuations also look cheap -- it trades at just two times forward earnings and its price-to-sales and price-to-book ratios are both well below 1.

Burry's claim that Sony's (NYSE: SNE) PS5 and Microsoft's (NASDAQ: MSFT) Xbox "Scarlett" will boost GameStop's hardware sales next year also makes sense, since the demand for the aging PS4 and Xbox One is currently at a cyclical low.

A couple plays a video game at home.

Image source: Getty Images.

However, Burry glosses over the fact that Microsoft recently launched a cheaper disc-free version of the Xbox One, and that trend could continue with Scarlett. Sony and Microsoft will also aggressively nudge gamers toward their own digital storefronts, which reduces the appeal of physical games.

I think Burry is right about cloud gaming, since Stadia, PS Now, and Microsoft's upcoming xCloud service still appeal only to a niche group of early adopters with high-speed internet connections. If Sony and Microsoft expected cloud gaming to take over within the next two years, they wouldn't bother equipping their latest consoles with high-end hardware for 8K graphics, 3D audio, and solid-state drives for faster loading times.

I also agree with Burry's idea of plowing GameStop's excess cash into buybacks. CEO George Sherman, who took the top job in April, wants to reserve that cash for "opportunities in the future," but none of its recent turnaround efforts -- including an expansion of its PowerUp Rewards program, the opening of an esports center in Texas, and the decision to merge ThinkGeek's online store with GameStop's -- seem capital intensive.

Will Burry succeed where other activists failed?

Burry isn't the first activist investor to take a stake in GameStop. Two big investors, Hestia Capital and Permit Capital, took an activist stance earlier this year to push GameStop to shake up its board, cut its operating expenses, and repurchase up to $700 million in shares via a tender offer.

Hestia and Permit eventually gained seats on GameStop's board, but there's not much evidence that their suggestions are moving the needle. Burry's fame and bigger stake might pressure GameStop to make more changes -- but it could also be far too late to counter the market shift toward digital downloads.

Burry is right about a few things: GameStop's stock looks cheap, its balance sheet is strong, and the fears about cloud gaming are irrational. However, Burry's suggestion that disc drives in the PS5 and Xbox Scarlett will "extend" GameStop's life is wrong -- both companies will likely launch cheaper disc-free versions at lower prices and tether gamers more tightly to their digital ecosystems.

Therefore, I don't think it's a good idea for investors to follow Burry's GameStop purchase. This retailer needs to actually show some flickers of life -- like rising comps and expanding margins -- before I consider it a turnaround play.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Leo Sun owns shares of AT&T. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), and Microsoft. The Motley Fool owns shares of GameStop and has the following options: long January 2021 $85 calls on Microsoft. The Motley Fool has a disclosure policy.

This article was originally published on Fool.com