U.S. Markets open in 9 hrs 7 mins

What Now for Michael Burry's GameStop?

Dr. Michael Burry is one of GameStop's (NYSE:GME) largest investors. Burry's current position in the company was revealed in the third quarter 2019 13F SEC filing of his hedge fund, Scion Asset Management.

Burry disclosed that he owned three million shares of the struggling retailer, or around 3% of the company. Soon after he announced this position, the legendary hedge fund manager wrote to GameStop's board, encouraging them to continue with the company's share repurchase policy.

In his letter, Burry said:

"As mentioned in our previous letter to the board, we have concerns regarding capital management at GameStop... We submit that when share prices are at or near all-time lows and more than 60% of the shares are shorted despite cash levels much higher than the current market capitalization, lack of faith in management's capital allocation is the default conclusion."

Solid balance sheet

In an interview with Barron's a few days after he published his open letter to GameStop's board, Burry told the publication that he believed the firm's "balance sheet is actually in very good shape," and the business "will have the cash flow to justify a much higher share price."

He went on to add that while the market is fixated on GameStop's exposure to streaming services, which is eating the group's market share, next year's consoles still using optical disk drives "is going to extend GameStop's life significantly."

He went on to tell Barron's that while the "streaming narrative dovetailing with the cycle is creating a perfect storm where things look terrible. [But] it looks worse than it really is."

The value investor added, "We're at low tide on the cash balance. The balance sheet checks out for me."

The right call?

Four months on from Burry's Barron's interview and it looks as if he was right, for a while.

After hitting a low of nearly $3 per share in mid-August, the stock rallied to nearly $7 before the publication of its third-quarter results earlier this week.

Unfortunately, the results were, in a word, terrible. The stock plunged 25% after the company warned that consumers are delaying purchases ahead of big console releases next year, precisely the catalyst that Burry hoped would wake up the stock.

Thanks to these delays, sales fell 23% in the third quarter. GameStop now sees full-year earnings per share in the range of 10 cents to 20 cents, down from an earlier forecast of $1.15 to $1.30.

But what about cash flows? The group's strong cash position and robust cash generation had been key reasons why Burry invested in the first place. Indeed, he told Barron's that he believed around 90% of GameStop's stores are free cash flow positive.

Falling cash balance

In the third quarter, GameStop's cash balance dropped to $290 million and its long-term debt balance fell to $419 million, giving a net gearing ratio of 20%, up from around 1.5% at the end of the third quarter of 2018.

During the quarter, the company repurchased 22.6 million shares of its common stock for a total price of $115.7 million, an average of $5.11 per share.

Following these repurchases, management claims to have repurchased 34% of the group's outstanding shares this year.

However, what concerns me here is GameStop's dwindling cash balance. Retailers need liquid balance sheets due to the timing of working capital inflows/outflows, especially over busy periods like the holidays. Low levels of cash can accelerate a retailer's demise as suppliers and insurers do not want to be exposed to an entity that might not pay its bills.

With this being the case, I think the next six months will be crucial for the company. If sales hold up over the holidays, GameStop might last long enough to benefit from the next console cycle.

If the group's cash balance continues to trend lower at such a rapid rate, and if sales continue to slide, the group might not make it.

Disclosure: The author owns no share mentioned.

Read more here:

Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.

This article first appeared on GuruFocus.