At a glance, GameStop (GME) is a tempting dividend stock for retired income investors.

 

GameStop offers a high dividend yield in excess of 6% and has increased its dividend every year since initiating its dividend program in 2012.

 

The company has a healthy payout ratio near 40% and consistently generates positive free cash flow as well.

 

But at the same time, it’s important to note that high yields, especially in this time of historically low interest rates, can be a red flag that a company is a “value trap,” meaning that something is deeply flawed about its business model.

 

Let’s take a look at GameStop’s high yield using our Dividend Safety Scores to see if the company could be worth owning in a diversified dividend growth portfolio.

 

Business Overview

Founded in 1994 in Grapevine, Texas, GameStop operates more than 7,600 stores in the U.S., Australia, Canada, and Europe.

 

Its primary business is selling new and used video game hardware and software, including accessories such as gaming consoles, controllers, gaming headsets, and memory cards. These segments account for more than 65% of GameStop’s gross profit.

 

GameStop GME Dividend

Source: GameStop Investor Presentation

 

In recent years, GameStop attempted to diversify its business by getting into the consumer electronics business, specifically selling new and used smartphones and tablets, as well as launching Spring Mobile.

 

Spring Mobile is an AT&T (T) authorized reseller that sells pre-paid phone plans under the Cricket Wireless brand. The company has also partnered with Apple (AAPL) to launch 72 Simply Mac specialty stores, which serve as tech support hubs for Apple products.

 

GameStop also owns a diverse portfolio of video game websites such as Ebgames.com, Kongragate.com, and Thinkgeek.com.

 

While 2016 saw non-physical gaming revenues of over $2 billion, at the end of the day GameStop continues to be a company whose fortunes remain tied to physical gaming hardware, which is an industry in secular decline.

 

Even management’s long-term plan to continue diversifying its sales, earnings, and cash flow, won’t change that anytime soon. Physical video games are still expected to account for about 50% of earnings in 2019.

 

GameStop GME Dividend

 

Business Analysis

As you can see, GameStop has had a problem in recent years with slowing sales and earnings growth.

 

GameStop GME Dividend

Source: Simply Safe Dividends

GameStop GME Dividend

Source: Simply Safe Dividends

 

Worse yet, the small amount of earnings per share and free cash flow per share growth has mainly been a result of the company buying back shares at an impressive rate of 6.6% per year over the last seven years.

 

When shares outstanding decrease, net income and free cash flow is higher on a per share basis even if their total dollar amounts haven’t changed. This game can only last so long if a business is unable to actually grow its bottom line.

 

GameStop GME Dividend

Source: Simply Safe Dividends

 

In recent quarters, GameStop’s financial engineering efforts have started to flounder, with sales declines resulting in deterioration in both profit margins and earnings per share.

 

GameStop GME Dividend

Source: Simply Safe Dividends

GameStop GME Dividend

Source: Simply Safe Dividends

 

The problem is that GameStop’s core business of selling gaming hardware and physical video games is coming under pressure from the likes of Sony and Microsoft (MSFT).

 

Specifically, the video game industry is evolving away from physical games and towards digital downloads.

 

For example, Playstation and Xbox are increasingly moving towards a subscription based business.

 

Rather than owning hard copies of the games played on their consoles (and that can be sold to GameStop for resale to other gamers at a profit), Sony and Microsoft are monetizing their gaming businesses at GameStop’s expense by renting out the games via online channels.

 

The need for a brick-and-mortar retailer is increasingly diminished by e-commerce yet again, and this isn’t just limited to new games either.

 

For example, Microsoft just announced Game Pass, a $9.99 per month subscription service that gives subscribers access to over 100 of the most popular older Xbox One and Xbox 360 games.

 

Worse yet? Subscribers will be able to purchase these games at a 20% discount to their retail price, news that directly impacts GameStop’s bottom line (GameStop generates over 30% of its gross profit from older game sales).

 

Wall Street understandably reacted violently to this news, with shares crashing 10% the day of the announcement.

 

GameStop GME Dividend

Source: Microsoft

 

All in all, GameStop’s struggle to hold onto its shrinking market share can be summarized by abysmal same store sales growth (-11% in 2016) and deteriorating profitability.

 

While GameStop has seen some success from its non-physical game businesses, mainly due to an increasingly aggressive acquisition strategy of adding ever more non-core businesses to its portfolio (see below), the margins on those businesses are lower than its legacy business.

 

GameStop GME Dividend

 

Unfortunately, this strategy has resulted in a steady decline in profitability, and most of GameStop’s profit metrics are now below those of its rivals.

 

Company Operating Margin Net Margin FCF Margin Return On Assets Return On Equity
GameStop 7.2% 4.3% 5.0% 7.8% 19.3%
Industry Average 7.6% 5.6% NA 7.6% 22.5%

Source: Morningstar

 

Management’s long-term growth plans of diversifying away from physical games might eventually return the company’s sales to positive growth territory, but these actions seem likely to continue coming at the expense of GameStop’s profitability.

 

In fact, GameStop’s free cash flow margin, one of the most important metrics for dividend investors (free cash flow is what funds the current dividend and allows its sustainable growth), has declined from a high of 7% in 2014 to just 5% over the past 12 months.

 

This trend could spell trouble for the company’s dividend profile going forward and seems likely to make favorable long-term total returns harder to come by for shareholders.

 

While it’s true that GameStop enjoys strong brand recognition, has a solid market share position in video games, and still generates nice free cash flow, finding a long-term replacement for its high-margin video game segment will be very challenging.

 

The company’s shotgun approach to quickly expand its business into adjacent and unrelated markets poses strategic and operational challenges, and GameStop seems likely to be growing into lower-returning businesses over time – a strategy I prefer to avoid as an investor.

 

Key Risks

GameStop, like Best Buy (BBY), is in a race against time to reinvent its business model while going up against better capitalized rivals such as Sony and Microsoft (digital video game sales/rentals), Alphabet (GOOGL) and Facebook (FB) (online advertising), Amazon (AMZN) (personal electronics sales), and Ebay (EBAY) (collectible sales).

 

However, up until now GameStop’s execution hasn’t warranted any faith in the turnaround plan.

 

In fact, during 2016’s holiday quarter (the most important for the company), sales actually declined by 16.4% due to same store sales of -18.7%.

 

Those disastrous results were far worse than even the most pessimistic analyst expectations. In other words, GameStop’s sales and earnings slide is not showing any signs of slowing down.

 

One of the problems is that the businesses it’s branching out into are no-moat, highly commoditized ones.

 

For example, selling smartphones and tablets is a tactic that Radio Shack attempted but ultimately ended up failing, with the company filing for bankruptcy.

 

Similarly, GameStop isn’t likely to be able to achieve the kinds of scale and network effects in its collectibles division to take on Ebay.

 

Meanwhile, competing with Microsoft and Sony in terms of a digital video games subscription platform is going to be extremely challenging, especially since GameStop’s smaller scale means that it would have to basically compete on price.

 

In other words, any growth in market share that GameStop could attain would likely come at the expense of profitability yet again.

 

The bottom line is that GameStop is likely to lack the resources to compete with its major rivals. And as you can see, while its recent de-leveraging efforts have been impressive, the company has had to reverse this trend in recent quarters.

 

GameStop GME Dividend

Source: Simply Safe Dividends

 

In fact, over the last two years GameStop has had to take on increasing amounts of debt to fund its turnaround efforts.

 

GameStop GME Dividend

Source: Simply Safe Dividends

 

GameStop’s BB junk bond credit rating also means that in a rising rate environment the company might not be able to find enough low cost growth capital to really take on the big boys in its chosen industries.

 

GameStop’s long-term success ultimately hinges on its ability to establish profitable, growing businesses in markets outside of gaming.

 

The company’s increased use of financial leverage to accelerate GameStop’s mix shift further raises its risk profile – especially for the dividend.

 

GameStop’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

Dividend Safety

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

GameStop has a Dividend Safety Score of 53, which may make you think it’s a high-yield stock worth owning. After all, the company has steadily increased its payout since it began paying a dividend in 2012.

 

GameStop GME Dividend

Source: Simply Safe Dividends

 

And indeed, when we look at two of the main factors that affect dividend safety (payout ratio and balance sheet), things actually look healthy at first glance.

 

With trailing 12-month EPS and FCF per share payout ratios of 40% and 35%, respectively, GameStop’s current dividend of $1.52 per share (a 6% yield) isn’t in immediate danger. In fact, the company’s payout ratio has been healthy since it began paying dividends nearly five years ago.

 

GameStop GME Dividend

Source: Simply Safe Dividends

GameStop GME Dividend

Source: Simply Safe Dividends

 

However, keep in mind that with declining sales, earnings, and FCF, those payout ratios are likely to continue rising over the coming years. That’s unless management can prove that the company has the ability to evolve into a dominant force within its chosen niches – an unlikely outcome, in my opinion.

 

Meanwhile, while the company’s balance sheet has been deteriorating over the past two years, the current debt level is far from dangerous.

 

After all, the current ratio is above one, and the leverage ratio remains pretty low. GameStop also has sufficient cash on its balance sheet to pay the current dividend for two years.

 

GameStop GME Dividend

Source: Simply Safe Dividends

 

The same is true when we compare the company’s credit metrics against its industry peers. As you can see, most of GameStop’s debt looks somewhat conservative relative to the company’s current cash flow.

 

Company Debt / EBITDA EBITDA / Interest Debt / Capital Current Ratio S&P Credit Rating
GameStop 0.99 18.15 28% 1.10 BB
Industry Average 1.48 NA 41% 1.34 NA

Sources: Morningstar, FastGraphs

 

However, GameStop’s debt figures above don’t account for a major liability the company faces each year – rent payments for the retail stores it leases.

 

GameStop paid over $380 million per year in rental expenses each of the last three years, dwarfing its annual interest expense ($45 million) and dividend payments ($154 million).

 

These leases are noncancelable agreements that will increasingly serve as an anchor on GameStop’s financial flexibility, assuming its retail locations continue losing customers.

 

If GameStop’s earnings and cash flows continue to decline, then the company’s current tactic of taking on more debt to fund its turnaround will result in ongoing deterioration of its balance sheet.

 

That explains why GameStop has a junk bond credit rating that forces it to pay 6% to 7% interest on its bonds.

 

If interest rates rise meaningfully over the coming years, GameStop’s financing costs could make it even more difficult for management to pull off the company’s transformation.

 

Either management can make good on its turnaround promises or the company’s increasing costs of capital could eventually force management to freeze the dividend or even cut it in order to divert the free cash flow towards paying down its costly debt.

 

GameStop’s dividend is not at risk of an imminent cut, but I wouldn’t be surprised to see its Dividend Safety Score continue falling throughout the next year if management fails to deliver profitable growth.

 

GameStop’s Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

GameStop has a Dividend Growth Score of 56, suggesting that the company’s dividend growth potential is about average.

 

However, GameStop’s dividend growth rate has been decelerating.

 

While it’s true that GameStop’s dividend grew 10.4% per year over the last three years, management’s most recent increase was just a 2.7% raise earlier this month.

 

GameStop GME Dividend

Source: Simply Safe Dividends

 

GameStop’s relatively good Dividend Growth Score is based on the company’s still solid fundamentals (from a payout ratio and balance sheet perspective) and its short but impressive three-year dividend growth rate.

 

However, you need to consider that recent dividend increases have barely been enough to keep up with inflation.

 

Over the next couple of years, GameStop could probably continue these token dividend hikes because its low payout ratio seemingly has room to moderately expand.

 

But if the company’s turnaround efforts continue falling short, a dividend freeze, followed by a dividend cut, will eventually become necessary.

 

Valuation

Over the past year, GameStop’s stock has been brutalized by Wall Street, with shares declining 21% compared to the market’s 17% increase.

 

That kind of underperformance means that GameStop is now one of the cheapest stocks on Wall Street, both from a P/E and dividend yield perspective.

 

Company P/E Historical P/E Yield Historical Yield
GameStop 6.8 10.8 6.0% 3.1%
Industry Median 20.5 NA 2.3% NA

Source: Gurufocus

 

In fact, the stock’s trailing 12-month P/E of 6.8 is now lower than 93% of global specialty retailers.

 

Similarly, GameStop’s 6% dividend yield is double its historical median yield of 3.1% and higher than 89% of its rivals.

 

However, while those facts might initially make GameStop appear to be a great value stock, remember the words of history’s greatest investor, Warren Buffett:

“It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.”

In this case, given its steadily declining fundamentals and iffy prospects for a successful long-term turnaround, it would be generous to even label GameStop a “fair company.”

 

In other words, for a company that may ultimately go the way of the Dodo, even today’s fire-sale stock price doesn’t make it an appropriate candidate for a mildly conservative portfolio – even if the dividend remains safe for the time being.

 

Concluding Thoughts on GameStop

Given the continued deterioration in GameStop’s business model and management’s desperate expansion strategy in pursuit of profitable growth, I don’t plan on ever touching this high yield stock.

 

Delivering safe, growing income and preserving capital are two key objectives of our Conservative Retirees dividend portfolio, and GameStop doesn’t seem aligned with either goal.