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GameStop (NYSE: GME) lost about 40% of its market value over the past three years, as rising digital downloads and declining mall traffic throttled its growth. However, that plunge reduced GameStop's forward P/E to 6 and boosted its forward dividend yield to nearly 10%.
Do that low valuation and high yield make GameStop an undervalued income stock? Or is that high yield a red flag indicating that its core business is deteriorating?
Image source: Getty Images.
Examining GameStop's dividend
GameStop started paying a dividend in 2012, but it paused its annual dividend hikes in 2017. It spent 88% of its free cash flow (FCF) on its dividend over the past 12 months, but its FCF levels have gradually declined over the past three years.
GME Free Cash Flow (TTM) data by YCharts.
For fiscal 2018 (which ends on Feb. 3), the company expects its FCF to come in "closer to $200 million" compared to its prior forecast of about $300 million. However, GameStop's recently closed its sale of Spring Mobile (which includes nearly 1,300 AT&T wireless stores) for $700 million should boost its cash flows next year.
Therefore, the company's dividend should remain safe in fiscal 2019. However, it might be wiser to cut its dividend and reinvest the excess cash into its core business or reduce its long-term debt of $471 million.
An evolving business
GameStop didn't sit still as digital distribution platforms disrupted its new and pre-owned software segment. Instead, it diversified its business by selling more consoles, hardware devices, collectibles, and mobile devices at its soon-to-be-divested AT&T stores.
It also acquired pop culture products retailer ThinkGeek in 2015 and launched its own digital downloads platform. During the third quarter, GameStop's revenue increased 5% year over year to $2.1 billion and its comparable-store sales rose 2.1%. Its adjusted EPS, which excludes non-operating impairment charges, rose 24%. Those headline numbers look solid, but there are some issues with its individual business units.
Breaking down the numbers
Thirty-five percent of GameStop's revenue came from sales of new video game software during the quarter. Pre-owned and value game products (both software and hardware) accounted for 19%, new hardware contributed 17%, and 9% came from sales of video game accessories. Here's how those four core businesses fared:
| Segment | Sales Growth (YOY) | Gross Margin | Change in Gross Margin (YOY) |
|---|---|---|---|
| New video game software | 11% | 22.1% | (190 basis points) |
| Pre-owned and value game products | (13%) | 43.1% | (50 basis points) |
| New video game hardware | 13% | 10.5% | (140 basis points) |
| Video game accessories | 33% | 36% | 40 basis points |
Data source: GameStop Q3 2018 report. YOY = year over year.