How Safe Is GameStop's Huge Dividend?

Markets Motley Fool

GameStop's (NYSE: GME) dividend yield recently climbed to near 9%, or about four times what an investor could earn through a diversified total stock market index fund. That head-turning level of income return is usually a red flag, especially when it's coming from a retailer. It was just last year that Mattel (NASDAQ: MAT) stock was paying an 8% yield, after all -- right before the toy giant suspended its dividend.

Continue Reading Below

Let's take a look at whether GameStop investors need to worry about a similar cut to their payout.

Earnings aren't a problem

This dividend has two major points going in its favor. First, GameStop's sales trends are healthy. Whereas Mattel's revenue had been dropping at a double-digit pace leading up to its dividend cut, the video game retailer is in much better shape.

Revenue rose at a steady 2% rate in each of the first three quarters of fiscal 2017. That growth pace beat management's targets, which initially called for minor declines. It also sped up during the holiday season to put the company on track for comparable-store sales gains of about 5% for the full year. That result should mark a solid rebound for GameStop, considering comps fell 11% in 2016.

Meanwhile, the dividend is well covered by earnings. Mattel had been paying out more in dividends than it was generating in net earnings, which is not sustainable. But GameStop's payout ratio is closer to 45%, with dividend payments of $1.52 per year easily covered by the $3.25 per share the retailer is on pace to earn in fiscal 2017. And with the critical holiday season having basically met management's targets, there's little risk of a shocking growth downgrade.

Continue Reading Below

Warning signs

Yet there are key warnings signs for income investors to watch. GameStop's profitability is declining, for one, as its sales mix shifts away from (high-margin) pre-owned software and toward (low-margin) hardware sales. In past years the retailer had offset the tiny profits it made on popular new console devices like the Nintendo Switch with far stronger video game sale profits. But that's not happening anymore. Instead, declines in many of its most profitable categories led gross margin to shrink to 34.7% of sales last quarter from 36.1% in the prior year. The drop trickled down to the bottom line, too, and operating profit is down to 4% of sales right now from 5% a year ago.

GameStop's new business lines aren't posting exciting numbers, either. The technology brands segment underperformed management's targets over the holidays, in part due to limited supply of the Apple iPhone X. That could be a temporary issue, but the retailer also warned that it expects to take an impairment charge of as much as $400 million, meaning this consumer tech business segment is far less valuable than executives had hoped.

The reduced profitability and sluggish results from the tech brands division could nudge GameStop's management team toward a stingier capital return program. The dividend payment has only been in place since 2012, after all, so there isn't a long track record at risk. Few income investors would fault the retailer for skipping its annual raise, either, given the massive current yield.

But the business is healthy enough today that there's no big danger of a Mattel-type suspension happening anytime soon. Yes, GameStop could bulk up its cash reserves by slashing or ending its dividend, especially if its next quarterly report shows a sharp drop in profitability. But that seems unlikely given what we know about the retailer's generally steady business trends today.

10 stocks we like better than GameStop
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and GameStop wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of January 2, 2018

Demitrios Kalogeropoulos owns shares of AAPL and GameStop. The Motley Fool owns shares of and recommends AAPL. The Motley Fool owns shares of GameStop and has the following options: long January 2020 $150 calls on AAPL and short January 2020 $155 calls on AAPL. The Motley Fool has a disclosure policy.