Did GameStop Need to Cut Its Dividend?

As buying video games has increasingly become an online experience, it's no secret that GameStop (NYSE: GME) has had a difficult time adjusting. However, investors are still shocked by how poorly GameStop is performing as the company's stock price crashed by as much as 40% after it reported earnings for the first quarter of 2019.

Not only were its results disappointing, but the company also surprised investors by eliminating its dividend. The interesting thing is that given its financials, that dividend was still sustainable. So why, then, did GameStop decide to ditch the payout?

Surprise dividend cut

Before the first quarter earnings report, many investors looked to GameStop as a "dividend stock" -- the company has paid a steady dividend since 2012. In the last 12 months alone, the company paid $1.52 per share in dividends, good for a massive 19% yield before management made its recent announcement.

According to the company, eliminating the dividend will allow it to preserve $157 million in cash per year that it can use to reduce debt and invest in growth initiatives. The objective of reducing debt is pretty clear, but the vague mention of "transformation initiatives" is probably frustrating to investors who have seen the company embark on multiple failed efforts in the past.

For example, in 2013, through a string of acquisitions, GameStop got into the business of selling AT&T phone plans and Apple IT services. This year, GameStop retreated from both businesses after they failed to gain traction.

For a company like GameStop that has seen revenue and earnings steadily decline, the elimination of the dividend has given investors little reason to hold on.

GameStop can afford to pay it

GameStop is intent on saving that $157 million in cash per year, but based on an analysis of its balance sheet and cash flow, it appears the company could have sustained the payout without getting itself into more trouble.

First, let's look at the GameStop's balance sheet. As of the end of the first quarter, GameStop had a net cash balance of $74.3 million. In other words, GameStop has more cash than debt on its balance sheet -- hardly a risky situation. Of course, the company will need to repay the debt it has incurred, but theoretically, it can use its cash on hand to wipe its slate clean.

Next, let's look at the company's cash flow. The table below shows that not only has GameStop consistently generated free cash flow over the past three years, but its cash flow has also been in excess of the total dividend payments. That said, free cash flow has been on the decline.

Metric 2016 2017 2018
Free cash flow $394.4 million $321.5 million $231.4 million
Total dividends paid $155.5 million $155.2 million $157.4 million

So why would a company with a positive net cash balance and a surprising amount of free cash flow cut its dividend? One explanation is that the cut was made preemptively, ahead of a further decline in cash flow or a planned acquisition. However, the explanations provided by the company don't appear to add up. Some level of debt reduction could have already been achieved, and GameStop didn't guide for an increase in capital expenditures for 2019.

What will GameStop do with the extra cash?

Aside from debt reduction, GameStop hinted that it would be investing in new initiatives aimed at sparking growth.

One of the bright spots at the company has been its collectibles business, where it sells pop culture-themed items such as toys and T-shirts at a separate chain of stores. Last year, GameStop reported collectibles revenue of $707.5 million generated from 103 dedicated stores. On the first quarter earnings call, management affirmed it would continue to invest and grow this business.

The rapidly growing esports industry is also an area GameStop wants to tap into. The company has partnered with Complexity Gaming to open an esports area and training center in Frisco, Texas, called the GameStop Performance Center. The company's ambition is broader than just sponsoring an arena -- it's hinted at bringing esports events to its local stores to increase store traffic and potentially introduce new lines of revenue. This initiative sounds like a creative use of the company's brand and existing retail footprint but is a long way off from becoming a viable business.

The problem with the collectibles business and esports: These growth initiatives are still too nascent to offset the massive amount of revenue the company is shedding from the drop in sales of new and used video games. In collectibles, GameStop simply needs to open more stores, but the path forward is less certain in esports.

A new direction for GameStop

GameStop investors are likely feeling whipsawed by the sudden change in capital allocation -- many shareholders likely saw the rich yield as GameStop's most attractive feature.

The company wants to improve its financial position so it can make growth investments, but the management team has yet to present a convincing road map to growth. The question now is whether the company was better off keeping its dividend until it can present a more actionable growth plan.

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Luis Sanchez has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends AAPL. The Motley Fool owns shares of GameStop and has the following options: short July 2019 $8 calls on GameStop, long January 2020 $150 calls on AAPL, and short January 2020 $155 calls on AAPL. The Motley Fool has a disclosure policy.