GameStop's (NYSE: GME) stock is trading at its lowest point in over a decade, due to sluggish mall traffic, competition from e-tailers, and its loss of physical software sales to digital download platforms. However, that sell-off reduced GameStop's forward P/E to 5 and boosted its forward dividend yield to 15%.
Value-seeking investors might be drawn to GameStop's low multiple and high yield, but those are red flags that indicate the company is in trouble. Let's see why GameStop is more likely a high-yield trap than an undervalued dividend stock.
GameStop generated 23% of its revenue from pre-owned and value video game products in fiscal 2018, which ended on Feb. 3.
This business faces four main headwinds -- digital download platforms that render physical discs obsolete, e-commerce marketplaces that sell gaming hardware, declining visits to malls, and cyclically lower sales of gaming consoles. That's why the unit's revenue fell 13% in 2018 and its gross margin declined from 45.5% to 43.4%.
Its new software business, which accounted for 30% of its sales, faces the same headwinds. That segment's revenue fell 5% last year as its gross margin dipped from 22.9% to 21.5%.
In previous years, GameStop offset those declines with higher sales of new video game hardware, which accounted for 21% of its 2018 sales. However, demand for current-generation consoles like the PS4, Xbox One, and Switch softened last year due to the saturation of the overall market. As a result, its new hardware sales dipped 1%, and the segment's gross margin contracted from 9.1% to 8.5%.
Not enough growth engines
GameStop's primary turnaround strategy has been to diversify its business away from games and consoles with sales of collectibles, game accessories, and mobile devices -- the last of which was recently discontinued with the divestment of its Spring Mobile stores.
Diversifying into collectibles, which was boosted by its takeover of ThinkGeek in 2015, was a smart move. Revenue at the business rose 11% last year and accounted for 9% of GameStop's top line. Its gross margin expanded from 32.7% to 33%.
Sales of accessories surged 22% and accounted for 12% of GameStop's top line, thanks to robust demand for gaming headsets amid the popularity of battle royale games like Fortnite and PUBG. The unit's gross margin also rose from 32.5% to 32.7%.
However, console gaming headset leader Turtle Beach (NASDAQ: HEAR) expects its growth to decelerate significantly in 2019 after triple-digit sales growth throughout most of 2018. The company attributed that slowdown to a cooling-off in the red-hot battle royale market -- which could torpedo GameStop's accessories business this year.
GameStop doesn't expect the growth of is healthier businesses to offset its other problems anytime soon. In fiscal 2019, it expects its revenue and comparable store sales to both decline 5% to 10%. It didn't provide any full-year earnings guidance, but analysts expect a 20% drop as its sales tumble and its gross margins contract.
Nobody's at the wheel
GameStop needs a capable leader to turn around its business, but its CEO seat has been vacant since last May, when Michael Mauler resigned after just three months on the job. GameStop then tried to sell itself, but it failed to attract any serious suitors.
Activist investors at Hestia Capital and Permit Capital recently started applying pressure on GameStop, which forced it to add two new independent directors to its board. Hestia and Permit, which own a 1.3% combined stake in GameStop, want it to pursue more aggressive turnaround strategies, return more capital to shareholders, and bring in a permanent CEO. But for now, those plans sound as vague as GameStop's own turnaround strategies.
Should GameStop slash its dividend?
GameStop spent $157 million on its dividend in 2018, which represents only 67% of its free cash flow. Its expected earnings of $2.68 per share this year should easily cover its $1.52 dividend with a payout ratio of 57%.
Therefore, GameStop probably won't slash its dividend anytime soon. It isn't starved for cash -- its cash and equivalents rose 90% annually to $1.6 billion last quarter after it sold Spring Mobile for $700 million. It also cut its long-term debt by 43% annually to $472 million.
But if GameStop doesn't fix its core business, its earnings will continue to deteriorate, its payout ratios will rise, and its cash flow will dry up. Those things could all happen within the next few years, so the stock could still tumble lower and wipe out any dividend gains. GameStop isn't doomed yet, but it deserves to trade at a low P/E, and its massive yield simply isn't worth the risk.
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Leo Sun has no position in any of the stocks mentioned. The Motley Fool owns shares of GameStop and has the following options: short April 2019 $13 calls on GameStop. The Motley Fool has a disclosure policy.