GameStop (NYSE: GME) serves a valuable retail niche, trades at only six times earnings, and offers a tantalizing 7.5% dividend yield. Sounds appealing, doesn't it?
Unfortunately, in the words of gamer favorite Admiral Ackbar, it's a trap!
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GameStop is facing the disruption of its core business, making the long-term sustainability of its earnings and dividend questionable at best. Its shares have come under pressure in recent years, as investors' concerns regarding its future prospects have intensified. Yet more pain may lie ahead. In fact, here are three reasons why investors may want to stay well clear of GameStop's stock.
GameStop's customer value proposition resides in its wide selection of new and used video games. The company's trade-in business was its competitive edge; it was difficult for other retailers to replicate, and the sale of used games was highly profitable. Now, however, this core aspect of GameStop's business appears to be in terminal decline as the gaming world moves steadily toward digital distribution.
Gaming giants like Electronic Arts (NASDAQ: EA) and Activision Blizzard (NASDAQ: ATVI) have little reason to buck the trend, as digital game downloads are more profitable than shipping physical game discs. In fact, 61% of Electronic Arts' first-quarter revenue came from digital game sales, up from 54% in the prior-year period, while already more than 80% of Activision's revenue comes from digital sources.
Worse still, the trend toward digital is likely to accelerate. Electronic Arts CEO Andrew Wilson made the prediction that the video game industry would undergo more change in the next half-decade than in the past 45 years combined. With new and pre-owned video game sales still comprising more than 50% of GameStop's revenue, the retailer is particularly exposed to this rapidly changing gaming landscape.
Few signs of a moat
In response to these threats, GameStop is attempting to diversify into areas such as self-published games and collectibles, but it's hard to see what type of competitive advantage the struggling retailer has in these arenas over more entrenched competitors. Can GameStop's small game publishing division really compete with titans like Electronic Arts and Activision Blizzard? Will enough people seek out the collectibles offered in GameStop's stores rather than simply turn to websites like eBay for their memorabilia needs?
GameStop's management, for its part, is remaining optimistic. The company's collectible sales jumped 36% year over year in the second quarter, to $122.5 million, putting it on track to meet its 2017 revenue target of $650 million to $700 million. Looking even further ahead, GameStop believes its collectibles business can generate $1 billion in revenue by 2019.
Whether or not GameStop hits those goals remains to be seen, but even if it does, $1 billion in sales is less than 12% of GameStop's revenue over the past year. It will be a long time before collectibles can replace the company's game sales, if ever. Even when combined with its technology brand sales and game publishing revenue, these new focus areas of GameStop's business still only account for about 20% of its total revenue. So if its game sales begin to fall off a cliff, it's unlikely that GameStop's diversification efforts will be able to fully offset the decline.
The stock isn't as cheap as it appears
GameStop's bulls would argue that many of these risks are already priced into its stock, as evidenced by its low P/E ratio of 6, compared to about 24 for the S&P 500 index. But valuing a stock based on earnings that may not exist in the near future doesn't make a whole lot of sense. GameStop's P/E ratio may look a lot different five years from now -- and possibly even sooner -- if a major portion of its business is lost to the gaming world's digital transition.
Those who favor GameStop for its dividend will point to its 45% payout ratio. With less than 50% of its annual earnings being used to fund its dividend, GameStop's payout is likely not in danger of being cut in the quarters ahead. But it could take as little as one or two poor holiday selling seasons before management would be forced to consider reducing the dividend in order to preserve capital and shore up its balance sheet. And for the reasons we've discussed, this may be more likely than many GameStop bulls currently believe.
Not worth the risk
GameStop's stock price has been cut in half over the last three years. Yet with industry trends forcing the retailer to move into new businesses in which it has fewer competitive advantages, investors may be best served by staying well clear of its high-risk stock, which is looking more like a yield trap every day.
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Joe Tenebruso has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Activision Blizzard and eBay. The Motley Fool owns shares of GameStop and has the following options: short October 2017 $22 calls on GameStop. The Motley Fool recommends Electronic Arts. The Motley Fool has a disclosure policy.