Can GameStop Corp's Dividend Even Survive?

Investors remain sharply divided over video game retailer GameStop (GME 0.97%). The bears think that digital downloads will kill its physical video game sales, while the bulls think that it might survive by expanding into adjacent markets -- like collectibles and consumer electronics.

However, GameStop's low valuation and high dividend also make it look appealing to bottom-fishing income investors. The stock trades at just 6 times earnings, compared to the industry average of 47 for specialty retailers. It pays a whopping forward dividend yield of 7.3%, compared to the S&P 500's average yield of 2%.

Source: GameStop.

Some income investors smell an opportunity here, while others think that dividend is unsustainable. Let's take a closer look at that dividend and see if it's worth the risk.

Dividend history and historical yields

GameStop started paying a dividend in 2012, and it's raised that payout every year. However, that annual growth has become less impressive over the past three years.

Source: NASDAQ.

Nonetheless, GameStop seems committed to raising its dividend annually. As for the yield, it remains near an all-time high due to the stock's 50% decline over the past three years.

Source: YCharts

GameStop's 7% yield is unmatched by any other brick-and-mortar games and electronics retailer. By comparison, Best Buy (BBY +0.46%) pays a forward yield of 2.3%.

Payout ratios

The easiest way to see if a dividend is sustainable is to check its payout ratios -- the percentage of a company's earnings or free cash flow it spends on dividends. If that number exceeds 100%, the dividend could be cut.

Over the past 12 months, GameStop spent just 45% of its earnings and 30% of its free cash flow on dividends, indicating that it has plenty of room for future hikes. Those ratios are just slightly higher than Best Buy's -- the retailer spent 31% of its earnings and 22% of its free cash flow on dividends during the same period.

Earnings and free cash flow growth

However, GameStop's payout ratios will inevitably rise if earnings and free cash flow growth fizzle out. In terms of earnings growth, GameStop isn't doing that well. After posting solid earnings growth for several years, GameStop's adjusted earnings slipped 3% in fiscal 2016 as digital downloads and slumping mall traffic took a bite out of its physical game sales and trade-ins.

Analysts expect that pain to continue, with a 12% decline this year and nearly flat growth next year. That outlook is disappointing, but it's not bleak enough to justify a dividend cut. If anything, GameStop might raise its dividend more aggressively to appease investors.

Meanwhile, GameStop's free cash flow growth is tied to the cyclical video game market, with cash flowing in with new console or game releases and drying up between big launches. Despite those challenges, GameStop has done a solid job keeping its free cash flow in positive territory over the past few years.

Source: YCharts

Future tailwinds and headwinds

The popular bear thesis that "GameStop is the next Blockbuster" doesn't hold up well. Just over half of its revenue comes from sales of new physical video games and pre-owned video game products -- which are vulnerable to digital disruption.

The rest comes from sales of video game hardware, collectibles, and consumer electronics. GameStop has been boosting the weight of these businesses while pivoting away from sales of physical media.

Robust sales of Nintendo's (NTDOY 2.75%) Switch and mini-consoles, in-store VR demos, and a new trade-in partnership with Amazon (AMZN 2.47%) could all lure customers back to its brick-and-mortar stores.

So will GameStop's dividend survive?

GameStop probably won't cut its dividend anytime soon. It has a history of raising it annually, and it's supported by low payout ratios. Instead, investors should be asking if GameStop can survive the market shift toward digital distribution platforms.

If GameStop survives that shift by evolving into a more diversified retailer, its earnings and free cash flow could start rising again. But if it fails, its earnings and free cash flow growth could drop into negative territory -- which bodes ill for its dividend.