GameStop (NYSE:GME) shares touched a new low in August as investors punished the retailer following its fiscal second-quarter earnings report. The slump, though, pushed its dividend yield up to an even more enticing 8%.
That yield is so far above the market average that it's only natural for investors to wonder whether a dividend cut is on the way. Let's look at the big warning signs that would likely come before this generous dividend payout gets reduced.
In late March, GameStop's management ended its practice of issuing quarterly sales growth forecasts. Executives explained at the time that their intent in switching to annual guidance was to "reduce investor distraction" in an unusually volatile business environment. After all, GameStop had just ended a fiscal year in which comparable-store sales plunged by 11%, with the severity of the pullback in its core video game segment surprising the team.
Another negative shock like that would be a strong indication that a dividend cut was becoming necessary, but so far, no such bad news has arrived.
The company's initial 2017 forecast, issued in March, called for comps to range from flat to a 5% decline. CEO Paul Raines and his executive team reiterated that target in late May after the company announced a 2% comps improvement. GameStop then increased its guidance after posting a 1% comps uptick in the fiscal second quarter. In other words, halfway through the year, demand trends are progressing a bit better than executives had projected.
Collapsing profitability also would put the company on course for a dividend cut. The caution sign is up in this case, as GameStop's gross and net profit margins have both declined over the last six months.
Gross profitability fell by a full percentage point last quarter to 37% of sales. The good news is GameStop generated healthy earnings from its fast-growing consumer technology division. However, margins fell hard in both the video game hardware and software segments, implying the need for heavy promotions to keep inventory moving.
Income investors will want to keep a close eye on GameStop's profit strength. For now, management still has confidence in a full-year profit target that predicts just a slight earnings drop from 2016's result. A big reduction in the forecast might put the company in full-on defensive mode, and thus place the dividend in jeopardy, though.
Payout ratio spike
Finally, watch for a spike in the payout ratio -- the percentage of earnings that goes toward the dividend. At first glance, this metric appears to be in dangerous territory: GameStop's $0.76 of dividend payments in the past six months amounted to 95% of its profits over the period.
That's no reason to panic.
The retailer makes the majority of its earnings in the fourth quarter, which includes the holiday shopping season, so investors should instead evaluate the payout ratio on a trailing 12-month basis. This reveals plenty of cushion for the dividend, given that the $3.33 per share of profit over the past year is more than double the $1.50 in annual dividend payments.
GameStop's big-picture business trends show steady sales growth and a slight decline in profits. If that pattern continues -- or even worsens a bit -- there's no real danger to this dividend. A lot is riding on the upcoming holiday shopping season, though: Last year, Q4 accounted for 59% of annual earnings.
Demitrios Kalogeropoulos owns shares of GameStop. The Motley Fool owns shares of GameStop and has the following options: short October 2017 $22 calls on GameStop. The Motley Fool has a disclosure policy.