GameStop (GME -0.68%) shareholders can't seem to catch a break. The specialty retailer announced solid second-quarter earnings results last month but the stock still took a beating.
GameStop's operating metrics don't yet show the type of collapsing sales and earnings trends that Wall Street appears to be predicting for this business. Still, there are good reasons to consider selling this stock.
Management lowers the bar
GameStop executives were caught by surprise with the intensity of the pullback in their core video game segment last year. Halfway through the year, CEO Paul Raines and his team were projecting comparable-store sales declines of between 4.5% and 1.5%. Instead, comps ended up contracting by a brutal 11%.
Image source: Getty Images.
Another miss like that would suggest management isn't keyed into the major industry forces, and it would slap a big question mark on executives' long-term projections. So far, GameStop's 2017 targets haven't declined, though. In fact, they've risen slightly. Six months into the year, and the company believes it will hit the high end of executives' original forecast, which would translate into flat sales.
Most of GameStop's revenue is generated over the back half of the year, though, and so its outlook could change dramatically depending on sales trends over the coming months.
Diversity doesn't pay
The company understands that the video game niche is slipping out of its reach as gaming purchases move to the digital sales channel. That's why GameStop has spent years acquiring and building out complementary business lines including cellular service, consumer electronics, and collectible retailing merchandise.
If these new product lines suffer from much weaker economics than the video game segment, it might be time to consider moving on from this investment. That's why investors should keep a close eye on profitability.
Gross profit margin fell to 37% of sales last quarter from 38%. A closer look at that result shows a mixed performance. Profitability declined in the video game hardware division, which tends to happen when new products launch, like the Nintendo Switch. But GameStop offset most of that dip with help from above-average gross margin in the consumer tech segment. On the other hand, its collectibles unit dragged overall margin lower as its profitability worsened to 35% from 39%.
The dividend declines
GameStop's yield, which was already one of the most generous around, has jumped to nearly 8% thanks to a stock price that's shed 20% so far this year. The good news for income investors is that this incredible dividend is still well covered by earnings. The retailer generated over $3 per share in profits over the past 12 months while the dividend payment amounted to $1.50 per share.
GME Payout Ratio (TTM) data by YCharts
There's no danger of a cut to the dividend as long as the payout ratio stays comfortably perched at around 50%. Still, it isn't hard to imagine a scenario that convinces management to shore up capital spending and potentially slice this dividend, or at least leave it unchanged for a long stretch.
A surprisingly weak holiday season might cause the team to scale back its growth strategy, for example, likely by closing down a host of underperforming locations. GameStop would have to take big restructuring charges in this case, and so it wouldn't make sense to add to the pressure on its balance sheet by sending out a generous dividend at the same time that earnings are slumping.
As a GameStop shareholder, I'm encouraged that none of these potential red flags are showing up in the recent results, even as the risks loom heading into the critical holiday shopping season.
