GameStop (NYSE:GME) lost about 40% of its market value over the past three years, as rising digital downloads and declining mall traffic throttled its growth. However, that plunge reduced GameStop's forward P/E to 6 and boosted its forward dividend yield to nearly 10%.

Do that low valuation and high yield make GameStop an undervalued income stock? Or is that high yield a red flag indicating that its core business is deteriorating?

Two young men playing a video game as two young women cheer them on

Image source: Getty Images.

Examining GameStop's dividend

GameStop started paying a dividend in 2012, but it paused its annual dividend hikes in 2017. It spent 88% of its free cash flow (FCF) on its dividend over the past 12 months, but its FCF levels have gradually declined over the past three years.

GME Free Cash Flow (TTM) Chart

GME Free Cash Flow (TTM) data by YCharts.

For fiscal 2018 (which ends on Feb. 3), the company expects its FCF to come in "closer to $200 million" compared to its prior forecast of about $300 million. However, GameStop's recently closed its sale of Spring Mobile (which includes nearly 1,300 AT&T wireless stores) for $700 million should boost its cash flows next year.

Therefore, the company's dividend should remain safe in fiscal 2019. However, it might be wiser to cut its dividend and reinvest the excess cash into its core business or reduce its long-term debt of $471 million.

An evolving business

GameStop didn't sit still as digital distribution platforms disrupted its new and pre-owned software segment. Instead, it diversified its business by selling more consoles, hardware devices, collectibles, and mobile devices at its soon-to-be-divested AT&T stores.

It also acquired pop culture products retailer ThinkGeek in 2015 and launched its own digital downloads platform. During the third quarter, GameStop's revenue increased 5% year over year to $2.1 billion and its comparable-store sales rose 2.1%. Its adjusted EPS, which excludes non-operating impairment charges, rose 24%. Those headline numbers look solid, but there are some issues with its individual business units.

Breaking down the numbers

Thirty-five percent of GameStop's revenue came from sales of new video game software during the quarter. Pre-owned and value game products (both software and hardware) accounted for 19%, new hardware contributed 17%, and 9% came from sales of video game accessories. Here's how those four core businesses fared:

Segment

Sales Growth (YOY)

Gross Margin

Change in Gross Margin (YOY)

New video game software

11%

22.1%

(190 basis points)

Pre-owned and value game products

(13%)

43.1%

(50 basis points)

New video game hardware

13%

10.5%

(140 basis points)

Video game accessories

33%

36%

40 basis points

Data source: GameStop Q3 2018 report. YOY = year over year.

The only business that improved both its revenue and gross margin was the video game accessories unit, which was buoyed by sales of headsets for battle royale titles like Fortnite. Meanwhile, GameStop's higher-margin pre-owned business kept struggling as digital sales continued to disrupt the business of trading in physical games.

Still image of gameplay from Epic Games' Fortnite.

Fortnite. Image source: Epic Games.

GameStop's three smaller businesses -- technology brands, collectibles, and digital -- generated 8%, 7%, and 2% of its revenue last quarter, respectively. Here's how they fared in Q3:

Segment

Sales Growth (YOY)

Gross Margin

Change in Gross Margin (YOY)

Technology brands

(12%)

80.4%

760 basis points

Collectibles

12%

37.4%

(70 basis points)

Digital

22%

93.4%

170 basis points

Data source: GameStop Q3 2018 report. YOY = year over year.

The drop in technology brands revenue was caused by the closure of the company's AT&T stores, and that decline should accelerate following its sale of Spring Mobile.

Sales of collectibles were lifted by strong demand for Funko's Pop vinyl figurines, but those products are available at a wide range of online and brick-and-mortar retailers. The growth in digital revenue was encouraging, but the business remains too small to move the needle.

A murky future

GameStop recently announced that its comps during the nine-week holiday period rose 1.5%, which CFO/COO Rob Lloyd attributed to "strong sales in accessories, collectibles and digital which more than offset the decline in pre-owned sales and new video game hardware sales."

The company's total sales fell 5% during the period, but the drop was mainly caused by a 53rd week in fiscal 2017. Analysts expect GameStop's revenue and adjusted earnings to fall 4% and 20%, respectively, this year, followed by milder declines next year.

Some bulls believe that GameStop could be acquired soon, but none of those rumors have led to serious talks. Its core new video game software and pre-owned businesses remain under siege by new technologies, and its latest growth spurts -- especially in sales of gaming headsets and Funko figures -- could be tough to sustain.

Is GameStop an undervalued income stock?

GameStop's stock is cheap for obvious reasons, and I don't think the dividend is worth the risk. The dividend could be easily sustained by its FCF after the Spring Mobile deal, but that cash would arguably be better spent on improvements to its core businesses.

Leo Sun owns shares of AT&T. The Motley Fool owns shares of GameStop. The Motley Fool has a disclosure policy.