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GameStop Eliminates Its Dividend to Avoid Becoming the Next J.C. Penney

Adam Levine-Weinberg, The Motley Fool

At the beginning of this week, GameStop (NYSE: GME) had a sky-high dividend yield of approximately 20%. By Tuesday afternoon, when the gaming specialty retailer released its Q1 earnings report, that dividend was gone.

GameStop has plenty of cash right now, so the decision to eliminate the dividend likely came as a shock to most of its shareholders. However, with the company in the early stages of trying to reinvent itself, the board has decided that strengthening the balance sheet takes absolute priority. This may be painful in the short run, but it should allow GameStop to avoid the type of catastrophe that has called J.C. Penney's (NYSE: JCP) survival into question.

GameStop axes its dividend amid plunging sales

On Tuesday afternoon, GameStop announced that revenue fell 13.3% last quarter on a 10.3% decline in comparable-store sales. Plunging sales of gaming hardware drove more than half of the sales decline, as many of the gaming consoles on the market today are nearing the end of their lives. The good news is that gaming hardware carries very low margins, so losing out on this revenue won't hurt the bottom line much.

Of more concern, GameStop also reported a sharp decline in sales of pre-owned video games. That has historically been the most profitable part of GameStop's business. Unfortunately, the ongoing shift toward digital downloads may continue to disrupt the used video game market.

For fiscal 2019 as a whole, GameStop still expects a comp sales decline in the range of 5% to 10%. There's no clear timetable for when it might return to growth, either. New CEO George Sherman took the helm less than two months ago and just filled out his leadership team last week, so the retailer's long-term strategy is currently up in the air.

A family playing a video game

GameStop is seeking a strategy to address severe disruption of its core market. Image source: Getty Images.

That's why GameStop is eliminating its dividend. This move will save about $157 million of cash annually. Instead, the company is quickly reducing its debt load. It retired $350 million of debt last quarter and has also prepaid another $39 million of debt over the past few months, leaving it with just $436 million of outstanding borrowings as of June 3.

Avoiding the J.C. Penney trap

GameStop's recent financial moves stand in stark contrast to what J.C. Penney did near the beginning of the decade. Between fiscal 2010 and fiscal 2012, the struggling retailer paid out more than $450 million in dividends. Additionally, J.C. Penney spent $900 million buying back stock in fiscal 2011 to appease activist investors.

The timing couldn't have been worse. Also during 2011, J.C. Penney hired Ron Johnson as its new CEO, with a mandate to reinvent the tired department store chain. Johnson implemented an ambitious -- but extremely risky -- transformation strategy that ultimately failed.

Had J.C. Penney preserved its cash, it might have been able to recover from this big setback. Instead, it quickly found itself strapped for cash. In addition to raising $785 million through a dilutive stock issuance in late 2013, the company also added $2.6 billion of incremental debt to its balance sheet in that year. J.C. Penney's weak balance sheet has been an impediment to turning the business around ever since.

By contrast, while GameStop's pivot to an ultra-conservative financial policy may seem like overkill, it will maximize the new management team's room to maneuver.

Short-term pain for potential long-term gain

GameStop stock crashed as much as 40% in morning trading on Wednesday following the Q1 earnings release, even though the company unexpectedly posted a profit last quarter. Clearly, investors were dismayed by the company's revenue decline and the elimination of the dividend.

That said, paying down debt and preserving cash for potential strategic initiatives will give the new management team a better chance of turning GameStop around. Of course, there is no guarantee that GameStop will find a viable path forward in the face of rapid disruption in the video game market. However, investors may now be underestimating GameStop's chances of successfully reinventing itself.

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Adam Levine-Weinberg owns shares of GameStop and J.C. Penney. The Motley Fool owns shares of GameStop. The Motley Fool has a disclosure policy.