Dividends and Buybacks: The GameStop Conundrum

NEW YORK (TheStreet) -- One of the most compelling presentations I saw at this past May's Value Investing Congress was on the benefits of dividend growth and the power of combining dividends with share buybacks, the brainchild of Advisory Research's Bruce Zessar and Matthew Swaim.

Now, I've long been a proponent of the notion that increasing dividends may be a better measure of a company's success, health and future prospects than earnings alone. I also believe that increasing dividends demonstrates management's confidence in the business.

But Zessar and Swaim took that theory to new levels, citing research that contradicts the long-held theory that paying dividends can reduce a company's opportunities for growth.

Zessar and Swaim presented evidence that higher dividend payouts can actually lead to higher future earnings growth, although they are cautious on the higher-yielding names due to the possibility of dividend cuts.

Given the extraordinary amounts of cash on company balance sheets these days, there are a whole host of quality names that are both increasing their dividends and buying back stock (but I'll save those for another day). There are also some names that have shown some distress but are also pursuing the growing dividend/buyback path. I'm very curious about these situations.

On Thursday, GameStop ( GME), which is world's the largest videogame retailer, announced a 67% increase in its' quarterly dividend, from 15 cents to 25 cents. That would put the indicated dividend yield at a lofty 5.6%.

On the buyback side if the equation, the company repurchased 7.6 million shares during the second quarter alone (at an average price of $17.96), and has reduced shares outstanding by nearly 9% in the past year.

There's also an additional $300 million remaining on the company's most recent buyback authorization. Thursday, the company announced that it plans to return $2 billion to shareholders over the next four years via buybacks and dividends.

What's amazing about these developments is that GameStop is in an industry that is changing rapidly, moving away from purchases made at brick and mortar stores, of which GameStop has a great deal -- 6,628 to be exact -- toward digital. In fact, same-store sales fell 9.3% for the quarter.

While digital revenue rose nearly 27% to $134 million, that represented just 8.6% of total revenue. The company expects FY 2012 comparable same-store sales to be in the -2% to -10% range, it pegs full-year earnings in the $3.10 to $3.30 range, implying a price-earnings ratio under 6.

Clearly, this is not the type of company that Zessar and Swaim had in mind in their presentation. But my interest is piqued at this point. GameStop has periodically appeared on some of the value screens that I utilize, but these recent developments are very curious.

Companies don't typically raise their dividends if they know that such payouts are unsustainable. GameStop's dividend increase was extremely bold and the recent buyback spree would suggest management believes shares are undervalued.

The combination of the two either demonstrates an extreme level of confidence on management's part or a heavy dose of wishful thinking.

From a balance sheet perspective, there are pluses and minuses. On the plus side, GameStop has $138.7 million in cash and no debt, and trades about 0.8 times book value per share. On the negative side, much of book value, nearly $2 billion, is comprised of goodwill and intangibles, and the company is currently performing an impairment test on $920 million worth of intangibles.

Clearly, the markets are expecting little from GameStop, given the forward PE of 5 based on next year's earnings. Management, however, by its rather bold actions, is saying the Street has it all wrong.

I've seen similar situations in the past couple of years. Gannett ( GCI) is a great example.

All but left for dead, and arguably in worse shape than GameStop before rebounding, the company is also in an industry seen to be in decline. Gannett, however, has seen fit to aggressively raise its dividend in the past year, and is also buying back stock. The company continues to generate loads of free cash flow but is still viewed with disdain by many.

I'm keeping an eye on GameStop at this point, but I am not ready to pull the trigger.

At the time of publication the author had a position in GCI.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Jonathan Heller, CFA, is president of KEJ Financial Advisors, his fee-only financial planning company. Jon spent 17 years at Bloomberg Financial Markets in various roles, from 1989 until 2005. He ran Bloomberg's Equity Fundamental Research Department from 1994 until 1998, when he assumed responsibility for Bloomberg's Equity Data Research Department. In 2001, he joined Bloomberg's Publishing group as senior markets editor and writer for Bloomberg Personal Finance Magazine, and an associate editor and contributor for Bloomberg Markets Magazine. In 2005, he joined SEI Investments as director of investment communications within SEI's Investment Management Unit.

Jon is also the founder of the Cheap Stocks Web site, a site dedicated to deep-value investing. He has an undergraduate degree from Grove City College and an MBA from Rider University, where he has also served on the adjunct faculty; he is also a CFA charter holder.

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