3 Things Gap Is Doing Right

Aug.19.11 | About: The Gap, (GPS)

Gap (NYSE:GPS) is in a very tough situation and its 2Q '11 earnings prove it. Gap has seen net income drop considerably, about 19% compared to the previous quarter. This has mainly been due to discounting since second quarter gross margins were down about 2.7%, driven almost entirely by the drop in merchandise margins. This is definitely a difficult environment for a clothing retailer like Gap, but it's doing many things right as well. Here are some highlights.

International expansion: Gap is looking to increase the amount of locations that it was originally planning to open in China. Gap is also looking to open in an additional seven new countries. Gap is also taking advantage of partners, which will allow the company to grow much faster while not tying up capital.

Controlling expenses: Gap looks to keep a close handle on expenses by decreasing square footage and closing some locations.

Return money to shareholders: Gap looks to maximize shareholder returns through share buybacks and dividend distributions. Gap so far has returned over $880 million to shareholders. It's purchased $820 million in shares and $60 million in dividends.

These are the three main focuses of Gap going forward. Even though Gap has the right plans in place, it still has many challenges ahead. The economy may be a big issue that may affect performance. Discounting will definitely keep Gap in check; therefore, I don't expect any surprise moves anytime soon. I do have a feeling that this holiday shopping season may be better than what most are expecting, but given the recent volatility in the markets, it's still too early to tell.

Gap appears to be setting up for a strong move in a recovery which is typically the case for retailers, but its focus on the international market may benefit Gap more than other retailers that are holding back expansion plans. This will start playing a big factor in earnings if the US dollar were to devalue. I expect further deterioration in the US dollar.

Gap is definitely a company I will add to my watch list and may be a play for me once I see signs of a recovery. Even though I feel that its business will see further pressure on margins, I don't believe this would hurt dividend payout. The current payout is attractive and may cause me to start a position if the yields were to increase.

Buying cyclical businesses with strong dividends work well during economic recoveries because you get the benefit of possible dividend increases when they book higher earnings as well as appreciation in the stock.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.