GAP: Headwinds Provide Opportunity For Dividend Investors Struggling To Find Better Than 5% Yield

| About: The Gap, (GPS)

Summary

Gap’s stock has been battered by moderate revenue contraction and earnings contraction, which has caused its dividend yield to rise to nearly 5% in recent weeks.

Nothing in Gap’s history or future prospects suggests that Gap will be reducing its dividend anytime soon.

Long-term investors can maximize their dividend yield on Gap by purchasing the stock at current levels and riding the stock in the medium-term, when it is expected to recover.

The Gap, Inc. (NYSE:GPS), the global apparel retailer known for its Gap, Old Navy and Banana Republic brands, had a tepid first quarter. The San Francisco-based purveyor of casual, lifestyle and business clothing for men, women and children recently reported that its fiscal 2016 first quarter revenues were 5% lower than they were in the same period a year earlier.

Gap cited a challenging trend environment in the retail space, particularly in its higher-end Banana Republic brand where comparable store sales fell by 11% during the fiscal first quarter, as the primary driver for its weak performance. Gap's weaker sales were compounded by fluctuating exchange rates, resulting in a narrower operating margin of 6.5%, compared to 10.6% a year earlier. When combined with various restructuring charges associated with the closure of its shops non-performing locations, it's no surprise that Gap's fiscal first quarter earnings fell by nearly 47% from 56 cents to 32 cents per share.

Taken in a larger context, Gap's performance is not all that surprising: the US Census Bureau's latest report indicates that overall clothing and accessories sales rose by only 1.9% in the first trimester from the same period a year earlier. This result lagged the 3.3% rise in overall non-auto retail sales and suggests that consumers are being more cautious with their spending. It also aligns with the narrative of a soft patch in the US economy. Meanwhile, the global economy is estimated to have grown at its slowest pace in 3 years during the first quarter. This contributed to Gap's decision to dawn shutters at their 53 Old Navy in Japan to focus on other international markets with better potential.

Despite all this, Gap declared a July 2016 dividend of 23-cents per share, which equates to a 72% payout against the previous fiscal quarter's earnings. Meanwhile, due to the lukewarm environment for apparel stocks, Gap's shares are down by 22% in the year-to-date, bringing its annual dividend yield to a very attractive 4.9%. This is far better than the 0.72% yield on 2-Year US Treasuries and is among the highest dividend yields for large capitalization apparel stocks.

Indeed, to the extent that Gap's stock keeps falling and its dividend payouts remain the same, its dividend yield can only get more attractive. Yet the question is whether Gap can sustain its current dividend amidst slumping sales and earnings?

Dividends are ultimately a function of a company's cash position. In Gap's case, its operating cash position faces a pair of dual headwinds: dwindling margins and restructuring charges. To wit, Gap's current Operating Margin of 6.5% represents its second straight quarter of declining margins, is approximately half its operating margin from fiscal 2013 (and about 49% lower than its margin for Fiscal 2014) and is its lowest margin in the last decade.

Meanwhile, Gap is set to incur about $200 million in cash expenses associated with various store closures and the restructuring of its operations. All else being equal, this would represent approximately 15% of its Cash and Equivalents and while its cash remains at a healthy level of $1.37 Billion, it is worth noting that its weaker profits caused Gap to drawdown on its cash by $145 Million in Fiscal 2015.

Nonetheless, Gap remains on solid financial footing with debt-to-equity (0.52-to-1.00) and current (1.54-to-1.00) ratios that are better than the average of its peer group and the S&P500.

The average analyst estimate for Gap's Fiscal 2016 earnings is for it to earn $1.83/share. Even at Gap's current dividend payout of $0.23/share per quarter, its earnings would be more than sufficient to cover its current level of dividends.

Gap has a long history of continuously paying dividends irrespective of annual fluctuations in its profits. It has continually increased its per-share dividend since 1987, a period that includes three recessions and significant global upheaval. From 2007 to 2009, a 3-year period that represented the trough of its profits for the last decade, Gap still managed to pay-out nearly 30% of its profits as dividends. It has sustained approximately the same level of dividend in the years since and paid out nearly 41% of its net profit as dividends in Fiscal 2015. Were Gap to retain its dividend at its current level for Fiscal 2016, it would have paid out approximately 50% of its profits as dividends.

CONCLUSION

Ultimately, the question regarding Gap shouldn't be whether it will reduce its dividend - as we've demonstrated, this is highly unlikely given its relative financial strength and overall history - but whether dividend-seeking investors can maximize Gap's attractive dividend yield by waiting for an opportune time to buy the stock.

That opportunity has arrived: investors who purchased Gap shares in the last 3 weeks - when Gap shares dropped to a 52-week low - maximized their dividend yield the most with Gap's dividend yield rising to a high of 5.4%.

With Gap's shares hitting a 5-year low in the last month and now staging a recovery, we believe that there is an opportunity for investors to lock-in an attractive dividend yield of close to 5%. In particular, long-term investors who purchase $1,900 worth of Gap shares can expect $92 of passive income.

To be sure, Gap - and by extension, apparel stocks - are not in favor given the recent soft patch in the economy. Investors shouldn't expect Gap's stock price to double anytime soon. However, a macro argument can be made that consumer-focused stocks like Gap will be the first to recover once the economy resumes its acceleration. Moreover, Gap's management has put in place a recovery strategy that not only includes the usual cost-cuts - its international and domestic store closures by themselves will yield $25 million in annual savings - but also brings a focus on delivering on-trend product offerings and better international positioning.

This latter strategy should enable Gap to capture momentum in competitive emerging markets, where it intends to further expand its presence and its upside is greatest. Gains in this region (and recovery in the US) are expected to drive Gap's revenues going forward and it is forecasted to post nearly 8% revenue growth in the next 5 years - a rate better than what's predicted for the S&P500. Moreover, even amidst lower earnings expectations in the short-term, Gap is trading cheaply with a Forward Price-Earnings (P/E) ratio of 9.4x - a steep discount to the 24x P/E of both its sector and the S&P500.

As such, over the next twenty-four months, we can foresee a situation where an improvement in Gap's revenue profile and earnings results in the stock trading at the high-end of consensus expectations of $33.00/share - a significant capital gains upside to complement an already attractive dividend yield.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Black Coral Research, Inc. is a team of writers who provide unique perspective to help inform dividend investors. This article was written by Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.

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