Gap Stores - Check The Pockets In Those Jeans!

| About: The Gap, (GPS)
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Summary

GPS has a 14-year history of nothing but positive quarterly earnings, most, if not all, of which met or exceeded analysts' estimates.

GPS's dividend payout ratio has historically been under 40%, and is now just barely over 50%.

GPS looks like a good candidate for writing covered calls.

Undoubtedly, worldwide clothing retailer Gap Stores' (NYSE:GPS) best days as a growth stock are in the past. I can't recommend GPS as a straight buy these days, not even for the 4% dividend, which they've increased for 13 straight years, and which appears well-covered by current and projected earnings, and available cash. Yet, there's plenty of money to be made with this solid, dividend-paying stock, particularly if you use equity options (puts and calls) to stake out your initial positions and/or boost your returns.

GPS shares enjoyed their best run, a gain of roughly 1100%, from 1995 through 1999, and had another nice upward move of about 250% from 2012 through 2014. Nothing like those moves is likely to recur, but I wouldn't be surprised to see the stock price climb 25 - 50% over the intermediate term if GPS can merely maintain its steady earnings.

Many so-called "brick-and-mortar" retailers are struggling to survive, as on-line shopping has greatly curtailed their traffic and sales. Some, like Sears (NASDAQ:SHLD) and J.C. Penney (NYSE:JCP), are on the verge of going under. Others, like Kohl's (NYSE:KSS) and Macy's (NYSE:M), are feeling the pinch. Sports Authority went down for the third time in 2016, filing for bankruptcy and closing all stores.

GPS is not immune from the woes plaguing retail in general. Eighteen months ago, the Washington Post, among others, reported that GPS would close 175 stores and cut about 250 jobs.

Some key points:

- Unlike general merchandise department stores, GPS primarily sells clothing, and while some people do buy clothing on line, there will always be lots of people who'll want to go to a store where they can see, feel, and try on clothing before they buy;

- GPS has posted positive earnings for 56 consecutive quarters, despite on-going difficulties with their Gap and Banana Republic brands;

- Their EPS for at least the past 15 quarters has meet or exceeded estimates, with no negative surprises;

- For most of the past 10 years, the dividend payout ratio was comfortably below 40%, and only broke above 50% in the past 12 months;

- GPS is a very actively traded stock, averaging 6.5 million shares per day; therefore, there is a VERY active options market with WEEKLY expirations associated with GPS stock.

A quick look at Morningstar.com's valuation data for GPS shows the company's metrics compare favorably against industry averages and the S&P 500:

As of 1/27/17 GPS Industry Avg S&P 500 5Y Avg
Price/Earnings 13.4 22.9 20.3 14.5
Price/Book 3.3 5.5 2.8 5.1
Price/Sales 0.6 1.1 2.0 1.0
Price/Cash Flow 5.4 10.4 12.4 8.3
Div Yld % 4.1 1.8 2.2 2.6

Reuters, among others, reported on Friday, January 27, 2017, that GPS announced the head of its struggling Banana Republic brand would be leaving the company. The market obviously saw this as a negative, and sent the stock price down 5.4%, from $23.87 to $22.58, pushing the yield north of 4 percent.

But, on January 30th, with the DJIA down about 180 points late in the session, GPS firmed up nicely and was up 1+ percent.

Friday's move down was a good opportunity to sell some puts a few months out. An important point about naked puts is, with stocks of solid companies like GPS, which have active weekly options markets, you can scope out future company events, such as projected ex-dividend dates and earnings reports, and execute your put sales accordingly. Around those events, stock price action tends to be somewhat predictable, and you can use that to your advantage with options.

Not only can you use naked puts to pick an entry price to buy stock, but with stocks like GPS, you can calculate a yield you'd like, and sell puts accordingly. For example, if you'd like to own GPS, but only if it yields 5%, then divide the annual dividend (0.92) by the yield you want (.05), and sell puts with a strike at or near that price ($18.40).

If you do that, and you are assigned the stock, you're not only collecting the yield you want, you can then turn around and boost your returns by selling covered calls. Again, you can base your call sales around dates of future dividends or earnings announcements, which should tend to give you more predictable results.

If you're not assigned the stock, you keep the credits you got from selling the puts, and move on.

I picked up a very quick $462 from GPS, like so:

- On January 5, 2017, bought 400 shares GPS at $23.28, then sold two calls, strike $23, and two calls, strike $23.50, expiring January 6th. The $23 calls were assigned, netting me $121, and the $23.50 calls expired, netting me $151. That was a pretty good one-day deal.

- On January 6, 2017, I sold two calls, strike $23.50, expiring January 13th, and two puts, strike $23, expiring January 20th. The calls were assigned, netting me $105, and the puts expired, netting me $85. Not a bad return for about two weeks, I think.

I stayed with GPS, selling two $22 strike puts expiring February 24th, for a net credit of $127, two $21 strike puts expiring March 7th, for a net credit of $116, and four $20 strike puts, expiring June 16th, for a net credit of $355. You can track those to see how they turn out, if you like.

If selling naked puts seems a bit too exotic, then GPS currently looks like a good candidate for covered calls. Indeed, that was my first move with the stock, as described above. The stock price has been fairly steady of late, the company will announce quarterly and yearly earnings late in February, and is projected to announce the next dividend with an ex-date in late March, payable in the second half of April. Options traders LOVE GPS; there is plenty of meat on those weekly options.

Regarding the increasing dividend, past payout boosts, as shown on Dividend Channel, don't hew to a predictable schedule. The dividend has been 23 cents for the past eight straight quarters, which equals the longest run without an increase going back to 2005. I'm sure any future increase depends on the steadiness of the company's earnings, but, although GPS is facing some challenges, as noted above, it appears healthy overall. Analysts are predicting steady revenue and solid earnings for the latest quarter, as well as for the next couple of years. I anticipate GPS will boost its payout sometime in 2017.

Good luck with your trading and investing efforts.

Disclosure: I am/we are short GPS PUTS.

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.