Gap Inc.'s Dividend Likely To Freeze

Summary

• I believe there is a strong possibility Gap will freeze its dividend in October.
• The answer lies in the company's quarterly guidance.
• Is there a better option on the CCC list?

Gap Inc. (NYSE:GPS) has been a mainstay on the fashion scene for as long as I can remember. Founded in 1969, the company's products are available in 90 different countries in around 3,700 stores, according to its website. Operating through its best known brands of Gap, Banana Republic and Old Navy, along with others, the company is a mainstay in shopping centers and malls. It has been paying a dividend for the past 29 years, increasing yearly for the past 12 years, and currently sports a yield over 4%. However, I feel there is a high chance the dividend is frozen when the company's planned October dividend is announced. I will explore my reasoning going forward and look to see if there is currently better value on the CCC list.

"High dividend payers that have been progressively increasing their dividends, that’s what retail investors will want."

- Dennis Gartman

I bought into Gap Inc. for the first time in September 2016 as the result of a called covered put. Since then, I have written numerous options on the stock, had it sold away from me once through a covered call, and then got it back again in December, 2016 through another option. Most notably I wrote a covered call in May 2017, effectively lowering my personal cost basis to $21.34. Rated in the high 80s by my stock screener, at the time that I bought the stock, I believed I was trading risk for security. GPS had a current ratio over 1.5, almost twice as much working capital to long-term debt, yielding 3.5% with a payout ratio of around 50%. Add to this the fact I pulled the name off the Contender tab of the CCC list, meaning the company had continued to increase through the Great Recession, I thought I was golden. Then the Jan 2017 CCC list popped. The list is a living breathing document and changes slightly over time. Scrolling through the stocks, I noticed that Gap now had a red number for the "No. Yrs" tab. From the note attached to this change: "Added Red color to No. of Years for streaks extended by default (potential 2017 Freezes)."

Gap couldn't cut, right? We're in a bull market, and the company has already made it through the hard years. Well, I am now convinced we will see at least a dividend freeze in October. Two recent excerpts that have led me to this conclusion:

1. "For the full year, we continue to expect earnings per share for fiscal 2017, which includes the 53rd week to be in the range of 1.95 to 2.05" Teri List-Stoll, executive VP and CFO, on the Q1 earnings call.

	2012-01 (FY11)	2013-01 (FY12)	2014-01 (FY13)	2015-01 (FY14)	2016-01 (FY15)	2017-01 (FY16)
EPS	1.56	2.33	2.74	2.87	2.23	1.69	5-yr. EPS Gr.	2.0%
Dividend	0.45	0.5	0.7	0.88	0.92	0.92	5-yr. Div Gr.	16.0%
Payout Ratio	28.8	23.9	22.3	30.8	37.3	54.7	5-yr. Payout Gr.	17.4%

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(Source: Morningstar)

As you can see from the chart above, EPS has been trending down the past few years, with a 5-year growth rate of only 2%. This while the dividend has increased almost 20%, causing the payout ratio to almost double at the end of FY16. Based on forecasted numbers quoted above from Ms. List-Stoll, we will be optimistic and call FY17's EPS to be $2.05/share. GPS's 10-year payout average is only 29.7%, and using $2.05 EPS, GPS would have a payout ratio of 44.9%. Is this bad? In a bubble, no - my stock screener assigned a perfect score for stocks paying less than 50%. But based on historical averages, this number is about 50% higher than where GPS has held it for 10 years. I believe the company will not want to increase it any higher than it currently is.

2. "We paid a dividend of $0.23 per share during the first quarters of fiscal 2017 and fiscal 2016. Including the dividend paid during the first quarter of fiscal 2017, we intend to pay an annual dividend of $0.92 per share for fiscal 2017, consistent with the annual dividend for fiscal 2016" - Gap's most recent 10-Q.

^ Gap's fiscal calendar runs from February to January.

Above are Gap's dividends paid out for calendar year 2016 and 2017 to date. The estimated payments for Q3 and Q4 ’17 fall in line with the guidance provided in the company’s latest 10-Q as quoted above. If the company does intend to "pay an annual dividend of $0.92 per share for fiscal 2017, consistent with the annual dividend for fiscal 2016," then calendar year 2017 will see the same amount paid per share as in calendar year 2016. Thus, Gap is doomed to fall off the CCC list on October 26, 2017.

What does one do now? As a dividend growth investor, I am not interested in owning a stock that is not consistently increasing its dividend. Therefore, I will personally begin writing covered calls on the stock. One of my favorite things to see when writing options on a company is that it offers strike prices on the $0.50 or the dollar, and that it offers them weekly. Gap does both!

To date, I have collected $471.39. As stated before, my personal adjusted cost basis is $21.34. My current entry price is $26. My goal is to write the calls as close to my strike as possible; however, I am currently sitting on a $1,000 short-term capital gain for 2017, therefore, I would not be completely disheartened if my shares were called away and ate up some of that short-term gain tax.

Is there a better option listed on the CCC?

For a comparison to Gap Inc. I filtered the CCC list down to all Apparel and Clothing-related industries. Running the numbers through my stock screener, I came up with five companies which currently rate higher than Gap.

Following its earnings announcement back in May, Foot Locker (FL) cratered and currently sits 38% below its 52-week high. The company currently sits comfortably based on its financial sheets, with a low level of financial leverage against it. Another promising sign is the stability in its dividend growth.

Foot Locker Dividend Growth

1/10 A/D	5/10 A/D	1-yr. DGR	3-yr. DGR	5-yr. DGR	10-yr. DGR
0.936	0.930	10.8	11.3	10.8	11.6

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Foot Locker has shown consistent dividend growth right around 10% for the past ten years and does not seem to be slowing down. Comparing that to Gap, we see a different picture:

Gap Inc. Dividend Growth

1/10 A/D	5/10 A/D	1-yr. DGR	3-yr. DGR	5-yr. DGR	10-yr. DGR
0.099	0.330	1.1	13.8	16.0	12.4

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Here we see dividend growth solid over 10-, 5- and 3-year periods, but it has drastically fallen off recently.

Retail is currently in a downturn while everyone tries to figure out the long-term effects of companies such as Amazon (AMZN). Foot Locker may provide valuation at current prices, but one should continue to proceed with caution and ensure they do their due diligence prior to initiating a position in this sector. Looking to own companies which are more "brand" known than store-owned may be the way forward, as displayed by Nike's (NKE) recent announcement of beginning sales of certain items directly on Amazon.

Analyst’s Disclosure: I am/we are short GPS. 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.