On Sale At The Gap: A Yield Above 4%

| About: The Gap, (GPS)

Summary

Given today’s nano-yields, a stock yielding 4% is at least worth a look.

Brick-and-mortar apparel merchant Gap doesn’t impress in terms of growth prospects.

But it’s not a dumpster fire, and with the stock yielding 4%, that translates to a strong investment case.

This Is A Reprint Of An Article Previously Published On Forbes.Com

A stock with a 4% dividend yield: I’m not saying it’s an automatic Buy for income investors (nothing ever is), especially when it involves brick-and-mortar retail. But in this continuing era of nano-yields, one has to at least look. As it turns out, I can’t warm up so easily to growth prospects, but then again, with a 4% yield, we don’t need much along these lines.

Why this Stock is Being Considered

You’re way ahead of the game if, before you start to evaluate or read about a stock, you recognize that there are really good reasons for taking the time to look at this stock as opposed to the thousands of others you could be considering. As to Gap, Inc. (GPS):

  • It’s a present holding of the portfolio generated by the Portfolio123 Equity Income Designer Model, which you can follow for free on Portfolio123 (which is important since that’s where you’ll find out if or when to sell).
  • This is an equity-income strategy that relies on Mr. Market for guidance in the area of dividend security. Mr. Market has demonstrated himself as an able judge of this sort of thing (high-yielding portfolios often underperform lower-yielding portfolios, telling us that when Mr. Market is concerned about dividend security and bids the stock down, and the yield up, he's often right). This is significant because Mr. Market is able to consider qualitative data as well as numbers (and can, therefore, better judge whether or not a payout ratio is reasonable in the context of a particular business, whether or not a company's fundamental prospects are likely to deteriorate, etc.). So, unlike many equity income models, this one doesn’t just have a minimum allowable yield; it also has a maximum allowable yield. The model also requires favorable analyst sentiment.
  • For more about this model, click here.

What We’re Looking For

Assuming the strategy interests you, a yes-or-no decision on the stock should depend on whether (1) you like the yield, which is now about 4%, and (2) whether you think the dividend is reasonably secure. Don’t worry about dividend growth. When you see a yield this high (consider that it’s a little more than double the 1.9% yield on the S&P 500 ETF (SPY)), you have to recognize that Mr. Market has given up the ghost in the area of growth. We’d like to think we can get more than zero, but we shouldn’t expect it unless interest rates rise as a result of an economy strong enough to lift all boats, even the less thrilling ones like GPS.

Expect to see risk and baggage. With a yield this high, you have to know it’s there. The question is whether it’s more than you are willing to accept.

Apparel Brick-and-Mortar Retailing, Oy Vey

It seems like only yesterday when going to the mall to shop till we drop was the great American pastime (sorry baseball). Back then, who could resist stores like Gap, Banana Republic, or Old Navy. It’s not as if there weren’t a gazillion other choices, but years of returns on equity well above 20% suggest this company got more than its fair share of love from shoppers.

That was then. Now, the great American pastime is harder to pin down, but chances are it has something to do with looking at and tapping screens, maybe to talk about one’s self, maybe to read things, maybe to buy things (Yeah! GPS might still be in the running), maybe to watch or listen to things, or who knows what. Whatever the case, we know people aren’t running to brick-and-mortar stores the way they used to. And, even when or to extent they do, Father Time is the enemy of all fashion brands as old brands become, well, old, and it becomes more hip to be into other things.

GPS's brands aren’t dead. As is inevitable in a business like this, some quarters are better than others depending on the ebb and flow of consumer tastes and hits or misses on the part of GPS's fashion mavens, but on the whole, this remains a very, very profitable company. And, in fact, it’s still looking to breathe new life into whatever growth engine it thinks it can still power up (see, e.g., the company’s still-small Althea active-wear brand). But for better or worse, it’s not exactly fashion forward nowadays. It’s mainstream.

And, this is why it’s so darn important that we remember why we’re looking at the stock in the first place. We’re not trying to latch onto the next big thing. We’re not even looking for a dividend growth story. What we want is a decent yield that isn’t plagued by the high risks of reductions or defaults (with respect to the latter, see junk bonds). So, come to think of it, mainstream, in terms of style and affordability, is probably just what the dividend doctor ordered.

We’re not looking for it to be the big gorilla in apparel retailing. What we really want is for GPS to not be a dumpster fire. And, that, I believe, is something we have.

Brick and Mortar - Really?

Yes, I know GPS, it sells over the web, like everyone else. But its bread and butter is still brick and mortar. So, if we’re to own GPS even for dividend stability, we at least want to know that this business is not completely dead.

Ironically, Amazon.com (AMZN), the company that has probably had the single biggest hand in leading many to write obituaries for brick and mortar may be the one most likely to sell us on the notion that the activity is, indeed, very much alive and well. It already launched its own brick and mortar bookstores and is starting to give such merchants lessons in how to marry cyber and non-cyber formats (a topic for another day). And, if that weren’t enough, AMZN’s pending acquisition of Whole Foods (WFM) further drives home the message that there is life beyond one’s personal screen. (And, by the way, Jeff Bezos isn’t the only big name to invest recently in this area. Add Warren Buffett to the list.)

Within apparel, a big issue in terms of going digital is the ease and experience of product returns (which has to be significant since buyers aren’t trying them on in a store before completing their purchases). But the industry seems to be very much attuned to this, and Amazon is working to be part of a solution.

Shareholder ego would prefer to see pioneer. Shareholder dividend collection goals could live without that. I’m not bothered by the fact that other retailers are running with the ball early on. Not everybody has to be a leader in everything, and I’m certainly not going to throw a fit if a company whose stock yields 4% seems more likely to be a follower – even if, long term, it means closing a lot more stores and selling a lot more merchandise online even if through, gasp, gasp, Amazon.com, which, by the way, it already does. So, we don’t have to lock into the notion of GPS being a portfolio of brick-and-mortar stores. Perhaps we should be thinking of it (and others) as a multichannel brand curator. (We long ago got used to consumer companies outsourcing sourcing and manufacturing and distribution. Why can’t GPS de-emphasize and maybe eventually ditch its stores or even its own website and sell through e-commerce portals?)

Some Numbers

So, it looks like GPS can still enjoy a long corporate life, albeit, perhaps, a less exciting one than it may have had at times in the past. But we also see that the company will probably have to adapt to new ways of thinking and operating, a situation which, outside of Wall Street and its neurotic obsession with meeting or beating each quarter’s guidance, is actually quite human; non-investors have a word for it: “normal.”

For those who own the stock to benefit from a well-above-average yield, however, the question becomes whether the company likely has the breathing room to at least maintain its dividend even if it experiences setbacks along the way (another phenomenon that is ragingly normal).

Table 1 suggests GPS has the cushion it and income-seeking shareholders need.

Table 1 (in mill.)

The key Inflows:

Important Outflows

Surplus

Cash Fr. Oper.

Divided

CapEx

Acquisitions

2011

1,744

252

557

0

935

2012

1,363

236

548

0

579

2013

1,936

240

659

129

908

2014

1,705

321

670

0

714

2015

2,129

383

714

0

1,032

2016

1,594

377

726

0

491

2017

1,719

367

524

0

828

Data from S&P Compustat via Portfolio123.com and reflects Compustat standardization protocols. Fiscal years end in January.

I’ll bet you noticed and wondered about some recent declines in the dollar amount of dividends paid. The per-share dividend (what we care about) has not gone down. The number of shares is what has fallen because the company used some of its surplus cash flow to repurchase common shares; a good thing for equity investors.

On the whole, Table 1 offers us a lot of good news. The dividend is incredibly well covered, especially for stock the yield for which about doubles the S&P 500. Note, too, that capital spending, often a huge item, is highly discretionary. And, with the store base more likely in my opinion to shrink rather than grow going forward, I don’t see future capex as a threat to maintenance of the dividend.

Table 2 helps us view GPS's operations in context of companies around it.

Table 2

GPS

Medians

Industry

S&P 500

Total Debt 2 Equity

0.46

0.34

O.83

LT Debt 2 Equity

0.44

0.27

0.73

Interest Coverage TTM

18.19

7.08

7.49

% Ret. On Assets TTM

9.28

4.85

5.03

% Ret. On Assets 5Y Avg.

13.86

6.10

5.36

% Ret. On Equity TTM

25.71

9.77

14.47

% Ret. On Equity 5Y Avg.

36.60

11.32

14.48

GPS is marginally more leveraged than others, but its interest coverage is a heck of a lot better. And, that’s because when it comes to plain-vanilla profitability, GPS is way ahead of the pack.

Table 3 digs a bit deeper into the operating components of profitability.

Table 3

GPS

Medians

Industry

S&P 500

% Gross Margin – TTM

40.77

36.40

41.33

% Gross Margin – 5Y Avg.

41.47

37.80

39.59

% Operating Margin – TTM

8.79

5.52

16.74

% Operating Margin – 5Y Avg.

11.41

6.98

16.96

Inventory Turnover - TTM

4.52

3.55

5.38

Asset Turnover - TTM

2.02

1.88

0.53

Data from S&P Compustat via Portfolio123.com and reflects Compustat standardization protocols; ratios based on Portfolio123 protocols. TTM = trailing 12 months

Overhead-type expenses are more prominent for specialty retailers than the SP500 as a whole, so operating margin for the group is lower. But GPS has been better than its peers. But due to lesser asset intensity (reflected in asset turnover), GPS is more than able to offset its lower margins and ultimately earn higher returns.

Table 4 finishes up by looking at stock valuation metrics (aside from the yield, which we already know is high for GPS)

Table 4

GPS

Medians

Industry

S&P 500

PE using Est CurYr EPS

11.54

14.39

19.22

PE using Est Next Y EPS

11.30

12.39

17.41

Proj. LT EGS Gr Rate

7.50

11.50

10.14

PEG

1.54

1.23

1.88

Price/Free Cash Flow

11.85

16.27

29.52

Price/Sales

0.59

0.49

2.52

Price/Book

3.23

1.68

3.31

GPS's PE ratios are low as is its Price/Free Cash Flow. Its PEG ratio is ok but higher than the specialty retail median. But to compute PEG, we use the estimated growth rate, and with GPS, we’re working from a noticeably more conservative number (i.e. one that is less likely to exceed what the company can deliver). Price/Sales for the group and for GPS are low, but that makes sense given restrained growth expectations here.

GPS has a high price/book, but that’s par for the course given its high return on equity. And, on this basis, GPS looks undervalued relative to the SP500, which has a slightly higher price/book but much lower return on equity.

Conclusion

We can always find something about the numbers to nit-pick. But considering that we’re assessing dividend risk relative to the well-above-par yield (which should lead us to expect higher risk), I think we’ll be hard pressed to find a better fundamental profile for stocks in this yield range.

Disclosure: I am/we are long GPS.

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

About this article:

Expand
Tagged: , , , Apparel Stores
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here