Gap Inc. (NYSE:GPS) is a global apparel and accessories retailer, but nearly 80% of its revenue is generated in the U.S. The company sells products for men, women and children under different brands, such as Gap, Banana Republic, Old Navy, Intermix and Athleta.
Shares of Gap recently fell to a 52-week low after JPMorgan analyst Matthew Boss downgraded the stock from "neutral" to "underweight," then cut his price target from $30 to $24.
Some causes of this downgrade include headwinds from higher transportation costs, rising wages and tariffs, which would affect Gap’s direct sourcing exposure to China (currently at 27 percent).
In addition, retail stocks took a beating amid a market selloff in October 2018. One main catalyst for the retail declines was the unpredictable U.S.-China trade relationship that could reduce global growth and profits.
The aforementioned news is obviously not good for Gap, but short-term pessimism could provide buying opportunities for the patient value investor. This article will focus on the current state of the business fundamentals and how it has performed over the past 10 years, what these findings mean about the future possibilities of the business, and what the real value of Gap is versus the share price. The conclusion will aim to help short-term investors make a more educated decision, while other patient, long-term dividend investors will be able to determine if GPS is a worthwhile investment for the long run.
Snapshot of the Company
A fast way for me to get an overall understanding of the condition of the business is to use the BTMA Stock Analyzer’s company rating score. It shows a score of around 73/100. Therefore, GAP is considered to be a good company to invest in, since 70 is the lowest good company score. GAP has high scores for Ability to Recover from Market Crash or Downturn, ROE, ROIC, Gross Margin % score and a decent score for 10-Year Upward Price Per Share. However, it has low scores for Earnings per Share and PEG Ratio. These findings show us that GAP seems to have fairly good fundamentals since a majority of categories high scores, but there is some issue with Earnings (a key component to a company’s performance), which needs to be examined.
Before jumping to conclusions, we’ll have to look closer into individual categories to see what’s going on.
Let’s examine the price per share history first. In the chart below, we can see that price per share was inconsistent for the past 10 years. We see little growth from 2009-2010, a price drop in 2011, and more rapid growth from 2012-2014, followed by a decline from 2014-2016. The past 2 years show steady share price increase. Overall, share price average has grown by about 93% over the past 10 years, or a Compound Annual Growth Rate of 7.56%.
(Source: BTMA Stock Analyzer - Price Per Share History)
Looking closer at earnings history, we quickly see that earnings growth has been inconsistent over the past 10 years. These inconsistent earnings make it much harder to accurately estimate the future growth and value of the company.
(Source: BTMA Stock Analyzer - EPS History)
Why are Gap’s earnings so inconsistent? It seems that there are multiple causes. First of all, the retail sector in general is cyclical. There are booms and busts according to supply and demand caused by seasons and the state of the economy. Below, you can see a historical chart of sales volatility due to the cyclical nature of the retail sector.
In addition, in the past 10 years, there has been a major shift in the way that retail sales are processed. Around 2007, more sales were being generated through online rather than physical stores. From that point onward, companies that relied too much on physical store sales without developing their online store presence have suffered. Companies like The Gap that rely on mall foot traffic have also experienced significant setbacks.
Another reason for Gap’s inconsistent earnings could be caused by its loss/gain of market share when compared with competitors. The table below shows how the company’s various brands (The Gap, Old Navy and Banana Republic) combined to show an overall declining trend in apparel market share from 2009 to 2014. Therefore, you can see that Gap’s inconsistent earnings can’t really be pinpointed to one cause. Gap’s inconsistencies have been caused by general issues facing the retail sector as a whole and by company-specific issues like loss/gain of market share. Because of these reasons, we can understand that Gap and retail stocks in general may not be the best choice for investors that are interested in consistent and stable earnings and returns. On the other hand, you may be interested in Gap if you are a short-term investor who’s able to stay involved in taking advantage of the cyclical ups and downs of this volatile sector in order to make quicker in-and-out gains.
Since earnings and price per share don’t always give the whole picture, it’s good to look at other factors like gross margins, return on equity and return on invested capital.
The return on equity decreased from 2014 to 2017. However, ROE started increasing again during the past year. Even though the 5-year average ROE is good at around 34%, it is worrisome that the ROE decreased by around 42% within the past 5 years.
(Source: BTMA Stock Analyzer - ROE History)
Let’s compare the ROE of GAP Inc. to the apparel retail industry. According to CSIMarket.com, the ROE of the retail apparel industry varied from 11.78% to 34.06% quarterly, which means that GAP Inc. is within the acceptable ROE levels for the industry.
Return on Invested Capital directly correlates to the Return on Equity. I’m interested in consistent ROIC and ROE of 16% or more, so GAP is meeting my terms in this area with the lowest ROIC of 16.81% occurring in 2017 and a 5-year average of about 24%.
(Source: BTMA Stock Analyzer - Return on Invested Capital History)
Gap Inc.'s Gross Margin Percent history shows that margins have been decreasing in 2015-2016 and then increased again during the past two years. The change is not concerning though, since Gross Margin levels have remained mostly stable between 36% and 39%. This is a good sign, as I prefer to invest in a company with consistent margins over 30%.
Looking at other fundamentals involving the balance sheet, we can see that the debt-to-equity is at a good level at 0.39.
Gap’s Current Ratio of 2.03 is also good, indicating that it has enough assets to pay its current liabilities.
According to the balance sheet, the company seems to be in good financial health. The Price-Earnings Ratio of 12 indicates that Gap could be selling at a discount price when comparing its P/E Ratio to a long-term market average P/E Ratio of 15. The 10-year and 5-year average P/E Ratio of Gap has been between 13 and 13.5.
Gap currently pays a dividend of 3.55% (or 3.51% over the past 12 months).
(Source: BTMA Stock Analyzer - Misc. Fundamentals)
The Story Behind The Dividend
With regard to dividend history, I’m first interested in knowing if the payout ratio is sustainable. At this time it’s around 41%, which means that there is still lots of room to grow the dividend. Also notice that GPS has a history of buying back stocks, which contributes to higher payout ratios.
If we look only at the dividend yield, we see a range of 2.04-4.10%. This stock pays out a decent dividend, but the dividend payouts have not been consistently increasing.
From the above chart over the past 5 years, we can see that the dividend yield TTM has been inconsistent. Therefore, this stock may not be desirable for investors who want an increasing dividend that pays out consistently over the long run.
Although GPS participates in share buybacks, sometimes buybacks don’t make sense, as according to Warren Buffett, “There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds - cash plus sensible borrowing capacity - beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively calculated.”
In the example of GPS, the company appears to have ample cash, as indicated by its safe debt-to-equity and good current ratio. The company also has a high borrowing capacity.
“With debt at a relatively low 13.92% of its enterprise value compared to an overall benchmark of 25% (Note: The peer median is currently 3.23%), and a well-cushioned interest coverage level of 18.19x, GPS-US can probably borrow quickly.”
Now to see if the buyback timing made sense. From the view of a share price chart over the past 5 years, the worst times to do share buybacks would have been when GPS was climbing highest in stock price. This would have been around 2014-2015. If we look at the dividend chart above, we can see that this was a time when GPS was buying back the most number of shares. Therefore, it seems like GPS hasn’t done a good job of returning value to shareholders through share repurchases because they have executed the buybacks when the stock has a worse chance of selling below its intrinsic value.
If I were currently interested in buying GPS now for the dividend, I would be trying to buy when the dividend yield was highest relative to its past. From the chart below, we can see that the dividend yield is near its highest point relative to the past 10 years. Therefore, it could be a good time to buy now if my priority is a better-than-average return through dividends.
Overall, the dividend situation with GPS is below average. First of all, the dividend yield is not consistently growing, and share buybacks have not been executed during optimal times. The good points are that the dividend yield is at a high when compared to the past. In addition, Gap’s payout ratio is sustainable and has more room to grow.
This analysis wouldn’t be complete without considering the value of the company versus share price.
Value Vs. Price
For valuation purposes, I will be using a diluted EPS of 2.14. I’ve used various past averages of growth rates and P/E ratios to calculate different scenarios of valuation ranges, from low to average values. The valuations compare growth rates of EPS, Book Value and Total Equity.
In the table below, you can see the different scenarios, and in the chart, you will see vertical valuation lines that correspond to the table valuation ranges. The dots on the lines represent the current stock price. If the dot is towards the bottom of the valuation range, this would indicate that the stock is undervalued. If the dot is near the top of the valuation line, this would show an overvalued stock.
According to this valuation analysis, GPS is overpriced in multiple categories.
- If GPS continues with a growth average similar to its past 10 years' or past 5 years' earnings growth, then the stock is overpriced at this time.
- If GPS continues with a growth average similar to its past 10 years' book value growth, past 5 years' book value growth and past 5 years' equity growth, then the stock is overpriced.
- According to GPS’s typical P/E ratio relation to the S&P 500's P/E ratio, GPS is undervalued.
- If GPS continues with a growth average as forecasted by analysts, then the stock is overpriced.
This analysis shows an average valuation of around $25-26 per share (or $27.59, if using the EPS TTM of 2.28).
According to the facts, GPS is financially healthy in a long-term sense in having enough equity as compared with debt, and in the short term by having enough cash to cover current liabilities. Gross margins are satisfactory and mostly stable. Its dividend situation is not ideal, since it doesn’t provide a consistently growing dividend yield for investors, and the stock is overpriced in all but one category according to the provided valuation analysis. Gap’s inconsistent earnings and the erratic and cyclical booms and busts of the retail industry make the company more difficult to analyze and value. Another concern is that returns on equity and invested capital have fallen significantly over the past 5 years.
“Over the next five years, the analysts that follow this company are expecting it to grow earnings at an average annual rate of 9%. This year, analysts are forecasting earnings increase of 21.17% over last year. Analysts expect earnings growth next year of 5.21% over this year's forecasted earnings.” (Source: Gap Forecast Earnings Growth)
If you invest today, with analysts’ forecasts, you might expect at best about 9% growth per year. Plus, we’ll add the current 3.55% forward dividend. This brings the annual return to around 12.55%, and this is probably a best-case scenario.
Here is an alternative scenario based on Gap’s past growth. During the past 10- and 5-year periods, the average EPS growth rate was about 4% and -4%, respectively. Plus, the average 5-year dividend yield was about 2.98%. So, we’re at a total return of 6.98% to -1.02%. Therefore, our annual return could likely be much less than 12.55% on certain years but rarely higher than 12.55% on other years as the company goes through cyclical boom and bust periods. This is because of the inconsistent earnings pattern of GPS, which makes it difficult to expect a certain earnings growth.
If considering actual past results of GPS, which includes affected share prices, and long-term dividend yields, the story is a bit different. Here are the actual 10- and 5-year return results.
10-Year Return Results if Invested in GPS:
Initial Investment Date: 11/4/2008
End Date: 11/4/2018
Cost per Share: $13.03
End Date Price: $27.91
Total Dividends Received: $6.846
Total Return: 166.74%
Compound Annualized Growth Rate: 10%
5-Year Return Results if Invested in GPS:
Initial Investment Date: 11/4/2013
End Date: 11/4/2018
Cost per Share: $37.23
End Date Price: $27.91
Total Dividends Received: $4.569
Total Return: -12.76%
Compound Annualized Growth Rate: -3%
From these scenarios, we have produced results from -3% to 10%. I feel that if you’re a long-term patient investor and believer in Gap, willing to sweat through the erratic booms and busts of the cyclical retail industry, you could expect Gap to provide you with around a 10% annual return if you wait for the right time to sell. But, for the short-term swing trader or impatient investor, Gap’s inconsistent earnings and the possibilities of low or even negative returns might not be worth the risk.
As a comparison, the S&P 500’s average return from 1928 to 2014 is about 10%. So, in a best-case scenario with GPS, you could expect to have similar results as an S&P 500 index fund. But in a worst-case scenario, you’re more likely to have a worse return than the S&P 500 index fund, and you could possibly be at a loss.
For me, the choice is certain. I would take an objective look at this company and realize that my money could be better invested in a more consistent company and likely a more consistent industry at this time.
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