With a Little Belt-Tightening, Gap Should Put Cash in Investors' Pockets

Clothing companies have been among the hardest-hit retail stocks in the past few years, and Gap Inc. is no exception. Share of the retailer have declined 29% so far this year, completely missing the broader S&P 500 Index rally. It's no wonder. Intense competition among apparel makers and brands has been exacerbated by the entrance of e-commerce retailers, who can offer consumers new styles and greater convenience than brick-and-mortar operators such as the Gap. Yet, at the same time, the Gap remains profitable, and the stock appears to be significantly undervalued. In addition, the stock offers a high dividend yield of 5.3%, making it very attractive for income investors. For investors willing to take the risk, The Gap could generate high returns if its turnaround succeeds. A Tale of Two Clothing Brands The Gap is an American clothing and accessories retailer with a presence worldwide. The company has a market capitalization above $6 billion. The Gap operates 6 individual brands: Gap, Banana Republic, Old Navy, Intermix, Hill City, and Athleta. In a nutshell, The Gap is two retailers: Old Navy, and everything else. While no individual brand is performing particularly well for The Gap, its Old Navy brand remains its strongest performer by a wide margin. This disparity was on full display in 2018, as Gap Global comparable sales -- which measures performance at stores open at least one year -- fell 5%, while Old Navy sales increased 3%. In the fiscal year 2018, the company generated net sales of $16.6 billion,which represents growth of 4.6% over the previous year, thanks largely to Old Navy. In 2017, Gap Global sales declined 1% while Old Navy sales increased 6%. This trend has continued in 2019. In the most recent quarter, The Gap reported first-quarter earnings of 60 cents per share, which included a one-off gain from a building sale. Adjusted earnings were 24 cents. Comparable store sales fell 4%, while inventory increased 10%. Not surprisingly, Gap Global served as an anchor on the overall company, posting a comparable-sales decline of 10%. Because of the Gap brand, the company's 4% comparable sales decline badly missed the analyst consensus estimate of a milder 1.5% decline. This explains the extremely poor performance of Gap shares over the past year. Fortunately, management has a plan to get back on track. It involves slimming down its operations by closing under-performing stores that have used excess resources and cannabilized performance. A total of 230 Gap stores at slated to close over the next two years, with a net closure of approximately 30 stores for 2019. In addition, management expects to create shareholder value by spinning off Old Navy in 2020. This will provide Old Navy the opportunity to flourish as an independent company with its own dedicated management team, while the remaining company can focus on Gap and its other collection of brands. The various challenges facing The Gap have weighed on margins, and this is expected to continue over the following year. First quarter gross profit margin this year was 36.3% as compared to 37.7% in the first quarter of 2018, while adjusted operating profit margin declined to 3.5% from 6%. As a result of rising operating costs associated with the store closures and initiatives to revitalize the portfolio of brands, operating costs will likely increase, resulting in lowered profit expectations. But these costs should be temporary until the store closures and brand revitalizing initiatives are completed. The company should therefore remain profitable, with stable earnings-per-share. Earning per share will be boosted by the company's aggressive share repurchases. Management has announced plans to repurchase $200 million shares this fiscal year. At least stable EPS will allow the company to continue paying its hefty dividend to shareholders. The Gap: Discounted Stock on Sale The Gap's turnaround will proceed over the next few years. In the meantime, the Gap remains a profitable company with a high level of cash returns to shareholders. And, the stock is appealing for bargain hunters, thanks to its rock-bottom valuation. The company currently pays an annual dividend of 97 cents per share, representing a high dividend yield of 5.3%. Despite the company's challenged fundamentals, the dividend appears secure, as the Gap has a projected dividend payout ratio of 47% for this year. This is a distinct benefit of investing in a company that remains profitable, even if growth is slowing, as it can continue to return cash to shareholders. The Gap has been an impressive dividend growth stock for many years. It has increased its dividend payout since 1989, and has a 10-year dividend growth rate of 15.1%. Dividend growth has unsurprisingly slowed in recent years, but with a high yield of 5.3%, the Gap remains a highly attractive stock for income investors. The stock is valued at just 9 times its 2019 EPS forecast. This is a fairly low multiple for a profitable company. Even if Gap stock fails to see its valuation multiple expand, the stock could generate satisfactory returns to shareholders through EPS growth and dividends. I expect 5% annual EPS growth over the next five years, due largely to margin improvements and share repurchases. Combined with the 5.3% dividend yield, total annual returns could reach double-digits. The Gap is clearly not a growth story, but it doesn't have to be. All the stock needs to do is get expenses under control, close down stores that are losing money, and continue to buy back stock at the very low valuation. With the 5.3% dividend yield, the Gap is an attractive stock for value- and income-investors for those willing to take the risk of investing in the retail industry.

With a Little Belt-Tightening, Gap Should Put Cash in Investors' Pockets

While certainly no growth story, the Gap has a 5.3% dividend yield and is getting expenses under control to become an attractive stock for value- and income-investors.

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