Published by Bob Ciura on March 29th, 2017
Piggy-backing off of some of the world’s most well-known professional money managers is a good way for investors to find some new stock ideas.
Joel Greenblatt is the Managing Principal and Co-Chief Investment Officer of Gotham Asset Management, which manages approximately $15 billion.
Joel Greenblatt invests in several high-yield dividend stocks, many of which are also cheap value stocks.
For example, among the top 20 dividend stocks in Joel Greenblatt’s portfolio is The Gap, Inc. (GPS).
The Gap is a Dividend Achiever, a group of 271 stocks with 10+ years of consecutive dividend increases.
You can see the full Dividend Achievers List here.
Note: While The Gap is on the official Dividend Achievers list, it did not increase its dividend in 2016. It remains on the list (for reasons which are unclear), but it does not have 10+ consecutive years of dividend increases.
Times are tough for The Gap, but it could be a tempting turnaround play. And, it has a 4% dividend yield.
This article will discuss why The Gap stock could be attractive for dividend and value investors.
The Gap is a diversified clothing retailer, with a global footprint.
Source: Investor Relations
At the end of 2016, The Gap had 3,659 company-operated or franchised stores in 50 countries around the world.
It operates several brands, which include the following:
- The Gap (35% of annual revenue)
- Old Navy (44% of annual revenue)
- Banana Republic (16% of annual revenue)
- Other (5% of annual revenue)
The ‘Other’ category includes Piperlime, Athleta, and Intermix.
The Gap is also geographically diversified, although the majority of the company’s sales come from the U.S.
It operates in the following markets:
- U.S., Puerto Rico, and Guam (77% of annual revenue)
- Canada (7% of annual revenue)
- Europe (5% of annual revenue)
- Asia (10% of annual revenue)
- Other Regions (1% of annual revenue)
This is a challenging period for The Gap. Its sales and profit margins have deteriorated in recent years, due to intensifying pressure from online retail.
This has caused The Gap’s earnings-per-share growth to dramatically decline over the past several years.
The main cause of The Gap’s problems stem from the boom in e-commerce, which caught the company flat-footed.
Internet retailers like Amazon.com (AMZN) and others pose a huge threat to traditional brick-and-mortar retailers.
In many cases, Amazon can offer consumers the convenience of shopping and delivery at home, often for lower prices than can be found at physical stores.
The Gap is trying to catch up, although its major restructuring comes at a considerable cost.
The company expects comparable sales to increase slightly in 2017, but earnings-per-share are expected to decline in the high-single digit percentage range.
This has presented a major challenge that The Gap will have to overcome moving forward, if it is to restore positive earnings growth.
2016 was a very challenging year for The Gap. Total sales declined 1.8%, due to a 2% decline in comparable sales, which measures performance at stores open at least one year.
Earnings-per-share declined 24%, marking the second consecutive year of at least a 20% decline in earnings-per-share.
The biggest cause of last year’s decline in earnings-per-share was The Gap’s announcement that it would close 65 company-operated stores.
The store closures negatively impacted full-year earnings by $0.41 per share.
In addition, The Gap’s earnings-per-share were hit by a goodwill impairment charge for Intermix, of $0.18 per share.
The good news, if there is any, is that these store closures may help strengthen the company’s financial performance going forward.
By closing some stores and reducing its physical store footprint, the company hopes to become more streamlined and efficient, with a lower cost structure.
And, the deterioration of the company’s financial performance is beginning to moderate. Last year’s 2% decline in comparable sales was half the level of decline from 2015.
Competitive Advantages & Recession Performance
One reason why Internet retailers like Amazon have been able to take market share from The Gap and other brick-and-mortar companies, is because retail does not offer many competitive advantages.
Barriers to entry are low. And Amazon’s massive success has shown that, when it comes to clothing, consumers tend to value convenience and low prices more than brand loyalty.
That said, The Gap does enjoy strong margins. Despite the declines in sales, the company remained highly profitable last year.
And, The Gap still generates significant free cash flow, even though earnings-per-share are declining.
With the exception of 2015, The Gap generates free cash flow of at least $1 billion per year.
This helps The Gap stay profitable, even during recessions. Its earnings-per-share during the Great Recession are shown below:
- 2007 earnings-per-share of $1.09
- 2008 earnings-per-share of $1.34
- 2009 earnings-per-share of $1.58
- 2010 earnings-per-share of $1.88
The Gap’s consistent profitability and high free cash flow, even during recessions, gives it the financial flexibility to continue investing in its future growth strategies.
Valuation & Expected Total Returns
The Gap stock trades for a price-to-earnings ratio of 11.8, based on 2016 adjusted earnings-per-share.
It is a very cheap stock. The S&P 500 Index trades for an average price-to-earnings ratio of 26.
In light of the brutal operating environment for clothing retailers, it is difficult to see how The Gap stock would earn a higher valuation multiple.
The best way for The Gap to see its price-to-earnings ratio expand, would be for the company to return to earnings growth.
However, this is unlikely, at least for 2017.
That said, one catalyst The Gap still has working in its favor is its balance sheet.
Its assets include $1.8 billion of cash and equivalents, compared with just $1.2 billion of long-term debt.
In addition, The Gap has $2.6 billion of real estate value on the balance sheet. This could open up some opportunities for the company.
The Gap owns 3,200 of its stores, the vast majority of its total store count. It could pursue real estate sales, or possibly lease-back transactions, to monetize its vast real estate holdings.
It could then re-invest the proceeds into growth ventures, such as strengthening its mobile platform.
This could generate a higher valuation multiple for the stock.
Aside from expansion of the price-to-earnings multiple, The Gap’s future returns will be comprised of earnings growth and dividends:
- 1%-3% growth in comparable sales
- 1% earnings growth from share repurchases
- 4% dividend yield
Thanks in large part to its high dividend yield, The Gap could generate 6%-8% annualized returns, even with very low earnings growth projections.
This is a very challenging period for retailers. Many retailers are posting big sales declines, which has resulted in store closures across the industry.
However, not all retailers are struggling–some are even thriving, and raising their dividends by 20%+.
The Gap is a classic turnaround stock. It has a strong brand in its industry, but in retail, things can change quickly.
There are glimmers of hope starting to appear for The Gap, and the company’s earnings-per-share could grow once again, once its restructuring period is over.
Investors are being paid well to wait—The Gap has a hefty 4% yield, and the company generates more than enough cash flow to support the dividend.