Hailing with more than 3,700 stores and 141,000 employees, Gap (GPS) is one of the country’s most well-known retailers. The company runs its namesake Gap stores, along with Old Navy and Banana Republic shops across the world.
GPS stock weathered the financial crisis extremely well; unlike many other retailers, the company never faced a solvency crisis and shares quickly regained their value. As the economy recovered, GPS stock surged, moving into the $40s and offering a big win for anyone who had bought during the previous decade.
However, the company’s lack of growth has come home to roost in recent quarters, and the stock has gotten cut in half. Following not so bad earnings last month, GPS stock stabilized. Is now the time to buy into a nascent turnaround?
GPS Stock: Pros
Looks Cheap: Gap currently sports an 9.5 P/E ratio. Over the past 15 years, it has never exited a year with a P/E ratio much lower; at even the end of 2008 in the height of the financial crisis, it traded at a P/E in the 8s. GPS stock has a 9.4 forward P/E, indicating that earnings are expected to decline a bit in 2016 compared to last year. Still, a 9.4 forward P/E isn’t exactly expensive.
If the company can slow the decline in sales and stabilize its brands by the end of the year at a level of earnings near to where things stand now, the stock is very cheap. The market is pricing in sizable additional declines in sales and revenues. If those fears are mistaken, Gap stock should have a big rally ahead.
Big Dividend: For all of Gap stock’s recent troubles, no one would accuse it of mistreating shareholders. It aggressively buys back its own stock and also pays a large dividend. That dividend has, as expressed in yield, grown even larger as GPS stock slides. The company yields 4.8% at the current price.
Over the past five years, Gap stock has grown its dividend by 20% a year. The company prioritizes giving shareholders a large stake in the firm’s profits. Again, if the company can stabilize operations, you’re looking at an attractive yield going forward. Given 2015 earnings levels, the dividend is still safe. It’d take a significant decline in profitability from current levels before the company would likely cut the dividend.
General Retail Concerns Overdone: The past 12 months have featured a mega-trend. It’s been to buy Amazon (AMZN) and sell all other retailers. Since the great divergence began in the middle of 2015, Amazon is up more than 60%, while the SPDR S&P Retail ETF (XRT) is down 15%. The market has become quite preoccupied with the idea of Amazon aggressively taking share from the brick and mortar retailers. This is a valid concern, but I see no reason to think 2016 was a tipping point for the trend.
This earnings season started with further progression of the trend, as several mall retailers put up big earnings misses. GPS stock plunged in sympathy with its peers, well before Gap’s own earnings came out.
Retailers kept plunging until sector big dog Wal-Mart (WMT) put in solid earnings last month. Walmart stock jumped an eye-popping 10% on earnings day, and the retail sector finally let out a collective sigh of relief and put in a meaningful bounce. To the extent that Gap stock has fallen as part of the collective Amazon fears, that could be reversed in coming months as the brick and mortar retailers come back into favor with investors.
Gap Stock: Cons
10 Years Of No Growth: For the full-year 2005, Gap sold a total of $16.0 billion of products. For full-year 2015, the company’s sales were $15.8 billion. Over the past 10 years, the company’s total sales have actually declined. Considering that inflation alone ought to raise sales figures, it’s an ominous sign. Similarly, the company’s net income is down 20% from its average during the pre-financial crisis years. This is a company that has lost ground overall. When you see Gap’s positive growth in EPS, know that it’s coming because they are aggressively buying back stock. It’s not from improving results.
Over the past two years, things have gone from flat to negative. Net income fell from $1.3 billion in 2013 to $1.2 billion in 2014 and just $920 million last year. Revenues were down 5% over the last year as well. With the upcoming closure of 75 stores, the return of growth isn’t right around the corner.
All Brands Struggling: The Gap runs three different large brands. Generally, in the past, the company has been able to keep one or two of them working at any given time. Even if one brand was really weak, generally at least one would be strong and keep the overall numbers in a decent position. That has not been the case for the past year, however. Using the April 2016 figures, we find Gap was down 4%, Banana Republic was down 7%, and Old Navy was down 10%.
Through last summer, Old Navy was still showing positive comparable sales, while Banana Republic and Gap saw sales consistently decline. However, September 2015 would be Old Navy’s last month of sales growth, and since then, all three have put up negative comparable sales each and every month. This is more than a soft spot; the company has lost its way in terms of managing inventory and meeting customer desires.
Flimsy Balance Sheet: Despite the lack of any growth in The Gap’s business over the years, it has generally not been a bad idea to own GPS stock. That’s because Gap’s management has an ultra-aggressive capital return policy. In addition to paying a sizable dividend, The Gap managed to pull off a rather remarkable feat. Since 2005, the company has bought back more than 50% of its outstanding shares, dropping the share count from 900 million to around 400 million today.
Given the lack of any sort of net income growth, it’s a fair question how the company could afford both a strong dividend and to buy back more than half the company’s outstanding shares. The answer is that it weakened its balance sheet. The company’s cash position after the 2015 holiday season was just $1.4 billion, its lowest since 2002. The company typically carried almost $2 billion in cash on its balance sheet coming out of the holiday season to accommodate the softer non-holiday quarters and maintain an investment grade credit rating. Now it’s letting its cash pile diminish, and it’s also increased its debt position to $1.3 billion. As recently as 2009, the company carried no long-term debt whatsoever.
Gap Stock: Verdict
The Gap is the classic sort of stock the causes debates among conservative investors. GPS stock looks very cheap, and the dividend is nice. But if earnings keep falling, Gap stock will get cheaper and the dividend harder to support. If The Gap’s current trajectory continues, the stock is a value trap and will keep falling.
On the other hand, if sales stabilize, Gap stock would be cheap at the current price. As for me, I want to see sales stabilize, and I’m willing to wait a quarter or two for it. You can buy the stock here, it’s not a bad play necessarily, but it’ll be much safer once the brands show any positive signs of reconnecting with consumers.
At the time of this writing, Ian Bezek owned shares of Wal-Mart. He had no position in The Gap. You can reach him on Twitter at @irbezek.
