Shares of Gap (GPS -0.80%) rallied 5% after the apparel retailer posted its third-quarter earnings on Nov. 21. Its revenue rose 7% year-over-year to $4.1 billion, beating estimates by $100 million but marking its slowest growth in four quarters. Excluding the presentation changes from the ASC 606 accounting standard (which was adopted in the first quarter), Gap's revenue rose just 2%.
However, Gap's comparable-store sales stayed flat year over year. Its comps rose 4% at Old Navy and 2% at Banana Republic, but its midrange namesake brand -- which was a laggard over the past year -- posted a 7% decline.
Image source: Getty Images.
On the bottom line, Gap's net income rose 16% year-over-year to $266 million, as it focused on cutting costs. Its diluted earnings per share, buoyed by $100 million in buybacks, rose 19% to $0.69 and beat estimates by 2 cents. For the full year, Gap expects its comps to be "flat to up slightly" and for its EPS to rise 20% to 22%.
Gap's report seems lackluster, but its stock looks cheap at 10 times this year's earnings and pays a decent forward yield of 3.8%. Should investors see Gap as an undervalued income play, or should they stick with other dividend stocks instead?
Understanding Gap's problems
Gap's three core brands serve different markets. Old Navy caters to the low-end market and competes against fast-fashion retailers like H&M, Gap targets the midrange market and competes against mall-based rivals like American Eagle Outfitters (AEO -0.13%), and Banana Republic targets the higher-end market.
Unfortunately, the midrange market is disappearing as customers shift to either fast-fashion retailers or higher-end ones. Sluggish mall traffic and the crowded state of the midrange apparel market -- which has already crushed weaker players like Aeropostale and American Apparel -- exacerbate the pain.
That's why Gap's namesake brand has been stuck in a decline over the past year. That's troubling because it coincides with decelerating comps growth at Old Navy and stagnant growth at Banana Republic.
|
Q4 2017 |
Q1 2018 |
Q2 2018 |
Q3 2018 |
|
|---|---|---|---|---|
|
Old Navy |
9% |
3% |
5% |
4% |
|
Gap |
0% |
(4%) |
(5%) |
(7%) |
|
Banana Republic |
1% |
3% |
2% |
2% |
|
Total |
5% |
1% |
2% |
0% |
Source: Quarterly reports.
During the conference call, CEO Art Peck stated that he was disappointed with Gap's performance. Peck attributed the weakness to the impact of "operational missteps" from the previous year (which resulted in an unbalanced ratio of tops to bottoms) and weak specialty and flagship stores, which were a drag on the brand's health and performance.
Image source: Getty Images.
Peck stated that the company would evaluate "the bottom half" of Gap's 775 specialty stores, which generate half of the brand's revenue, and aggressively close hundreds of those locations to shift more of its sales online and into outlet stores. He noted that 20% of Gap's sales came from online platforms during the quarter, and 30% came from outlet stores -- and that both channels were faring better than its mall-based specialty stores. Peck expects the store closures to contribute $100 million to its earnings over the long term.
Better earnings and a reliable dividend
This indicates that Gap's overall comps and revenue growth will remain soft, but its margins and earnings could improve as it streamlines its business. That bodes well for Gap's annual dividend of $0.97 per share, which would account for less than 40% of its projected earnings for the year. Gap's 3.8% yield is also considerably higher than many of its industry peers -- American Eagle Outfitters (AEO), for example, pays a forward yield of only 2.7%.
However, Gap doesn't raise its dividend every year. Before the dividend hike this year, Gap's payout had remained unchanged for three years. Applying its cash flow toward turning around its namesake brand will also likely take precedence over future dividend hikes.
Investors should also note that the aforementioned ASC 606 shift inflated Gap's gross margins. On that basis, its gross margin stayed flat year over year at 39.7%. But if we exclude that shift, it actually declined 160 basis points due to declining merchandise margins, a result of higher shipping costs and promotional activity at Gap. AEO's gross margins, by comparison, consistently expanded in recent quarters.
The bottom line
Gap's dividend looks reliable and the stock looks cheap, but I'm concerned about its revenue growth, which could decelerate significantly as it closes weaker Gap stores and Old Navy's growth slows down. Therefore, I'd stick with more dependable dividend stocks until Gap gets its act together.
