(Published by Bob Ciura on March 29)
Piggybacking off 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 (Trades, Portfolio) is the managing principal and co-chief investment officer of Gotham Asset Management, which manages approximately $15 billion.
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 Greenblatt’s portfolio is the Gap Inc. (GPS, Financial).
The Gap is a Dividend Achiever, a group of 271 stocks with 10-plus 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-plus 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.
Business overview
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, Financial) 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.
Growth prospects
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 41 cents per share.
In addition, the Gap’s earnings per share were hit by a goodwill impairment charge for Intermix, of 18 cents 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 and 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 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 and expected total returns
The Gap stock trades for a price-earnings (P/E) ratio of 11.8, based on 2016 adjusted earnings per share.
It is a very cheap stock. The Standard & Poor's 500 Index trades for an average P/E 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 P/E 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 reinvest 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 P/E multiple, the Gap’s future returns will be comprised of earnings growth and dividends:
- 1% to 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% to 8% annualized returns, even with very low earnings growth projections.
Final thoughts
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 –Â 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.
Disclosure: I am not long any of the stocks mentioned in this article.
Start a free seven-day trial of Premium Membership to GuruFocus.
