This Stock Is One Of Its Industry's Cheapest -- And Most Generous

Marshall Hargrave
January 23, 2014

In the notoriously fickle apparel industry, trends can change quickly. For investors who are looking for exposure to the sector, it's best to be diversified.

The Gap Inc. (NYSE: GPS) is one of the best diversified apparel retailers in the market. In addition to its three core brands (Gap, Banana Republic and Old Navy), it has a popular women's athletic brand, Athleta, that's been going head to head with Lululemon (Nasdaq: LULU) and winning market share. With its brand portfolio, Gap has a unique ability to target low-end and high-end shoppers alike. 

Gap got very aggressive with its promotions in December, including offering discounts of up to 50% off for most of the month. This should have helped drive more traffic to Gap's stores as consumers flocked to deals and focused on discount brands. 

What's more is that Gap recently posted December same-store sales that were flat, but sales for the holiday season were up 2% year over year. In its most recent quarter, Gap posted earnings per share (EPS) of $0.72, up from $0.63 in the year-earlier period. 

Back From The Brink
Do you remember how Gap struggled in the latter part of the past decade? It may seem unlikely now, but Gap had declining same-store sales every year from 2005 to 2010. 

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Then, in 2011, the retailer started to turn things around. Gap focused on improving its brand assortments and styles, improved brand marketing and eliminated underperforming stores. The strategy paid off, and Gap posted same-store sales growth of 5% in its 2013 fiscal year.

  Gap has focused on improving its brand assortments and styles, brand marketing and eliminating underperforming stores.  

To keep up this trend, Gap continues to increase traffic to its stores and online sites. The retailer has been boosting its online business and working to expand its global footprint. By the end of this year, Gap hopes sales from overseas stores and its online sales will account for 30% of total sales, which would be an increase of 3% over last year.

With its ability to generate strong free cash flow, Gap can reward investors in a number of ways beyond EPS growth -- and one of the most overlooked aspects of Gap is its potential for "Total Yield.

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Simply put, "Total Yield" stocks are companies that use the cash they generate to pay steady dividends, buy back large amounts of their own stock, and pay down debt. Our research shows that companies that execute on all these fronts outperform the S&P 500 -- and regular dividend investing -- by a wide margin.

Reaping The Rewards 
Since 2004, Gap has returned more than $14 billion to shareholders through dividends and buybacks. In the first nine months of last year, Gap paid out $232 million in dividends and spent $875 million buying back shares. As a result, its return on equity is over 40%, the highest it has been over the past decade. Gap has also kept its balance sheet in a very manageable position, with a debt-to-equity ratio of 40%. 

Gap's forward dividend yield is 2.1% amounts to a payout of less than 25% of earnings. That payout ratio remains low even after Gap increased its dividend payment 900% since 2004, to the current $0.20 a share. 

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It's also worth mentioning that Gap has buy-in from several high-profile investors. The largest shareholders remain the founding Fisher family with a 38% stake in the company, but after them are Steve Mandel's Lone Pine Capital and John Griffin's Blue Ridge Capital with stakes of 5% and 1.4%, respectively.

Risks to Consider: The retail sector is extremely competitive, and shoppers' tastes can change in an instant. Failure by Gap to stay on top of current trends could lead to a loss in sales and customers. However, Gap has been in business since 1969 and has shown that it can adapt to a changing market environment.

Action to Take --> Buy Gap with 15% upside to $44. That's just under 16 times forward earnings and is still well below peers such as American Eagle (NYSE: AEO) and Urban Outfitters (Nasdaq: URBN). Not only is GAP one of the cheapest stocks in the industry, it also has one of the highest dividend yields.

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