Gap Inc. Just Became an Undervalued Dividend Play

Shares of Gap (NYSE: GPS) tumbled 15% on May 25, after the apparel retailer posted mixed first-quarter results. Its revenue rose 10% year over year to $3.78 billion, beating estimates by $180 million. Its comparable-store sales rose 1%, marking its sixth straight quarter of comps growth.

Gap's net income rose 15% to $164 million, or $0.42 per share, but that missed estimates by $0.04. For the full year, Gap anticipates flat to slightly positive comps growth with 20%-27% earnings growth. Those headline numbers seem decent, so the stock's drop to a year-to-date low seems to be a major overreaction.

I personally believe that Gap is an undervalued dividend play at these levels. Let's dig deeper into its first-quarter numbers to see why.

A mixed bag of comps

Gap's comps were a mixed bag during the first quarter. Its growth at Old Navy decelerated, its namesake brand remained under pressure, but its higher-end Banana Republic brand posted surprising growth.

During the conference call, Gap CEO Art Peck attributed Old Navy's slowdown to a "slight drag due to weather," but noted that the brand saw a "dramatic improvement in trends when the weather turned late in April," and that momentum continued "into the second quarter." Peck said that Old Navy saw "growth in nearly all categories," with denim products posting its "biggest quarter comp in the brand's history."

Peck admitted that Gap's namesake brand faced pressure from "the carryover of operational missteps" last year. Peck claims that Gap's weakness isn't caused by a weak reception for its products, but rather by operational challenges that it's trying to rectify.

As for Banana Republic, Peck attributes the brand's turnaround to the "development of cleaner, better edited assortments that have a clear brand appropriate point of view," as well as robust demand for its sweaters, bottoms, and dresses.

Gap might seem dangerously close to posting negative comps again, but we should recall two things: It expects comps growth this year, and the growth of its Athleta activewear brand could eventually offset any weakness in its three core brands.

Gap expected its margins to decline

Investors were also likely worried about Gap's margins. Its gross margin dipped 0.2 percentage points to 37.7% for the quarter, while its operating margin slipped 1.3 percentage points to 6.1%.

CFO Teri List-Stoll attributed those declines to the ongoing turnaround efforts at its namesake brand and "strategic decisions to aggressively clear inventory through sell-off." As a result, Gap's total merchandise inventory only rose 3.8% to $2.04 billion for the quarter.

List-Stoll noted that while those moves are weighing down Gap's margins, they set the company up "for cleaner stores," "better inventory positioning," and shorter lead times in the second quarter and the second half of 2018.

Why Gap looks like a great value play

Around $28 per share, Gap trades at less than 11 times this year's earnings, making it one of the cheapest American apparel retailers with comps growth. American Eagle Outfitters, which also has an impressive streak of comps growth, trades at 16 times this year's earnings. Guess?, which saved itself with strong sales in Europe and Asia, trades at 25 times this year's earnings.

Gap also pays a hefty forward dividend yield of 3.1%, which is higher than American Eagle's 2.5% yield but lower than Guess' 3.8% yield. Gap's combination of a low valuation and a market-beating yield should limit its downside potential.

How Gap can reach a better future

Gap's future depends on Peck's ability to fulfill his promises about plugging up Gap's operational inefficiencies, shortening lead times, maintaining tight inventories, and expanding higher-growth brands like Athleta.

Those problems won't be easily solved, but Peck's ability to fix Banana Republic -- which had been struggling for years -- bodes well for the future of its namesake brand. Therefore, I believe Gap has become an undervalued income play after its post-earnings drop.

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Leo Sun owns shares of American Eagle Outfitters. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.