Should This High-Yielding Retail Play Be on Your Radar?

If retail is dead, nobody told Gap Inc. (NYSE: GPS). In the recently reported third quarter, shares of the clothing retailer outperformed analyst expectations on the top and bottom lines by reporting adjusted earnings per share of $0.58 and revenue of $3.84 billion.

In the heavily watched same-store sales metric, Gap posted 3% growth versus 1% expectations. This makes the fourth straight quarter of same-store sales increases. Gap stock has enjoyed a strong run on the back of this turnaround -- year to date, shares have advanced by 32%, nearly double the S&P 500.

Should this high-yielding, cheaply valued retailer be on your shopping list?

Consumers want value over luxury

It's always a good idea for investors to follow Gap's results to get a feel on consumer behavior and income-segmentation effects. And that's because Gap is the embodiment of the "good, better, best" sales model with distinct brands for each price point: Old Navy, Gap, and Banana Republic, respectively.

While the company grew same-store sales 3%, sales growth was uneven throughout the brand lines. Old Navy, the value-oriented brand, increased same-store sales 4% on the back of higher traffic and conversion. On the opposite end of the spectrum, Banana Republic, the company's luxury line, experienced negative comps of 1%; the eponymous middle line, Gap, posted 1% growth. The results show that the retail consumer continues to emphasize value over luxury, even as the economy continues to improve.

However, Gap should get credit for improving its metrics on the Gap and Banana Republic lines. As a comparison, last year, same-store sales fell 4% and 6% for those segments, respectively. Old Navy matched last-year's growth rate of 4%. Continued improvement in the higher-cost lines should eventually show up on the company's income statement, as will growth in the company's Athleta line that CEO Arthur Peck, in the quarterly conference call, said was "on fire."

Value and yield investors should put Gap on their watch lists

Because investor perception of the death of retail is keeping share prices depressed, many retailers are now high-yield value plays. Gap is no different: Even with recent stock run, shares are more than 30% cheaper than the S&P 500 on a forward price-to-earnings basis. Currently, shares of Gap have a dividend yield of 3.2% versus the 2% S&P 500 yield.

Gap has no problem servicing the dividend. Over the last 12 months the company has produced $915 million in free cash flow (operating income minus capital expenditure) while paying out $364 million in dividends, a reasonable payout rate of 40%. The company also continued to buy back shares, another form of cash return to shareholders, at a rate of $100 million per quarter.

Of course, being cheap and having a high dividend yield isn't a substitute for a strong-performing company. That said, it appears Gap's run is being partially supported by the financials. On the last conference call, Peck once again raised the company's 2017 full-year guidance, the second time in the past two quarters. Now Gap expects adjusted EPS to come in $2.10 at the midpoint, a 5% increase from the guidance issued at the beginning of the year. A high yield, cheap valuation, and improving business warrant a closer look from income-oriented value investors.

10 stocks we like better than GapWhen investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and Gap wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of November 6, 2017

Jamal Carnette, CFA has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.