Dividend Watch: Gap Capital Return Growth Plan Looks Interrupted Ahead (GPS)

Last night came the news bomb that many analysts should have seen coming but were blindsided by the severity of the news.  Gap Inc. (NYSE: GPS) gave an earnings forecast that was much worse than Wall Street expected, mostly due to higher costs of goods. Gap now sees earnings between $1.40 and $1.50 per share for the year versus prior guidance of about $1.90 at the mid-point.  Sales were even down 1%.

One thing we cannot help but wonder about is the new higher dividend.  In April came the first higher payout of $0.1125 per quarter after a year of $0.10 per quarter dividends.  For the two-year period before then, the quarterly payout was $0.085 per quarter and $0.08 per quarter for the two years even before then.

Even with the new guidance, Gap’s  still offers more than ample dividend coverage for an annualized $0.45 payout to shareholders.  That is the good news.  The bad news is that we had ambitions for Gap to be a real and significant dividend grower ahead as part of its capital return strategy.  Many retail and apparel companies operate on low margins and they can’t afford to have massive dividends.  Gap is one of the post-growth retail apparel stocks that 24/7 Wall St. was expecting to be very aggressive in its return of capital to shareholders.

Here are the facts.  Gap said that it repurchased about 25 million shares for some $548 million in the first quarter alone.  Unfortunately, buying back stock is not the same as having a higher dividend by our take.  Also in the quarter the company raised some $1.65 billion of debt. The lower guidance is due mostly to rising materials costs, but the company also had a 9% inventory growth from a year earlier.

The back-side to the bad news is that, unless Gap sandbagged earnings so badly just so they could meet estimates, Gap is not going to be the aggressive dividend payer ahead that we were hoping for.  The balance sheet is still clean and liquidity is there to support a higher payout.  Unfortunately, Gap is still caught in the maturity phase of its own business cycle and is closer and closer to be even being post-reorganization and post-turnaround.

The result is that Gap is going to have become much more aggressive when it comes to returning capital to shareholders.  It can still grow its dividend from today’s level, but this new much lower guidance probably just took away a rapid acceleration in its return of capital to holders.

Gap ended its first quarter with a cash of about $2.5 billion.  We’d rather see the company focus on a real return of capital via dividends. In theory, Gap would have known for much of or at least part of the quarter that the pricing pressure and inventory building was a factor.  That $548 million for 25 million shares comes to a weighted average price of roughly $21.92 per share.  Gap closed at $23.29 before earnings, and now shares are down 17% at $19.29.

Gap trades almost 8 million shares a day, so out of roughly 70 business days in any given quarter it bought down roughly three day’s worth of volume.  Imagine if Gap had used that cash even for a one-time dividend after its earnings.  Gap is continuing to increase its return of capital, but we still expect to see more down the road.  Even after a restructuring is complete it is not as if you are going to suddenly see an explosion in its store count.

The growth days are over, so now the company has to tend to a rapid and continuously sustainable return of capital to its shareholders.  This new lower guidance is going to probably crimp Gap’s ability to do that for a while.  Gap’s new dividend rate for buyers today is now 2.3% because of the 17%-plus drop in the shares. That is a high dividend among peers, but we were expecting Gap to become the dividend leader.  That can still occur.  Our anticipation of that is now probably not until well into 2012 in a static environment.

JON C. OGG