It can be tempting to invest in a dividend stock for its ultra-high yield. But often, an excessive dividend yield is a sign that all is not well.
Elevated inflation and rising interest rates are changing consumer behavior. Retailers are either overloaded with inventory or have been forced to slash prices to clear out excess merchandise. A global recession is a real possibility, and retailers first and foremost need to make sure they're able to weather the storm.
In the case of The Gap(NYSE: GPS) and Kohl's(NYSE: KSS), getting through this downturn will almost certainly mean reducing or eliminating dividend payments. Both retailers are struggling as demand evaporates, and neither is in a financial situation to justify generous dividend payments to investors.
2022 was a tough year for apparel retailer The Gap. Comparable sales slumped 7% across all its brands, with the value-focused Old Navy brand doing the worst. Old Navy posted a 12% decline in comps; Gap brand suffered a 4% decline; Athleta booked a 5% decline; and Banana Republic broke the trend with a 9% increase. Unfortunately, Banana Republic accounts for just 14% of total sales.
Old Navy makes up more than half of total sales, but competition in the budget apparel category is fierce. Old Navy was heralded as Gap's savior just a few years ago, but now it's dragging down the company's results. Elevated inflation is likely part of the problem, as is tough competition from the likes of Target, Walmart, and Amazon.
Gap posted an adjusted loss in the fourth quarter of 2022 -- not what you want to see if you're a dividend investor. Its latest quarterly dividend of $0.15 per share works out to a forward yield of 6.2%, but the sustainability of that dividend is a concern. Sales are expected to be down by a low to mid-single-digit percentage in fiscal 2023.
Free cash flow was negative in fiscal 2022, and the company is actively searching for a new CEO. It seems probable that whatever turnaround plans are ultimately implemented will involve an elimination or reduction of the dividend. Gap simply can't afford it.
Gap could be a high-risk, high-reward turnaround stock for some investors. But for dividend investors, the struggling apparel retailer should be a hard pass.
Department store Kohl's is running into the same problems as Gap's Old Navy brand. Too much inventory forced aggressive markdowns and led to a depressed gross margin toward the end of 2022, and inflationary pressure is hurting demand.
Total sales were down 7.2% in the fourth quarter of 2022, and gross margin sank to just 23% as markdowns ravaged the bottom line. Kohl's posted a big loss for the quarter, although working capital improvements kept operating cash flow in positive territory. The company expects a 2% to 4% sales decline in fiscal 2023, along with an operating margin of just 4%.
Kohl's quarterly dividend of $0.50 per share is good for a dividend yield of 8.5%, but it represents a big use of cash that the company increasingly can't afford. Kohl's posted a free cash flow loss of $639 million in fiscal 2022. Meanwhile, the dividend consumed $239 million over that time.
Like Gap, Kohl's stock is a potential turnaround play. But investors shouldn't ignore the possibility that Kohl's could ultimately follow the path of now-defunct J.C. Penney. Kohl's is competing with discounters like Target and Walmart, both of which are likely better able to absorb inflationary pressure. Its balance sheet is also looking a little rough. Cash has dwindled and inventory is probably too high, given the demand environment.
Kohl's is focusing on expanding its in-store Sephora shops, simplifying pricing, reducing inventories, and paying down its debt. Inventory reduction can act as a one-off source of cash, which will help improve the balance sheet. But ultimately, Kohl's will need to be able to muddle through this tough period, and there's no guarantee it will make it to the other side.
Given the challenges facing Kohl's, a dividend cut seems like almost a foregone conclusion. Dividend investors excited about an ultra-high yield should think twice before investing in Kohl's stock.
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