Buy Gap Inc. (NYSE:GPS)

Target: $31

Buy Up To: $25

Option Trade: Buy to open the July 21, 2017 call on Gap Inc (GPS) with a strike price of $24 at $.45 or lower. Symbol (GPS170721C24)

Gap has navigated treacherous retail waters successfully. Despite the disappearance of mall traffic eroding sales at ts namesake Gap stores, the company has been able to generate profits every year, partly due to the strength in Old Navy stores.

Old Navy makes up almost half of Gap’s revenue and is responsible for most of its top and bottom line growth. With most of its stores non-mall based, Old Navy has escaped the drop in demand suffered by many mall-based competitors.

Comp sales for Old Navy, a measure of how sales at stores opened more than one year performed, are up for the third quarter in a row, confirmation that the company’s designers have product and price lined up well.

Gap’s product margins have been improving for the past year but in the first quarter of 2017 were close to the super high levels of years past and an indication of how high they might go when total sales recover.

The company generates tremendous amounts of cash and just paid down $400 million of debt that it borrowed in 2015. Improving profits and the repayment of this debt caused Moody’s to upgrade the outlook on Gap’s debt from negative to stable earlier this month.

More importantly, with profits lifting, Gap’s already solid cash flow should increase further. The stock has a free cash flow yield of almost 9%. This is an incredibly cheap valuation.

With fewer markdowns lifting profits, an upward trend in sales and a better grade from debt agencies, Gap may finally be making its way back to the shopping list of investors. My $31 target is based on a 15 P/E ratio applied to 2018 estimates of $2.05. Estimates expect little earnings growth for Gap, a conservative view.