Gap - Despite Short-Term Struggles, There Is Long-Term Appeal Based On A Sound Strategy

May.25.14 | About: The Gap, (GPS)


Gap struggled in the first quarter due to poor weather conditions.

Old Navy, Omni-Channel and foreign operations are running fine.

Yet traditional Gap stores are the main problem for now.

A solid long-term strategy makes shares appealing on dips.

Gap (NYSE:GPS) reported its first quarter results on Thursday after the market's close.

While results were not great, investors were prepared for a disappointment given the difficult environment for retailers in the first quarter. It came as a relief for the investment community that the company re-affirmed its full year outlook. Investors were furthermore relieved by improvements in sales in April.

First Quarter Headlines

Gap reported a 1% increase in first quarter sales which came in at $3.77 billion.

Reported earnings fell by 21.9% to $260 million. As a result of sizable share repurchases, the fall in earnings per share was limited. Despite share repurchases, earnings per share were down by 18.3% to $0.58 per diluted share.

Looking Into The Operations

CEO Glenn Murphy recognized that the company has been off to a slow start of the year. Gap witnessed a very difficult start to the first quarter, while trends improved towards the end of the quarter and in recent weeks.

Gap continues to focus on key future growth areas like the omni-channel business, global growth and a better responsive logistical system. The company opened 6 new Athleta stores, as it is still on track to operate 100 Athleta stores by the end of the year. The new chain is competing with the likes of Lululemon (LULU) in the growth market for yoga clothing.

Online sales were up by 13% to $575 million, making up a substantial part of total sales. Despite strong e-commerce sales, Gap reported a 1% drop in comparable store sales. Slow sales were the result of a poor performance of the Gap brand which reported a 5% drop in comparable sales. Banana Republic's comparable sales fell by one percent while Old Navy comparable sales were up by a percent.

As a result of sluggish revenue growth and initiatives to overcome this, operating margins were under pressure. Margins fell by 250 basis points to 11.7% of sales. While the reported drop in earnings per share appears dramatic, note that last year's earnings included a $0.04 benefit from a tax resolution.

Valuing Gap

Gap ended the quarter with $1.54 billion in cash and equivalents. Total debt stands at $1.39 billion which results in a very modest net cash position of around $150 million. The company has nearly $1.1 billion in lease incentives and other long-term obligations on its balance sheet.

Noteworthy, inventories significantly outpaced revenue growth increasing by 10.8% to $1.91 billion. This is a slight worry and could imply that gross margins might remain under pressure in the short run as the company is trying to reduce inventories.

At $41 per share, Gap is valued at $18.2 billion. This values equity in the firm at roughly 1.1 times annual revenues of $16.1 billion as reported over the past year. Based on the company's earnings outlook of $2.90-$2.95 per share for the coming year, equity is valued at 14 times annual earnings.

Gap's current quarterly dividend of $0.22 per share provides investors with a 2.2% dividend yield.

Store Update

At the moment, Gap operates 3,565 stores of which roughly 10% are franchise stores. The company has a modest presence in Asia and Europe with 231 and 190 stores, respectively.

The main focus of course remains on North America where the company operates 966 Gap stores, 1,005 Old Navy stores and 598 Banana Republic outlet stores.

This year's expansion will mainly focus on foreign markets. Store openings are targeted in China while outlet stores will be opened in the rest of the world. US store openings are highly focused towards Athleta stores, offset by store closures of underperforming Gap stores.

Takeaway For Investors

As outlined in a recent investor presentation, Gap aims to be the favorite brand for global consumers favoring "American Style" apparel. The future growth relies on China, store openings in the rest of the world, increased investments in omni-channel and seamless inventory management through a responsive supply chain.

Some specific targets include the $300 million in Chinese revenues to expand to a billion within three years. Omni-channel revenues of $2.3 billion per annum should increase significantly as well going forward, especially as Gap will invest another $300 million in online and in-store technologies.

What is really noticeable is the strong momentum of the company coming out of the tough quarter with comparable store sales increasing by 9% in April, driven by 18% comparable sales growth at Old Navy.

While the company is still a very much US-based company, Gap is making huge progress in omni-channel as well as foreign expansion. A lean balance sheet, strong track record and fair valuation at 14 times earnings creates long term appeal.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.