Investors in The Gap (NYSE:GPS) have been pleased with the company's second quarter results. Despite pre-announcing its results earlier in August, Gap managed to beat its own expectations thereby comforting investors in a tricky retail environment.
Second Quarter Highlights
GAP reported second quarter sales of $3.98 billion, a 2.9% increase compared to last year.
The company managed to leverage the modest sales growth into higher earnings, reporting a 9.6% increase in earnings to $332 million. Sizable share repurchases allowed earnings per share to grow by 17.2% to $0.75 per share.
Despite pre-announcing its results for the quarter earlier in August, the company managed to beat its own estimates and analysts estimates for the quarter.
Looking Into The Performance
Overall reported comparable store sales growth was flat for the quarter, with topline sales growing as a result of new store openings. That being said, topline sales were severely impacted by a 4% currency headwind resulting from adverse currency movements.
There has been some dispersion within the company's separate businesses. Comparable sales at Gap were down by 5%, sales at Banana Republic came in flat, while comparable sales at Old Navy were up by 4%.
Operating under three divisions isolates Gap to some extent to the ups and downs of operating an individual retail business. Old Navy is now the leading business, posting sales of $1.62 billion while sales at the core Gap business totaled $1.47 billion. Sales of Banana Republic came in at $704 million. The focus on the global strategy is slowing paying off, yet the company still relies heavily on the US in which it generates 77% of its sales, a percentage which is down 2 percentage points compared to last year.
The evermore competitive retail environment hit the company as well with gross margins being down by 110 basis points to 39.4% of sales. The company countered this by aggressively cutting operating expenses which fell by nearly 190 basis points to 25.2% of sales, offsetting gross margin pressure and some more.
Earnings per share growth were aided by sizable share repurchases explaining an eleven cent per share increase in earnings to $0.75 per share. It should be noted that five cents of this improvement resulted from the sale of a building owned by the company.
Thanks to the $0.05 per share benefit from the sale of the building, the Gap is now seeing full year earnings coming in between $2.95 and $3.00 per share.
A look At The Balance Sheet And Valuation
At the end of the quarter, Gap held little over $1.5 billion in cash and equivalents while the total debt position amounted to $1.4 billion, resulting in a very modest net cash position.
With 443 million shares outstanding at the end of the quarter, and those shares trading around $45 per share, equity in the company is valued just shy of $20 billion.
On a trailing basis, the company has now posted sales of about $16.3 billion. Earnings on this basis came in at $1.24 billion which means that operating assets are being valued at 1.2 times annual revenues and 15-16 times annual earnings.
Long Term Operations Are Stagnant, Value Is Being Created
Despite all of Gap's growth ambitions, sales over the past decade have been exactly flat at little above $16 billion after falling to lows of little above $14 billion in 2010.
Earnings have been flattish at well at around $1.2 billion after falling to levels a bit below $800 million during 2007. Despite the stagnant sales and earnings, investors have seen a fair bit of value creation. Over this time period, Gap has repurchased about 55% of its shares outstanding, repurchasing an average of 7-8% of its shares per year.
For the future, the company aims to report growth in actual dollar terms again. In its 2014 investor presentation, Gap outlined plans to grow the business. The company aims to be the favorite company for ¨American Style¨ focusing on global growth, omni-channel operations, strong supply chain operations and seamless inventory capabilities. A particular focus is growth in China and omni-channel initiatives to drive mobile traffic transactions.
These initiatives are already paying off to some extent, with online sales for 2013 improving to $2.3 billion, or 14% of total sales. The contribution from China with $300 million in annual sales is much more limited, yet this has been achieved in just three years after the launch. Gap continues to aim for a billion in Chinese sales between now and three years time.
Earlier in August, Gap already pre-released the sales results indicating that comparable store sales growth in July totaled 2%, versus a flat result for the entire past quarter. These incremental gains throughout the quarter indicate that the company is seeing some real momentum currently. Gap sales fell by just 2% on a comparable basis for the month, while comparable sales rose by 6% for Banana Republic and 3% for Old Navy.
At the time the company guided for earnings of $0.73 and $0.74 per share as the company actually managed to top earnings. Investors are furthermore pleased with continued progress on some of its strategic targets including the opening of another 8 new Athleta stores during the quarter, bringing the total store count to 79 stores. Online sales were up by 11% to $515 million, although the pace of online sales is slowing down rapidly compared to last year.
Back in May, I last checked out on the prospects for the company. At the time I already liked shares despite a tough first quarter, with shares trading at about $41 at the time. Strong comparable sales at Old Navy, the omni-channel strength and targeted foreign expansion amidst a reasonably strong balance sheet and fair valuation were appealing in my eyes.
While I continue to like the shares, and especially the long term value being created through share repurchases, I am a bit more cautious now and would not necessarily chase the shares after the recent momentum.
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