Gap Saves Its Way to Higher Profits

At first glance, the Gap Stores (GPS) report of a 51% increase in net profit for the most recent quarter looks like great news. Looking a little deeper there are signs of trouble.

A key measure of success for retailers, same store sales, shows that on average, sales fell by 10% in stores that have been open at least a year. Overall, sales were down 5.1% across the board for Gap owned stores. Sales are down and not expected to turn around in the short term. Each existing store is taking in less money. You can cut costs for a while, but there's a sharp limit to how much can be cut without doing long term damage to the business. Unless sales pick up in the next six months, Gap may be hard-pressed to meet its earnings estimate of $1.30 -$1.35 for the full year. At this point, it is still saying it will get there.

Gap Chief Executive Mark Murphy said he plans to consolidate some stores going forward to reduce costs even further. It remains to be seen whether he can shift sales from those closing stores to others in the chain. In the face of this consolidation, Gap is still opening new stores. It did, however, announce a reduction in the number of planned new stores for the year from 115 to 100.

Similar results have been reported by other clothing retailers, as they also moved to control costs during the first half of the year. The market has been bad for retailers and looks to remain that way for some time. Hot Topic (HOTT), for example, also beat analysts' estimates for the quarter, but cautioned of a poor sales and earnings outlook for the rest of the year. Hot Topic shares plummeted by 21% on the day of the announcement.

Gap may be able to hold out a little longer if it has additional room for cuts, but unless the outlook for sales changes, it's only a matter of time for it to start cutting expectations as well. Gap shares so far are holding up well, up nearly 5% to $19.88 at the close on Friday. This comes after hitting a 52 week low of $14.77 as recently as July 11th.

Gap hopes to breathe new life into Old Navy, one of the chains it owns, by commissioning designers Todd Oldham and Patrick Robinson to rework the Old Navy line. Gap also awarded interim president Tom Wyatt that post on a permanent basis. Meanwhile, Old Navy sales were down 16% versus the same quarter a year ago. Congratulations on the well deserved promotion, Tom.

One piece of good news for Gap though was a growth in online sales. A strong focus here during the quarter saw online sales rise by 11%, though it's still a small part of the overall business. Gap Stores owns Banana Republic and Old Navy, in additional to the self-named Gap Stores.

Stock position: None.