Mind The Gap

Summary

• The poor financial performance in the first quarter, combined with inventory management issues and unsustainably high dividends, make the stock unattractive.
• Declining consumer confidence, coupled with high energy prices are likely to create further headwinds for the firm in the near term.
• Our outlook on Gap is currently bearish.

Justin Sullivan/Getty Images News

Gap Inc.'s (NYSE:GPS) share price has fallen more than 70% in the last 12-month period compared with the ~12% decline of the broader market. We expect the outperformance of the firm to continue in the near term, due to the firm's financial performance and certain macroeconomic headwinds, therefore we believe that currently the stock is a sell.

Data by YCharts

In this article, we will take a deeper look at some of the factors that make Gap's stock unattractive for us right now.

Poor first quarter financial performance

In the first quarter of 2022, Gap has reported a 13% decline in their net sales year over year, as a result of divestitures, store closures and EU partnerships. Not only net sales were disappointing, but the gross margin has also contracted by as much as 930 bps, compared to the year ago quarter, due to higher discounting in the Old Navy stores and the elevated commodity prices, leading to increased freight costs.

Net loss for the quarter has been $0.44 per share, compared to the net earnings of $0.44 per share in the year ago quarter.

To get a better understanding of the business, we have to take a look at which segments and brands have been driving this decline.

Net sales (GAP)

The largest decline in net sales have been seen in Old Navy, which used to be the main driver of growth for the firm. The decrease was primarily driven by the size and assortment imbalances combined with the inventory delays. The decline in the Gap brand was mainly caused by the lower demand in China, due to the Covid-19 restrictions and the failure of the firm to pass over inflationary cost increases to its customers. These figures are even more concerning as Old Navy and Gap represent about 76% of the sales. Also, a concern that the firm has been focusing on closing Banana republic and Gap stores, while increasing the share of Old Navy. However, in this quarter the Banana Republic brand was actually the strongest driver of growth by far.

Sales by segments (GAP)

This mis-alignment between supply and demand has likely been leading to the decline in inventory turnover.

Over the past five years, Gap's inventory has been increasing, while its sales stayed relatively flat. This tendency has led to a decreasing inventory turnover and a worsening inventory management.

Inventory turnover ratio (Macrotrends.net)

In the first quarter we have seen many firms struggling with inventory management, including larger retailers like Target (TGT) and Walmart (WMT), because they did not have the right kind of inventory available. Gap appears to be in the same boat. Generally, we like to invest in businesses that have stable or improving inventory turnover and therefore a more efficient inventory management. As Gap is failing to efficiently address the issue, we have a bearish outlook on the firm.

To sum up, in our opinion, Gap's financial performance, its operational outlook and its strategy is not particularly attractive. Although the firm is focusing on turning these trends around by improving its brand loyalty, its omni-channel sales strategy (e.g.: by acquiring Drapr in 2021 to boost its digital sales experience), we have not seen significant positive results so far. We believe it is better to avoid Gap's stock right now, as macroeconomic headwinds are likely to create further challenges for the firm.

Unsustainable dividends

In May, Gap has declared a quarterly dividend of $0.15 per share, which represents a forward dividend yield of 6.6%. The high yield appears to be attractive, however we have to understand how sustainable these payouts are.

Gap's current TTM Dividend Payout Ratio (Non-GAAP) is 100%. This figure is the ratio of the total amount of dividends paid out to shareholders relative to the net income of the company, meaning that the firm is currently using all its net income to pay dividends.

Further, if the dividend is kept at the current level, due to the expected decline in earnings, this ratio is expected to increase above 100%, with Dividend Payout Ratio (FY1) (Non-GAAP) reaching as much as 161%, meaning that the firm cannot even cover its dividend payments with their net income.

These high ratios are suggesting that the current dividend is not sustainable and a dividend cut is inevitable, if the earnings of the firm do not increase. Based on these ratios, we do not recommend this stock for investors looking for safe and sustainable dividend payments.

Declining consumer confidence

Although consumer spending has remained high so far this year, consumer confidence has been steadily decreasing over the last months. The U.S. consumer confidence has reached its 10-year low, approaching levels seen in 2008-2009.

U.S. Consumer confidence (Tradingeconomics.com)

Low consumer confidence is likely to affect the spending behavior of the consumers, leading to delaying or cutting purchases, first on durable goods, then on discretionary/non-essential items, and last on services. As GPS is a retailer of consumer discretionary goods in the apparel retailer industry, selling for example, tees, fleece, eyewear, handbags, fragrances etc., we expect the firm to be substantially impacted by the low consumer confidence and the changing spending patterns.

We believe that the change in spending patterns could actually benefit some of the low-cost retailer of consumer discretionary goods, as people are looking for cheaper alternatives and better deals. Check out our previous article on why The TJX Companies (TJX) could be a more attractive option, if you are considering investing in a retailer right now.

High commodity prices

In early 2022, energy prices have skyrocketed with the start of the geopolitical conflict in the Eastern European region. Oil prices (WTI) have reached highs of $125 per barrel in March, while gasoline prices have also kept increasing throughout the year.

WTI price (Tradingeconomics.com)

In our opinion, the elevated energy and gasoline prices, leading to increased transportation and freight costs, as observed already in the first quarter results, are likely to have significant negative impact on GPS's financial performance in the near term, potentially causing margins to further contract.

Although there have been some positive news lately, including OPEC+'s willingness to increase oil output by a larger than expected amount, starting from July, the oil and gasoline prices have not come down substantially.

As the uncertainty regarding the Russia-Ukraine conflict is likely to remain high in the near term, we do not expect a significant decline in the energy prices. Therefore, we maintain our bearish outlook on the stock.

Key Takeaways

The firm's poor first quarter financial performance, combined with the unsustainably high dividend, makes the stock currently unattractive.

As the current macroeconomic environment is challenging, we do not expect a rapid turnaround of the business in the near term.

Declining consumer confidence, coupled with elevated energy prices are likely to create further headwinds for the stock.

Our outlook is bearish.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.