Resizing Gap

In early February of this year, I aired my complaints and concerns about Gap (NYSE: GPS  ) and its then-fledgling turnaround. Three quarters have since ticked by, with Gap closing its fiscal year and finishing off its first and second quarters of this year. Since we're now nearing the end of the third quarter, and with the heady holiday shopping season just around the way, I thought I'd give Gap another chance to win my affection.

I'll confess up front that I have a love-hate relationship with this company. Having been a shareholder through both the go-go years and the anemic ones, my attitude with Gap has become one of "Show me something." Ever the skeptic, ever the scorned, I've been waiting for Gap to give me something I can hold onto.

I want Gap to prove its worth to me, to convince me that I haven't stood by it in vain. I've been such a patient shareholder, through ballooning debt and a ridiculously expanded store base, through nauseating fashion choices and marketing miscues, through 30 straight months of declining comps, through Mickey Drexler and now Paul Pressler from Mickey Mouse land.... Oh, I've seen it all.

Now, I want to see better.

Sales trends
Let's start by checking out Gap's total and comparable store sales growth for its fiscal year-end, and for the past three quarters (including fiscal 2002's fourth).

  Total sales growth
2002 FY = 4% to $14.5 billionQ4 2002 = 14% to $4.7 billionQ1 2003 = 16% to $3.4 billionQ2 2003 = 13% to $3.7 billion Comp sales growth
2002 FY = -3%Q4 2002 = +8%Q1 2003 = +12% Q2 2003 = +10%

Not too shabby, sure. The company is still working its way out of the same-store sales hole, though, and will really have to put up some good numbers for October and for the fourth quarter to prove that it's indeed on the way back to operating strength.

It was in October of last year, remember, that Gap began its current trend of positive same-store sales -- on the back of a whole slew of ugly negative results. It's decidedly easier to look good when you looked awful only a short time ago. Now, Gap needs to look good after looking good.

Getting a read on how the back-to-school season will turn out for Gap is difficult. Its August comps were up a mere 4% on top of last year's 2% drop. Its September comps, however, jumped 13% (versus a 2% dip) for the entire company, with the Gap brand contributing a gain of the same percentage.

That leads one to believe -- and leads me to hope -- that the company's fall marketing ultimately worked, pulling shoppers in for cords, jeans, and more. Could those ads with the shirtless guy in snug jeans have enticed men and women alike into Gap stores?

The earnings picture
Since we've seen the sales growth, let's look at Gap's earnings now. For fiscal 2002, Gap earned $477 million, reversing a loss of $7.8 million. That's still less than it earned in fiscal 2000, 1999, 1998, and 1997, but, hey, it's a start.

In the first quarter of this year, Gap earned $202 million, much better than the minuscule $37 million it earned in last year's Q1. The second quarter was more of the same, with Gap earning $209 million compared to $57 million a year earlier.

The company looks to be building its way back to sustainable earnings growth. I hope it adds to the coffers substantially in the third and fourth quarters of this year.

Marginsare my friends
I love margins. Sounds strange, I know, but there's just something so satisfying to me about seeing those little percentages there, in black and white, letting me know how much my company made off its sales and how effectively it managed its costs. With that in mind, then, Gap's are just screaming to be looked at.

Gross margin
FY 2000 = 37.1%FY 2001 = 29.9%FY 2002 = 34.0%Q1 2002 = 30.4%Q1 2003 = 38.0%Q2 2002 = 33.4%Q2 2003 = 35.9%

Gap's efforts to control its expenses and keep its inventory under control are working, as evidenced by the progress the company is making in its gross margins. More sales at full price means fewer markdowns, and that means better margins.

Its net margins are also on the mend, which is another good sign for Gap.

Net margin
FY 2000 = 6.4%FY 2001 = -0.10%FY 2002 = 3.3%Q1 2002 = 1.3%Q1 2003 = 6.0%Q2 2002 = 1.7%Q2 2003 = 5.7%

Inventory outlook
How about Gap's inventory management? This is something that has plagued the company in the past, with loads of inventory causing its margins to wither and its costs to rise. Gap started reining in its inventory last year and has been steadily trying to find the right balance since then.

In the first quarter, inventory levels rose about 18%, just a hair more than sales did. The second quarter was better than the first, with inventories rising just 9% (sales grew 13%). Gap is mercifully keeping its inventory at appropriate levels.

Flash that cash, baby
Finally, Gap's free cash flow is definitely improving. The retailer was free cash flow negative in fiscal 2000 by $567 million, and generated $378 million in free cash for fiscal 2001.

It came out way, way ahead in fiscal 2002, though, thanks mostly to its drastically reduced capital expenditures. Gap generated a whopping $935 million for the year, nearly double its reported net income.

Through the first six months of this year, Gap's keeping up the good work by generating $236 million in free cash flow. In the same period last year, it produced just $26 million.

Wrappin' it up
So where does this leave me -- swooning or scurrying for the door? I'd have to say somewhere in between. I'm absolutely pleased with the progress Gap is making, yet I'm still anxious about what the third and fourth quarters hold. This is when the comparisons will start to get tougher, and we'll be able to see what this turnaround's really made of.

I do believe Gap's management is working hard to fix the business and start growing again, and there's a lot to be optimistic about here. I'll be waiting and watching for the coming quarters' results, and hoping against hope that Gap will "Show me something" I like.

As mentioned, LouAnn Lofton owns shares of Gap, and she owns some other stuff, too. The Motley Fool is investors writing for investors.

For the best monthly stock ideas from David and Tom Gardner, check outMotley Fool Stock Advisor.


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