Foolish Forecast: Widening Gap

Khaki king Gap (NYSE: GPS  ) is back in fashion tomorrow, reporting its third-quarter earnings after close of trading. But investors should have few surprises in tomorrow's news. Two weeks ago, the company issued a preliminary report on its performance this quarter. To make sure you'll know what to expect tomorrow, here's a quick rundown of the news to date.

Same-store sales for the quarter declined 7%. Additional sales (netted by the 66 net new stores opened since this time last year) mitigated that damage, but not entirely. Overall, sales declined 3% for the quarter to $3.9 billion. On the basis of its sale numbers, Gap now expects to report $0.23 to $0.24 in diluted profits per share tomorrow. Wall Street analysts, playing their part as well-trained parrots, dutifully repeated the above numbers -- they, too, predict $3.9 billion in sales and $0.24 in profits will be reported tomorrow (hey, why stick your neck out when the company's already told you what it's going to tell you?).

Assuming Gap "hits its numbers," Q3 will make for quite a disappointment in a couple of respects. First, $0.24 per share would be a 14% decline from the profits Gap earned one year ago. Second, it would fall far short of previous expectations for the company. As recently as three months ago, analysts were hoping that Gap could earn $0.35 per share this quarter. But as noted in its earnings warning earlier this month, Gap has had problems not just with comparable sales, not just with getting "boots on the parquet" (customer traffic), but also with its response to these other issues. In an effort to attract customers and clear out fall inventory, Gap discounted its fall offerings substantially, pushing its margins "significantly below those of last year."

So, bad news is to be expected tomorrow. That's pretty much a given at this point. Fools seeking for a silver lining around Gap should focus on three potential bright points:

• Inventories: Gap promised that its inventories "per square foot" would decline year over year "in the low-single digits." Any improvement greater than 3% or so, therefore, would constitute good news.
  
  
• Buybacks: Gap bought back 71 million shares, or about 3.6% of its share count, over the first six months of this year. The more diligently Gap has continued that effort over the past three months, the better its per-share earnings should look going forward.
  
  
• Free cash flow: Over the past year, Gap has exhibited an unpleasant trend of reporting more GAAP income ($1.2 billion) than it generated in free cash flow ($1.1 billion). If Gap can move toward reversing that trend, then that, too, would be a plus.

For more Foolishness on Gap, read:

• Gap's Fashion Makeover
• Sluggish Gap's Silver Lining
• Gap's Closed-Door Policy
• Gap Launches Growth Initiatives

Fool contributor Rich Smith does not own shares in Gap. Gap is, however, a recommendation of Motley Fool Stock Advisor. For a 30-day free trial, click here.