Is Gap Inc. Destined for Greatness?

Investors love stocks that consistently beat the Street without getting ahead of their fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with robust and improving financial metrics that support strong price growth. Does Gap  (NYSE: GPS  ) fit the bill? Let's take a look at what its recent results tell us about its potential for future gains.

What we're looking for
The charts you're about to see tell Gap's story, and we'll be grading the quality of that story in several ways:

  • Growth: are profits, margins, and free cash flow all increasing?
  • Valuation: is share price growing in line with earnings per share?
  • Opportunities: is return on equity increasing while the debt-to-equity ratio declines?
  • Dividends: are dividends consistently growing in a sustainable way?

What the numbers tell you
Let's take a look at Gap's key statistics:

GPS Total Return Price Chart

GPS Total Return Price data by YCharts.

Passing Criteria

3-Year* Change

Grade

Revenue growth > 30%

12.1%

Fail

Improving profit margin

(0.9%)

Fail

Free cash flow growth > Net income growth

(18.5%) vs. 11.2%

Fail

Improving EPS

55.9%

Pass

Stock growth (+ 15%) < EPS growth

106.7% vs. 55.9%

Fail

Source: YCharts. *Period begins at end of Q3 2010.

GPS Return on Equity (TTM) Chart

GPS Return on Equity (TTM) data by YCharts.

Passing Criteria

3-Year* Change

Grade

Improving return on equity

66.8%

Pass

Declining debt to equity

93.5%

Fail

Dividend growth > 25%

100%

Pass

Free cash flow payout ratio < 50%

30%

Pass

Source: YCharts. *Period begins at end of Q3 2010.

How we got here and where we're going
Gap manages a mediocre four out of nine possible passing grades on today's assessment. The company's revenue and profit margin growth have been crimped by a weak economic recovery, and the competitive fashion industry isn't doing it any favors, either. Gap's free cash flow has also started to fall far from its net income over the past few quarters -- however, the company can still easily support its dividend payouts at the current cash flow levels. How might Gap return to a growth mindset in 2014? Let's dig a little deeper to find out.

Over the past few quarters, Gap has been pushing hard into the yoga apparel sector long dominated by lululemon athletica  (NASDAQ: LULU  ) , and Under Armour (NYSE: UA  ) , to a lesser degree. Fool contributor Andres Cardenal notes that the company has launched several Athleta stores near Lululemon locations to siphon off the latter's traffic by selling relatively cheaper products. Gap has also partnered with yoga instructors to offer a number of health and fitness classes in a rather blatant copycatting of Lululemon's strategy. In addition, Gap has benefited from its rival's recent stumbles: Last year, Lululemon had to recall many yoga pants due to a state of near-transparency under certain conditions, which is probably not the kind of visual most yoga-pant wearers want to project in the gym. Lululemon still receives numerous complaints over its product quality and poor customer service responses. Under Armour is capitalizing more directly on this fiasco, as it's recently begun a marketing campaign for its studio yoga line that makes light of Lululemon's "sheerness" problem.

Gap also had a stronger-than-expected holiday shopping season, as November and December sales rose by approximately 2% and same-store sales increased by 1% year over year. Consequently, the company delivered a strong earnings guidance for the fourth quarter. This doesn't necessarily point toward major long-term growth -- a 2% improvement barely keeps up with expected rates of inflation. In contrast, Urban Outfitters (NASDAQ: URBN  ) continues to benefit from higher-end brands Anthropologie and Free People, which saw same-store sales soar by 21% and 11%, respectively. Gap currently trades at a much lower valuation than Urban Outfitters -- its P/E is barely more than 13, compared to Urban Outfitters' P/E of 20 -- which could point toward either a superior value or a value trap, depending on one's opinion of Gap's future. Fool contributor Mukesh Baghel notes that Gap has an excellent track record of returning cash to shareholders: It recently announced a new $1 billion share repurchase plan, which has made it by far the best of its peers when it comes to reducing the number of shares outstanding:

GPS Shares Outstanding Chart

GPS Shares Outstanding data by YCharts.

According to YouGov BrandIndex, the Gap and Banana Republic brands have gained significant traction over the past few months, which is a positive for potential future sales growth. Fool contributor Brian Hill notes that Gap has been focusing on overseas expansion, opening 25 stores in Asia in the fourth quarter. Gap has also collaborated with new designers and brought out innovative new products, which might further improve perceptions and lure more customers to its stores.

Putting the pieces together
Today, Gap has some of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.

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