Is Gap Still on Track?

In its latest report Gap  (NYSE: GPS  )  posted mixed results. Though the retailer did beat analysts' expectations, its performance did not come near the results it posted last year. Does this mean that Gap isn't a good buy? Let's find out.

Fourth-quarter earnings
In the fourth quarter, GAP posted per-share earnings of $0.66 which beat analysts' expectations of $0.64. However, in comparison with its results in the year-ago period its earnings fell by 6.9%; this largely happened because Gap had one less week in the quarter as a result of a calendar shift. Year-over-year sales also declined by 3.2% to $4.58 billion, but analysts saw this as matching the consensus estimate of $4.59 billion. Online sales rose approximately 16% to $698 million.

Same-store sales ticked up by 1% during the quarter. The company was one of the few retailers that grew its sales despite the unfavorable weather conditions.

Gap's gross margin shrunk by 280 basis points to 34.8%, and its operating margin also dropped by 180 basis points to 11.4%. This occurred as a direct result of higher markdowns during the holiday season. Notably, the company reduced operating expenses by 8.8%, which reflected its effective cost management.

For the full-year, Gap reported an earnings jump of 18% while sales climbed by 5%. Comparable sales grew by 2%. In terms of brands, Gap delivered comps growth of 3%, while Old Navy and Banana Republic saw same-store sales growth of 2% and 1%, respectively.

What is Gap up to?
Gap has identified China as a potential high-growth region. For this reason, the company has been continuously expanding in the country. In 2013, Gap opened 34 new stores in China, which took its total store count in the country to 81 stores. As the company has received a great response from Chinese customers, it will open 30 more stores in the country this year. This will include five Old Navy stores; the retailer recently introduced its Old Navy brand in China by opening its first outlet there last month. Apart from China, Gap plans to open 25 new Old Navy stores in Japan this year.

Thanks to Gap's "Reserve in Store" service, the company's online business in the US has grown at a tremendous pace during the last few months. The service allows customers to reserve up to five items online to try on in a Gap or Banana Republic store. The customer receives an email or text within an hour which confirms that their items are on hold. The store will keep the merchandise on hold until the close of the next business day. As it has been a success, expectations call for the company to launch this initiative across all of the Banana Republic and Gap stores in the US pretty soon.

As part of its omni-channel expansion strategy, Gap is investing heavily in its online business. As part of this, the company is spending heavily to promote Reserve in Store. Moreover, the retailer is trying to improve its customer experience by making its website more user-friendly. The website will now serve up more personalized homepages according to customers' previous buying decisions, which will result in more customer engagement.

Apart from expanding internationally and investing in its omni-channel initiative, Gap has focused on improving its supply chain management as well. In 2013, the retailer eliminated lots of fabrics it didn't need. It now has a much smaller fabric library than it did last year, which has resulted in lower operating costs.

In fiscal 2014 Gap expects per-share earnings of $2.90-$2.95, which is below the consensus estimate reported by Thomson Reuters of $3.02 a share. The company gave a slightly lower outlook because it expects weakness in foreign currencies to cut around 5 percentage points from its earnings growth rate.

Industry peers
American clothing and accessories retailer American Eagle Outfitters (NYSE: AEO  )  didn't do well in the fourth quarter. Earnings fell to $0.05 a share from $0.47 in the year-ago quarter. Sales dipped 6.7% to $1.04 billion, while comps tumbled by 7%. As a result of heavy markdowns, gross margin also shrank from 41.2% to 29.4%. For the full year, earnings dropped 51% to $0.27; sales also declined by 5% to $3.31 billion.

The company's management said that the tough macroeconomic environment caused the weak performance in the quarter. The retailer still remains wary of economic conditions, which is why it has given a conservative outlook for its earnings next quarter.

Abercrombie & Fitch (NYSE: ANF  ) also reported a disappointing fourth quarter; earnings per share and sales fell by 56% and 12%, respectively. The company is currently working on lowering its operating costs so that it can offer lower prices to entice shoppers. It is also shutting down stores which aren't doing well. As part of this, the retailer will shut down its Gilly Hicks stores by the end of the first quarter of this year. In the next quarter, the company expects EPS of $2.15-$2.35; analysts expect EPS of $2.31.

Final thoughts
Gap's latest quarterly performance reflects its ability to generate healthy profit even under these tough economic conditions. Earnings dipped as a result of a calendar shift, not because of issues in the company's core business operations. The company has rightly identified China as a high growth area, as it will continue to boost its income in the future.

Gap's focus on expanding its Reserve in Store service and its investments in its omni-channel initiatives will definitely pay dividends in the near future. Improvements in supply chain management will further cut its operating expenses, which will result in a higher operating margin. Further, the retailer has given a strong outlook for this year as well. Taking all this into account, I believe Gap presents a good investment opportunity at this point in time.

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