Is Gap Still a Worthwhile Investment?

Do weak earnings indicate that Gap is no longer a buy?

Jul 3, 2014 at 5:00PM

Economic doldrums and intense competition have forced clothing retailers like Gap (NYSE:GPS), American Eagle Outfitters (NYSE:AEO), and Abercrombie & Fitch (NYSE:ANF) to operate on lower prices. This has in turn resulted in sluggish growth for these companies. In fact, some of these retailers have now started cutting their costs more vigorously in order to remain profitable.

Let's analyse Gap in detail and see where it's heading under these trying circumstances.

First quarter earnings
Gap's first quarter earnings came in at $0.58 per share, beating the Zacks Consensus Estimate of $0.57 per share. However, earnings were down 18% from the year-ago figure of $0.71 a share; this was attributable to higher occupancy expenses and cost of goods sold along with unfavorable foreign currency fluctuations.

Identical-store sales inched down 1%, while net sales ticked up 1.2% to $1,774 million. On a constant currency basis, net sales were up 2% from the comparable quarter. Gap's online sales also jumped 15% to $575 million.

Same-store sales for Gap Global fell by 5% while Banana Republic Global's comps dropped by 1%. Comps at Old Navy Global stores were up 1% compared to 3% in the last period's quarter.

What is Gap up to?
Besides paying its shareholders a cash dividend of $0.22 a share, Gap also bought its shares worth $219 million during the quarter. Last year, the company authorized a share repurchase program of $1 billion, of which $443 million shares are still remaining.

Gap has identified Asia as a potential high-growth region. During the quarter, it launched its first ever Old Navy company-operated store and e-commerce site in Mainland China. In addition, it also introduced its first ever Old Navy franchise-operated store in the Philippines and plans on opening four more during this year. Gap also introduced its first ever store in Taiwan during this quarter.

Gap also opened six new Athleta stores in the U.S., which is in line with its target of operating 100 Athleta stores by the end of fiscal 2014. Overall, the company opened 31 new stores while closing 16 stores, bringing the total store count to 3,565 across 48 countries. Going forward, Gap wants to open 185 company-operated stores in fiscal 2014. The company's primary focus remains on expanding its Gap stores in China and Old Navy outlets in Japan. It will also be shutting down 70 company-operated outlets.

Gap's Reserve-in-Store service, which has done a great job, has now been rolled out to 500 Gap stores and 400 Banana Republic outlets. The company expects the service to drive its sales in the coming years, which is why it's actively marketing it across the US.

Gap has reaffirmed its earnings' guidance for fiscal 2014; it expects earnings per share of $2.90-$2.95.

Industry peers
Because of weak top-line growth and increased markdowns, American Eagle Outfitters' first quarter earnings fell 89% from the prior-year quarter. The retailer's net sales dropped 4.9% to $646.1 million, missing the Zacks Consensus Estimate of $657 million. Identical-store sales declined by 10%; comps at Aerie stores decreased by 4%, while it declined 11% at AE Total Brand stores. Gross margin also shrank by 420 basis points to 34.9%.

In the next quarter, the company expects its per-share earnings to remain flat at $0.10, as it projects high single-digit decline in comparable sales.

Abercrombie & Fitch reported better-than-expected results in the first quarter; its revenue dropped by just 2% to $822 million, while analysts were expecting the company to post sales of $798 million. The retailer's loss per share came in at $0.17, which was lower than estimates of $0.19 per share. Though comparable-sales were down by 4%, there was significant improvement from previous quarters' high rates of comps decline. 

In order to keep a check on its losses, Abercrombie will be reducing its average unit costs in the coming quarters. It will also be shutting 70 stores this year to help reduce its expenses.

Final thoughts
Gap's first quarter earnings beat estimates, though it fell behind last year's figure. While the company kept opening new locations, it was hit with higher occupancy costs that lead to weaker earnings. Had foreign currencies remained stable, its net sales would have grown by 2%. One of the highlights of the quarter was Gap's tremendous growth in online sales. E-commerce, along with expansion across the Asian region, will fuel the company's growth in the future.

One area that the company should work on is its merchandize margins. In such a competitive retail environment, Gap can't increase its prices for more margins. Instead, it should try to cut down on its cost of goods sold, which kept increasing during the first quarter.

As the retailer is still in the expansion phase, it's bound to incur more expenses in the coming quarters. The company's comps across its major segments are decreasing, which is a worrying sign for investors. Considering this and the above discussion, I will remain neutral on Gap at this point in time. 

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Zahid Waheed has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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