Gap, the Value Trap

Editor's note: Gap is a Motley Fool Inside Value recommendation. The writer's views on Gap do not necessarily reflect those of Inside Value or its advisor. However, we at the Fool encourage contrary views on stocks and their companies, even the ones recommended in our newsletters. In that spirit, we present the following Take.

I never really bought the turnaround story at Gap (NYSE: GPS  ) , but now I'm starting to think that things are worse than I suspected. Management is beginning to sound desperate.

Exhibit A: Gap's latest earnings release. Read the subhead: "Company delivers nearly $1 billion in free cash flow and earnings per share of $1.24."

Simply put, I don't believe that a management team stretching so far to put a sunny face on what were, in truth, dismal results, can be trusted to do the right thing. Since the earnings release is clearly aimed at obscuring the true state of things, I took the liberty of rewriting Gap's bullet points in a manner that management may or may not find suitable. I think my versions are a better fit for shareholders who want the real picture.

  • For the full year, Gap delivers $951 million in free cash flow, which, technically, rounds up to $1 billion. Super, hey? Oh, and please don't look at the statements showing that our free cash flow is actually down 19.3% from last year.

  • Gap delivers crummy sales for the umpteenth quarter in a row. Our total sales declined 1.6% for the fourth quarter, with comparable-store sales sinking 6%. It looks like our competitors, such as Abercrombie & Fitch (NYSE: ANF  ) , Aeropostale (NYSE: ARO  ) , and even Ann Taylor (NYSE: ANN  ) and Chico's FAS (NYSE: CHS  ) , are really eating our lunch. But don't worry, we think we'll get our customers back, though we've shown no capacity to do so.

  • Oops. Our bad. For the full year, net sales were also down 2%, and comparable-store sales dropped 5%. That was on top of a flat year for 2004. (But hey, have some faith!)

  • We expect next year to look pretty much the same, but, no, don't look there ... look over here! We're raising our dividend!

  • Margins were ... well, never mind those margins. They were bad and getting worse all the time. Did we mention we're going to get our customers back and raise our dividend?

As you've gathered by now, I don't believe that my colleague Philip Durell made the right call on Gap when he recommended it for Motley Fool Inside Value. Let's be clear here: Gap is not like other Inside Value recommendations Anheuser-Busch (NYSE: BUD  ) or Coke (NYSE: KO  ) . Retail clothing is not a consumer staple that people keep buying no matter what. People don't stop at the corner grocery and buy Gap sweaters or boxer shorts out of habit, day in and day out. In clothing, the fad does matter.

Therefore, investors need to be very wary of grabbing shares of a retailer with decent cash flow but continuing sloppy sales. Gap's balance sheets will help to keep it from imploding, but while the cash flow is solid for now, it's dwindling.

And if Gap's not growing, it's worth little to me, despite its capital investments. I can get a better cash yield from a savings account; at least that earnings stream isn't getting worse every year.

Bottom line: If you buy Gap now, you buy on hopes for a turnaround that's nowhere in sight. Sure, much of value investing is getting in before the catalyst, but in Gap's case, I doubt there's one on the way.

So I disagree with Philip on Gap. But there are plenty of other Inside Value recommendations we agree on 100%. A guest pass will give you full access.

For related Foolishness:

Gap is also a recommendation ofMotley Fool Stock Advisor.

Seth Jayson is picky about his cheap. At the time of publication, he had shares of Aeropostale but no positions in any other company mentioned. View his stock holdings and Fool profile here. Fool rules are here.


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