Foolish Forecast: The Expectations Gap

Never underestimate the power of diminished expectations.

All year long last year, and into the first quarter of this one, Gap (NYSE: GPS) has managed the neat trick of reporting declining year-over-year profits ... that nonetheless exceed Wall Street's even more declining expectations. Will the pattern continue when Gap reports Q2 earnings Thursday afternoon?

What analysts say:

• Buy, sell, or waffle? Twenty-four analysts mind the Gap, up one from last quarter. Eight now say to buy it, a baker's dozen are holding, and three counsel selling.
• Revenue. On average, they're looking for sales growth to flatline at $3.72 billion.
• Earnings. Yet in another neat trick, profits are predicted to leap 27% to $0.19 per share.

What management says:
Stock Advisor selection American Eagle Outfitters (NYSE: AEO), Aeropostale (NYSE: ARO), Abercrombie & Fitch (NYSE: ANF) -- we watched the big-name clothiers report sagging July comps earlier this month, and Gap was no exception. (The exceptions, it seems, came rather at merchants with broader merchandise besides just clothing, such as Target (NYSE: TGT) and Inside Value recommendation Wal-Mart (NYSE: WMT).)

As fellow Fool Alyce Lomax described at the time, Gap's same-store sales declined 7%, hurt by especially weak sales at Old Navy (where comps fell off a cliff, down 18% year over year). Admittedly, Banana Republic and the eponymous Gap brand posted positive same-store sales -- but at 1% and 2% respectively, even they were nothing to brag about.

What management does:
For the quarter, sales appear to have missed analyst targets once again. According to Gap's August press release, sales declined 1% to $3.69 billion. What's more, the only reason sales hit even this mark was thanks to the addition of new stores. Existing-store sales declined 5% year over year for the quarter, with Gap North America joining Old Navy in negative territory this time, and only Banana Republic boasting positive comps.

My hunch, therefore, is that Thursday's news will reveal that sliding sales took economies of scale with them, and that we'll see the declining margins shown below continue.

Margin	1/06	4/06	7/06	10/06	2/07	5/07
Gross	36.6%	36.4%	35.4%	35.9%	35.4%	35.0%
Operating	11.0%	10.6%	8.9%	8.5%	7.7%	7.2%
Net	6.9%	6.7%	5.8%	5.7%	4.9%	4.4%

All data courtesy of Capital IQ, a division of Standard & Poor's. Data reflects trailing-12-month performance for the quarters ending in the named months.

Two Fools say:
In her column earlier this month, Alyce mentioned how "hope springs eternal" at Gap -- yet always proves unfounded. Citing the firm's rich valuation when compared to American Eagle or Abercrombie, Alyce remains unconvinced that Gap's a buy.

So in the tradition of creating hopes for Gap to later betray, allow me to offer this thought in defense of Gap: In the sales release described above, Gap Senior VP for corporate finance Sabrina Simmons observed that the company had successfully "cleared through summer product at all three brands and total company merchandise margins were significantly above last year." Now ordinarily, when a retailer makes a major push to clear out inventory, its sales rise but its margins fall, because to move the inventory, the retailer must first discount it (hurting margins). In Gap, we may be seeing the converse of this tradition. Sales fell, inventory still went, but according to Simmons, margins improved (at least in July).

It seems to me that Gap is saying it has managed the neat trick of reducing inventory without sacrificing margins. Moreover, I believe management (at least for the next 48 hours) when it says this. After reviewing the last couple of quarters' results, I see that sales have risen modestly (about 3% on average), while average levels of inventory were held flat year over year. Gap didn't have piles of unsold inventory that it needed to move, so perhaps it was indeed able to hold the line on margins -- albeit at the cost of sales growth. Like the lady said, hope springs eternal.

(Speaking of which, the two Foolish investing newsletters that recommend Gap, Motley Fool Stock Advisor and Motley Fool Inside Value, will be hoping the company turns a corner on Thursday. If you want to get the inside view of what our experts think about the upcoming results, make sure to activate your trial subscriptions to one, or both, newsletters today.)

Fool contributor Rich Smith does not own shares of any company named above. Disclosure is always in fashion at The Motley Fool.