Thursday, May 14, 1998

Cash-King Portfolio Report
by Tom Gardner

Alexandria, VA (May 14, 1998) -- Fools, get your scorecards out.

Gap Inc. announced first quarter earnings today of $1.7 billion in sales and $136 million in net profits, and we're dancing a Foolish jig as we sort through the report. Our CEO, Millard Drexler, said of the performance, "Our sales and earnings gains were driven by strong performances across all our brands -- Gap, Banana Republic and Old Navy."

Gap's numbers just look outstanding for this seasonally weaker period for the company. Sales and earnings pounded forward as Gap also strengthened the underlying supports to its business. Sometimes, a company's spectacular performance in the here and now can hinder its long-term prospects (allowing executives to cash out options at a premium today before sailing away to Maui). Once again with Gap, the short-term appears only to be enhancing the long-term potential of the company's brand and operations.

We will, in passing, mention that Gap's 1st Quarter earnings per share (EPS) of 34 cents beat Wall Street estimates by 3 cents. But we speak of it only in passing, since the Cash-King approach takes us together beyond the income statement. Companies can always "manage" financial statements to show slightly-inflated or deflated numbers, and so the true merits of the performance must be found elsewhere.

Just think about the accounts receivable entry. In the purest sense, a company's announced sales and earnings should not reflect any of these uncollected bills. For shareowners' digestion, these collectibles would ideally be referenced on the balance sheet but not included in the income statement. Today, various public companies -- small and large -- use receivables to meet or beat today's estimates. The Cash-King model seeks to weigh the true value of earnings, to root out the purest form of those earnings, through our Foolish Flow Ratio calculation.

For all of us, I think meeting or beating Wall Street earnings estimates is only a shallow measure of a company's genuine quarterly performance.

"Ok, enough theory for the day! Move on, move on!"

Let's start with Gap's income statement for the quarter.

The Income Statement

For the three months ending May 2, 1998, Gap posted sales of $1.7 billion, up 39.6% from the year ago period. Net profits came in at $136 million, up 61% over the 1st quarter last year. That ranks as one of our favorite income-statement qualities -- rapid sales growth being outpaced by earnings growth.

It warms our Foolish hearts.

For the quarter, Gap drove gross margins higher by four percentage points, up from 36% last year to 40%. Our company's product sales process is getting lighter and more efficient by the hour as Gap maintains pricing power in the world of casual clothing.

And finally, management went out into the open marketplace and bought back 2% of the company over the past year. Gap's fully diluted shares outstanding now sit at 405 million, down from 413.3 million at the close of the 1st quarter last year. The company might want to consider killing that 0.30% dividend yield in favor of share repurchasing. How Foolish would that be!

Onward to the balance sheet...

The Balance Sheet

From the year ago period, the company now has $836 million in cash versus $356 million. How did that happen? Gap Inc. took on a half-billion of low-rate, long-term debt last year to enable investments in marketing and expansion. So, today, alongside its $836 million in cash, Gap has $496 million in long-term debt.

On the current assets side of the balance sheet, as was noted in our buy report, Gap doesn't carry any accounts receivable -- since it bills customers up-front for every product. We love that. And the company's inventory rose by 31% over the 1st quarter last year, matching up nicely against the 39.6% growth in sales. For obvious reasons, we like to see sales growth outpacing growth in inventories.

Down on the current liabilities line, our company bounced accounts payable a couple notches higher to $814.9 million from $509.8 million, or up 59.8%. And you guessed it, that means Gap is going to ring up a more attractive Flow Ratio this quarter than in the 1st quarter last year. For Gap, with no receivables, the Flow Ratio balances on the inventories (assets) and accounts payable (liabilities). Gap's challenge is to sell its product out faster than it has to pay its suppliers.

In fact, let's run the calculations for Gap's 1Q Flow Ratio together. My 7th grade math teacher, Bob Brown, (who doubled as a standout baseball coach in the D.C. area) taught us to show all of our steps. So here they are (take a deep breath here, those of you who dread numbers, this is a piece o' cake):

                  (current assets - cash) 
 The Flow Ratio = ------------------------- 
                     current liabilities 
 x = Current assets - cash  
 x = 1844.4 - 836.3 
 x = 1008.1 
 y = current liabilities 
 y = $999.0 
 The Flow = x / y 
 The Flow = 1008.1  /  999.0 
 The Flow = 1.01 

And that Flow Ratio of 1.01 marks for a dramatic drop by Gap from a Flowie of 1.17 during the same period last year. Huzzah!

Now, to get down into the Flow range of the truly superior in the Cash-King Portfolio (Microsoft at 0.31, Coca-Cola at 0.61), Gap will have to continue pounding away at its systems for managing inventory. It's a constant battle. The faster that our company can get finished product onto the shelves, over to plastic bags, into consumer hands, and out the door, the better. Directionally, with its Flow Ratio falling 13.7% over the same period last year, Gap is getting ever closer to our bulls-eye. We like that. Very much.

Ok, let's take a final look at the Cash-King criteria and see how Gap matched up to our standards for the first quarter (again, these are only 1st quarter numbers, not the stats for the last 12 months):

Basic Cash-King Criteria 
 Market Capitalization....................$22.3 bil. 
 Gross Profit Margin...........................40.0% 
 Avg. Net Profit Margin........................ 7.9% 
 Cash (and short-term securities)..........$836 mil. 
 Long-Term Debt............................$496 mil. 
 Cash as % of Debt.............................1.69x 
 The Flow Ratio.................................1.01 

Gap beats all of our standards, except for one. Gross margins, though they ever inch higher, are still below our ideal perch of 50%. The material costs of Gap's business are still a bit too high for our liking. But true to Step 6 of our 11 Steps to Cash-King Investing, generally speaking the direction of a company is more important to us than its present location.

Gap shares were down fractionally on the day after touching a new high of $55 3/8 in the early afternoon. Here's a link to Gap's 1st Quarter Report.

To close, while it was a fine report, we were disappointed that Gap chose to hold a conference call with analysts this morning at 8:30 in New York without at least providing a taped replay for individual investors. That said, if you have any questions about today's column, please drop your queries in the CK Message Folder.

Fool on!

Tom Gardner


Stock  Change    Bid 
 CHV   +1 5/16  85.88 
 KO    +  1/2   77.75 
 GPS   -  3/8   54.00 
 EK    -1 1/16  70.56 
 XON   +  1/8   73.75 
 GM      ---    75.06 
 INTC  -  5/16  84.50 
 MSFT  +2       88.88 
 PFE   -1 15/16 108.25 
 TROW  -1 3/16  35.38 
                  Day   Month    Year  History 
         C-K      -0.31%   0.55%   9.07%   9.07% 
         S&P:     -0.13%   0.50%  11.59%  11.59% 
         NASDAQ:  -0.04%  -0.16%  12.86%  12.86% 
 Cash-King Stocks 
     Rec'd    #  Security     In At       Now    Change 
     2/3/98   22 Pfizer        82.30    108.25    31.53% 
     2/3/98   24 Microsoft     78.27     88.88    13.55% 
    2/27/98   27 Coca-Cola     69.11     77.75    12.51% 
     5/1/98   37 Gap Inc.      51.09     54.00     5.70% 
     2/6/98   56 T. Rowe Pr    33.67     35.38     5.05% 
    2/13/98   22 Intel         84.67     84.50    -0.21% 
 Foolish Four Stocks 
     Rec'd    #  Security     In At     Value    Change 
    3/12/98   20 Exxon         64.34     73.75    14.63% 
    3/12/98   20 Eastman Ko    63.15     70.56    11.74% 
    3/12/98   17 General Mo    72.41     75.06     3.67% 
    3/12/98   15 Chevron       83.34     85.88     3.04% 
 Cash-King Stocks 
     Rec'd    #  Security     In At     Value    Change 
     2/3/98   22 Pfizer      1810.58   2381.50   $570.92 
     2/3/98   24 Microsoft   1878.45   2133.00   $254.55 
    2/27/98   27 Coca-Cola   1865.89   2099.25   $233.36 
     5/1/98   37 Gap Inc.    1890.33   1998.00   $107.67 
     2/6/98   56 T. Rowe Pr  1885.70   1981.00    $95.30 
    2/13/98   22 Intel       1862.83   1859.00    -$3.83 
 Foolish Four Stocks 
     Rec'd    #  Security     In At     Value    Change 
    3/12/98   20 Exxon       1286.70   1475.00   $188.30 
    3/12/98   20 Eastman Ko  1262.95   1411.25   $148.30 
    3/12/98   17 General Mo  1230.89   1276.06    $45.17 
    3/12/98   15 Chevron     1250.14   1288.13    $37.98 
                               CASH   $3910.83 
                              TOTAL  $21813.02 
 *The year for the S&P and Nasdaq will be as of 02/03/98