The Rule Maker Portfolio, Feb. 25, 1999

<THE RULE MAKER PORTFOLIO>

Gap's Earnings
Reaching for monopoly

By Tom Gardner ([email protected])

ALEXANDRIA, VA (Feb. 25, 1999) -- It was a rumbling, bumbling, stumbling day on the market. Our stocks fell a half percent. The market fell a little more. We find ourselves racing toward the end of our thirteenth month with a seven-percentage-point lead over the S&P 500, and facing minimal tax payments -- on just our dividends -- come April 15th. We're pleased.

My article yesterday on Dell Computer drew a very active response, and I thank you for that. I'm not thankful that there was just an active response -- no, no, that would make a Dennis Rodman or Susan Powter out of The Fool. I'm not excited about the level of the response, but rather the quality of it.

I learned a good deal more about Dell's business over the last 24 hours, and I thank those who chose to courteously and thoughtfully disagree with me. That's the beauty of this public forum. And, while I still feel that, over the long haul, the machine businesses are not nearly as attractive as the inside-the-machine businesses (that is, the automobile versus the oil inside the automobile), I was nevertheless reminded by many of you that Dell has done a remarkable job of adapting to changing conditions.

I believe the industry does bear careful scrutiny, though.

Now, my consideration of Dell's business in yesterday's report and my segue to coverage of Gap's earnings report today both remind me to restate our core principles as Rule Making investors: Use our ideas here as a guide, but make up your own mind. I don't expect all of our coverage to be correct, particularly the analysis we do on companies that we have chosen NOT to invest in.

And so, the most important principle of this entire forum is that you evaluate your own situation, read and communicate with the hundreds of thousands of other members here, and ultimately, make your own determination. Use our ideas as a guide, but make up your own mind. I hope yesterday's column on Dell has you doing just this. And I hope today's report on Da Gap achieves as much.

This morning, our Rule Making retailer, Gap Inc., announced its year-end earnings. And the company made us proud to be owners. Sales were up 40%. Gross margins improved by 1.7 percentage points. Net margins climbed 0.4 percentage points. And the company's Flow Ratio fell 9.1%, to 0.84.

On the stat sheet, Gap's gross margins for the quarter were 41%. Its net margins were 10.4%. Our casual-duds company now has $9 billion in sales and is valued at $36 billion. And it closed the year with more than 2,400 stores around the world (1106 Gap, 635 GapKids, 289 Banana Republic, and 398 Old Navy
stores).

The only sign of concern on our company's financial statements is the debt our guys are racking up to expand from one street corner to the next. Today, Gap has $565 million in cash and $496 million in long-term debt. This represents a softening of their cash-to-debt ratio to 1.1 at quarter's end. A decline in this ratio is never a good thing, but I'm not terribly concerned at this point.

Why?

Because Gap's expansion has led to strong sales growth, rising margins, the repurchase of 9.5 million shares, and tighter asset management (cf. the flow ratio). And, this borrowing has taken place in a low-interest-rate environment. Gap Inc. is putting that additional cash to very good use today. So, I'm not anxious about the weakening here -- but this is an item to keep a close eye on in the quarters to come.

Now let's take a look at the numbers according to the layout of criteria in Rule Breakers, Rule Makers. Fool member Domer has expressed an interest in our laying all of the book's criteria out online. I promise to do just that. Because I'm just returning from our book tour, I haven't had a chance to rework our 11 Steps with Rob, Phil, and Al to include these new features. That will be coming soon. (You should also know that this model is ever changing, and we welcome your input.)

For now, consult your Breakers/Makers guide, or query Fools in the Rule Maker strategy folder for guidance on the criteria and scoring system.

Gap's Fourth Quarter

1) Brand (0-1 pts)
Familiarity         1
Openness            1
Optimism            1
Legitimacy          1
Inevitability       1
Solitariness       1
Humor               1
Subtotal      7

2) Financial Location (0-2 pts)
Mass Habit          2
Gross Margins       1  (above 40%)
Net Margins         2  (above 10%)
Sales Growth        2  (above 10%)
Cash-to-Debt        1  (greater than 1x)
Flow Ratio          2  (below 1.0)
Your Interest       2 
Subtotal     12

3) Direction (0-3 pts)
Gross Margins       3   (rising)
Net Margins         3   (rising)
Shares Out.         3   (falling)
Cash-to-Debt        0   (falling)
Flow Ratio          2   (down less than 10%)
Expansion           3
Subtotal               14

4) Monopoly Status (0-4 pts)
Gross Margins       2 (0-5 pts higher)
Net Margins         0 (lower)
Cash-to-Debt        0 (lower)
Fool Flow Ratio     0 (higher)
Convenience         4 (easier to buy)
Subtotal           6


Gap vs. The Limited

4) Monopoly Status (0-4 pts)
Gross Margins       4 (5 pts+ higher)
Net Margins         2 (5 pts+ higher)
Cash-to-Debt        4 (25% higher)
Fool Flow Ratio     4 (25% lower)
Convenience         4 (easier to buy)
Subtotal           18

• Rule Maker Strategy Folder
• Rule Maker Companies Folder

Stock  Change    Bid
AXP   +  3/16  107.88
CHV   +  3/16  78.50
CSCO  -1 7/16  98.50
KO    +1 5/8   64.50
GPS   +  1/8   62.88
EK    -2 1/16  66.88
XON   -  38/69 67.31
GM    -1 3/8   83.63
INTC  -2 5/8   127.75
MSFT  +  5/8   153.50
PFE   -1 5/8   130.88
SGP   -1 1/16  54.13
TROW  -  11/16 29.88
YHOO  +5 3/16  155.38

                   Day   Month    Year  History
        R-MAKER  -0.46%  -3.45%   4.69%  32.47%
        S&P:     -0.67%  -2.71%   1.60%  25.76%
        NASDAQ:  -0.54%  -7.15%   6.12%  40.77%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   24 Microsoft     78.27    153.50    96.12%
    5/1/98   55 Gap Inc.      34.37     62.88    82.94%
   6/23/98   34 Cisco Syst    58.41     98.50    68.63%
    2/3/98   22 Pfizer        82.30    130.88    59.02%
   2/13/98   22 Intel         84.67    127.75    50.87%
   2/17/99   16 Yahoo Inc.   125.81    155.38    23.50%
   8/21/98   44 Schering-P    47.99     54.13    12.78%
   5/26/98   18 AmExpress    104.07    107.88     3.66%
   2/27/98   27 Coca-Cola     69.11     64.50    -6.67%
    2/6/98   56 T. Rowe Pr    33.67     29.88   -11.28%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo    72.41     83.63    15.50%
   3/12/98   20 Eastman Ko    63.15     66.88     5.90%
   3/12/98   20 Exxon         64.34     67.31     4.63%
   3/12/98   15 Chevron       83.34     78.50    -5.81%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   24 Microsoft   1878.45   3684.00  $1805.55
    5/1/98   55 Gap Inc.    1890.33   3458.13  $1567.80
   6/23/98   34 Cisco Syst  1985.95   3349.00  $1363.05
    2/3/98   22 Pfizer      1810.58   2879.25  $1068.67
   2/13/98   22 Intel       1862.83   2810.50   $947.67
   2/17/99   16 Yahoo Inc.  2013.00   2486.00   $473.00
   8/21/98   44 Schering-P   2111.7   2381.50   $269.80
   5/26/98   18 AmExpress   1873.20   1941.75    $68.55
   2/27/98   27 Coca-Cola   1865.89   1741.50  -$124.39
    2/6/98   56 T. Rowe Pr  1885.70   1673.00  -$212.70

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo  1230.89   1421.63   $190.74
   3/12/98   20 Eastman Ko  1262.95   1337.50    $74.55
   3/12/98   20 Exxon       1286.70   1346.25    $59.55
   3/12/98   15 Chevron     1250.14   1177.50   -$72.64

                              CASH    $185.03
                             TOTAL  $31872.53

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