<THE RULE MAKER PORTFOLIO>

Checking in on the Gap

by Tom Gardner

ALEXANDRIA, VA (May 17, 1999) -- This week, we'll be reviewing five leading companies that recently posted quarterly earnings. I'll kick the ceremonies off by analyzing the first-quarter performance of our round-the-corner, Rule-Making retailer, Gap Inc. (NYSE: GPS).

Gap has been in the Rule Maker portfolio for just more than a year, having entered on May 1, 1998. The company's value has increased 82% during that time, as Da Gap has driven Levi Strauss into chaos, while stirring enthusiasm for drawstring pants and swingin' khakis around the country.

Gap is the third best-performing stock in our portfolio.

And so it was with great anticipation that I awaited Gap's trip to the market microphone to announce its first quarter numbers. The result? Sales of $2.28 billion, earnings of $202 million, earnings per share of $0.34, with a rise in both gross and net margins. Those earnings-per-share (EPS) figures outperformed Wall Street estimates by two cents. And the growth in sales and earnings of 32% and 49%, respectively, also outperformed expectations.

For investors focused on the income statement, Gap registered an outstanding quarter.

And, like clockwork, Wall Street went into action. Retail analysts at investment bank Lazard Freres started the applause. They raised sales and earnings estimates and reiterated their target price of $75 per share for Gap. BancBoston Robertson Stephens followed suit by restating their "Buy" rating and filing upward adjustments to their estimates.

And, amidst all the whooping and hollering, Gap's stock has... continued its rapid ascent? Risen without pause? Reached out to new horizons? Scaled to a higher peak? Uh, mmm, nope. Gap has bumbled around $60 a share since the report, after touching a high of $77 back in mid-April. Clearly, the market has found something to worry about -- and I think our Rule-Maker spreadsheet has revealed and reveals again at least part of the problem.

First, take a look at the following three spreadsheet calculations:

  1. This link leads to Gap's present standing versus three leading competitors: Abercrombie & Fitch (NYSE: ANF), The Limited (NYSE: LTD), and American Eagle Outfitters (Nasdaq: AEOS).
  2. This link shows a comparison between Gap and its number one competitor, Abercrombie & Fitch.
  3. And this link reverses things, comparing Abercrombie's position, after its recent earnings announcement, back against Da Gap.

In sorting through the numbers, you'll spy a trend forming. Again, Gap's income statement looks terrific. Margins are up across the board. Sales are exploding for a company of this size, and earnings are more than keeping pace. Yet the company's total Rule Maker score has fallen from 43 points to 36 points today.

The problems for Gap peek out from their balance sheet. Here, the retailer has reduced its cash position by $380 million over the past year, while riding its long-term debt up $50 million. These reflect the heavy marketing costs and net-share repurchasings that were part of Gap's adventure. The company has been on a flat-out marketing sprint, trying to cut down the competition for national mindshare. Doing so demanded some serious spending.

A level below that spending, Gap's most recent quarter shows a 45.5% climb in merchandise inventory. Whenever inventory outpaces sales growth (up 32% this quarter), your Rule Maker managers fly a red flag over the financial statements. We want product turns to speed up, not slow down. So, even though Gap has since stated that the inventory rise is tied to its anticipation of rising demand at Banana Republic and Old Navy, we're hesitant. We just can't overlook the fact that same-store sales at its flagship Gap stores have been running down 5% over last year -- which may be contributing to the growth in unsold product.

The end result of the past year is that Gap's rating has now fallen below that of Abercrombie & Fitch -- the smaller, though leaner of the two. Abercrombie has more rigorously managed its growth, holding its Flow Ratio to 0.71 (while Gap's has climbed to 1.13), and inching margins higher without the short-term assistance of debt financing. Abercrombie, heading into the rest of this year, is the leaner, meaner retailing organization.

This does not mean that Gap's results haven't been great this year. Heck, how often are you going to spin 82% out of a large-capitalization business in a single year? Gap's year has been a success. That said, Gap has fallen into Third Tier status. This is a mild disappointment. It's what will have us more closely following Gap's balance sheet in the quarters ahead.

Finally, while trying to distinguish myself as much as possible from Jimmy the Greek guru predictions, I find it very hard to believe that Gap will duplicate over the next three years its appreciation of 369% over the last three years. Yes, we have a great company on our hands. I can't imagine not holding this one for more than a decade. That said, the competition is creeping up and our casual clothes retailer has plenty of challenges ahead.

Tomorrow night, Phil's back for a look at Cisco Systems' (Nasdaq: CSCO) recently announced earnings.

Tom Gardner, Fool

05/17/99 Close

Stock Change    Bid
AXP   +  7/8    121.63
CHV   +1 7/16    95.88
CSCO  +1        116.44
EK    -  7/8     76.75
GM    -2 13/16   80.31
GPS   -1 9/16    61.06
INTC  +1 7/16    59.44
KO    +1 7/8     67.13
MSFT  +2 1/4     79.13
PFE   +1 3/16   114.38
SGP   -  13/16   47.06
TROW  -  3/32    37.69
XON   +  1/4     79.00
YHOO  +4 7/16   161.81


                  Day     Month  Year    History
        R-MAKER  +0.62%  -3.27%   8.42%  37.19%
        S&P:     +0.13%   0.32%   9.29%  35.19%
        NASDAQ:  +1.34%   0.75%  16.84%  54.99%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   48 Microsoft     39.13     79.13   102.19%
   6/23/98   34 Cisco Syst    58.41    116.44    99.34%
    5/1/98   55 Gap Inc.      34.37     61.06    77.66%
   2/13/98   44 Intel         42.34     59.44    40.39%
    2/3/98   22 Pfizer        82.30    114.38    38.97%
   2/17/99   16 Yahoo Inc.   126.31    161.81    28.11%
   5/26/98   18 AmExpress    104.07    121.63    16.87%
    2/6/98   56 T. Rowe Pr    33.67     37.69    11.92%
   8/21/98   44 Schering-P    47.99     47.06    -1.94%
   2/27/98   27 Coca-Cola     69.11     67.13    -2.87%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon         64.34     79.00    22.79%
   3/12/98   20 Eastman Ko    63.15     76.75    21.54%
   3/12/98   15 Chevron       83.34     95.88    15.04%
   3/12/98   17 General Mo    72.41     80.31    10.92%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
   6/23/98   34 Cisco Syst  1985.95   3958.88  $1972.93
    2/3/98   48 Microsoft   1878.45   3798.00  $1919.55
    5/1/98   55 Gap Inc.    1890.33   3358.44  $1468.11
   2/13/98   44 Intel       1862.83   2615.25   $752.42
    2/3/98   22 Pfizer      1810.58   2516.25   $705.67
   2/17/99   16 Yahoo Inc.  2020.95   2589.00   $568.05
   5/26/98   18 AmExpress   1873.20   2189.25   $316.05
    2/6/98   56 T. Rowe Pr  1885.70   2110.50   $224.80
   8/21/98   44 Schering-P   2111.7   2070.75   -$40.95
   2/27/98   27 Coca-Cola   1865.89   1812.38   -$53.52

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon       1286.70   1580.00   $293.30
   3/12/98   20 Eastman Ko  1262.95   1535.00   $272.05
   3/12/98   15 Chevron     1250.14   1438.13   $187.99
   3/12/98   17 General Mo  1230.89   1365.31   $134.42

                              CASH     $70.09
                             TOTAL  $33007.22

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it adds $2,000 in cash (which is soon invested in stocks) every six months.

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