<THE RULE MAKER PORTFOLIO>
The Jekyll and Hyde
of Gap's Financials
ALEXANDRIA, VA (August 16, 1999) -- On Friday, I walked through the first half of the Rule Maker Criteria in our quarterly check-up of Gap Inc.'s (NYSE: GPS) earnings. To briefly review, Gap continues to be a phenomenal growth story, but pressure is mounting from the competition.
Tonight, we'll turn to the numbers in search of further clues as to how our casual clothing retailer is executing its business plan. Lest "the numbers" make your eyelids heavy, stick around because I'll be supplementing this report with some of the juicy details that were revealed on Gap's closed-door analyst conference call (more on that later).
Sales Growth -- This was a good news-bad news quarter for Gap sales. First, the good news. Sales of $2.5 billion during the quarter translates into a 29% year-over-year growth rate, which is well ahead of our benchmark of 10% growth. For the past three years now, the company has grown sales by a compound annual rate of greater than 30%. Operating across 20.4 million square feet, this quarter's $120 of sales per square foot, up 12%, was the highest ever.
Now for the bad news. Same-store sales rang in at a somewhat disappointing 8%, which was -- to be fair -- on top of last year's super-charged 18% increase. Here's how the second quarter same-store sales broke down on an approximate percentage basis among the three major brands:
Gap - negative low single digits
Banana Republic - positive low teens
Old Navy - positive low 20's
July, in particular, was a slow month for Gap. On August 5, the company reported July same-store sales growth of a paltry 2%, down from a 19% increase a year ago. That news sent the shares tumbling nearly 8%. The slowdown in Gap's performance deserves some explanation.
The first culprit was the comeback of fashion. Until recently, Gap's "basics" line of apparel was praised for being a risk-free retail strategy. Khakis, jeans, and T-shirts never go out of style, especially when backed up by great advertising. By steering clear of fads, it was thought that Gap would never be left holding the bag on unwanted passe items.
Enter "lifestyle" retailer Abercrombie & Fitch (NYSE: ANF). Several years ago, this brand was just an up-scale version of The Gap with more of an outdoorsy image. But now, the company has switched gears and turned towards a more fashion-oriented look. Abercrombie's strategy is driven by the belief that college kids lead the fashion wave. The company keeps its design people on a number of major U.S. campuses watching for emerging trends. Even though the brand has garnered a preppy, perhaps even snobby image, Abercrombie is enjoying phenomenal success. For more on that, see last Wednesday's Fool Plate Special.
The recent popularity of fashion apparel caught Gap by surprise. Practically overnight, Gap's bread-and-butter basics weren't the hot item they were last year. This is not to say that basics are "out" -- of course not. But Gap needs to do a better job of stocking an appropriate array of fashion items to meet current tastes. Fashion apparel will keep customers coming back and, in effect, drive greater sales of the usual staples of khakis, denim, and tees. According to management, the stores will be shifting to a greater proportion of fashion items in the very near future. The company also intends to improve its in-store displays. That comes as good news considering a recent Gap store report from my sister (see Friday's report for an introduction to Anna, the fashion wonder girl -- doubt her judgment at your own risk):
"They seem to be trying to make a statement by clashing. The face-outs (example outfits hanging on front of racks) in the front were all two-toned clashing shades of the same color!"
The second drag on sales was an intentional delay in the fall advertising campaign and merchandise roll-out. Management sharply curtailed television advertising during July so that it could instead devote greater resources to a more powerful back-to-school ad campaign during August. The thinking was that it makes more sense to advertise when people are buying clothes, not vacationing. The strategy makes sense, but we better see a strong August and September to make up for the weak July.
Finally, one issue that is not impacting sales is Old Navy cannibalization on The Gap. There are now 100 adjacent locations of The Gap and Old Navy. According to studies by the company, a new Old Navy store tends to reduce the same-store sales of an adjacent Gap by a mid-to-high single digit percentage basis, but only in the first year-and-a-half, and then the difference disappears.
Gross Margins -- Second quarter gross margins came in at 41.2%, which is up from the year-ago 40.4%, but down slightly from last quarter's 41.4%. Anyway you cut it, Gap doesn't quite meet our 50% benchmark, but the company is moving steadily in the right direction. Over the past five years, gross margins have expanded by more than 500 basis points (or 5 percentage points). Part of the improvement comes from lower occupancy costs as a percentage of sales, which reflects the greater impact of warehouse-style Old Navy stores on the overall mix. Gross margins also benefit as the company continuously searches for the lowest factor cost production geographies.
Management attributes the sequential gross margin decline to greater sales of marked-down inventory. This is where the company takes a hit for being behind on the fashion curve.
Net Margins -- This quarter's net margin of 8.0% marked an increase over last year's 7.2% but a decrease from the first quarter's 8.9%. Here, Gap comes in ahead of our 7% benchmark, but the sequential decline is somewhat disconcerting considering the gains that should've come with the cutback in advertising expenditures during the quarter. Another expense that's beginning to weigh on net margins is interest expense, which now accounts for 0.1% of sales, up five-fold (by dollar amount) from a year ago.
Cash-to-Debt Ratio -- Here's where the financials take a turn for the worse. We like to see cash climbing and debt dwindling. The opposite is true of Gap's balance sheet, where the ratio of cash-to-debt now stands at 0.46 and is dropping with each passing quarter. Our benchmark for this ratio is 1.5x more cash than debt. As it stands now, $520 million more debt than cash -- not good. To make matters worse, the company used $159.5 million to repurchase 3.8 million shares during the quarter (which gives an average price of $41.97 per share).
Buying back stock and taking on debt are inline with the company's top two priorities of: 1) growth on top of growth; and 2) improvement in returns. During strong economic times like we have right now, a highly leveraged (i.e., high debt) balance sheet makes returns look fantastic. Gap's annualized return on equity for the past six months is 60%. But leverage works both ways. If our economy fell into recession, Gap would take it on the chin, and doubly so because of its debt load. Let me be clear that as of right now, Gap's debt isn't at an obscene level, but the direction is disturbing.
Considering the company's stated commitment to growth and high returns, there's little reason to believe the company will be paying off its debt anytime soon. Unless there's a change in financial policy, I expect Gap will continue to use debt to finance its store expansion. For the full 1999 fiscal year, capital spending will top $1 billion, and with 20% store count growth expected for fiscal year 2000, more debt is on the way.
Again, if management pulls off a successful expansion with no interruptions from external shocks, then the rewards will be great for Gap shareholders. But if recession or advertising flop or any other unpredictable event gets in the way, then the downside will be all the more painful with an increasingly leveraged balance sheet.
Flow Ratio -- If expanding debt weren't enough cause for concern, Gap's working capital management also appears to be deteriorating. This quarter's Flowie of 1.25 is up from 1.10 a year ago and up from 1.13 in the prior quarter. That's bad news folks, especially considering that the culprit is inventory. It's never good to see inventory grow faster than sales, but that's exactly what's happening at Gap on both a year-over-year and sequential basis. Compared to last year, inventory is up 36% versus a 29% increase in sales. The picture is even worse on a sequential basis with inventory up 25% versus only an 8% rise in sales.
Considering what we already know about the company's problems catching up to consumers' demand for more fashion items, Gap could be facing a glut of basics. That wouldn't be too bad considering that basics don't go entirely out of style, but nevertheless, it may lead to more mark downs in the upcoming quarter, which would again put pressure on gross margins, and thus would pinch the bottom line.
For a glimpse at all the numbers, I ranked Gap versus its primary competitors: Abercrombie & Fitch, Limited, and American Eagle Outfitters. I also ranked Abercrombie versus the same companies, and found its financials to be much easier on the eyes -- no debt, low and declining Flow ratio, and expanding margins.
For the second quarter in a row, Abercrombie looks like a superior company to our Rule Maker. Right now, Gap may be a more prolific chain of brands, but no doubt, Abercrombie intends to expand in a similar fashion. If it can keep same-store sales high, expand its brand, and keep a tight rein on its balance sheet, our company may face some troubling times ahead. This is a story to watch closely.
Now, looking back through this column, you may notice a few facts that weren't an extrapolation from the numbers and weren't part of Gap's earnings press release. That would be the information I obtained by listening to Gap's closed-door analyst conference call, which was actually an audio feed from a live presentation to analysts in New York (I was able to sneak in as a "portfolio manager"). By listening to that call, you would've even learned that Gap expects sales for the year to come in at $11.5 billion. The Gap CFO even went so far as to explain to analysts how to arrive at that number -- start with square footage growth and then apply mid-single digit comp store sales estimates. See, being an analyst isn't so hard!
If you're a Gap shareholder, prospective shareholder, or even just a member of the investing public who thinks public companies should be required to divulge such information to all parties, then please consider giving Gap a call at 1-800-333-7899 (ask for corporate communications). Phil and I spoke last Wednesday with a "Debbie" in Gap's corporate communications who was very understanding of our concerns and who stated that Gap was considering opening these calls. Perhaps if the company realizes the demand for this information from investors like you, then they'll be more likely to change their policy.
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Day Month Year History R-MAKER +0.20% 0.51% 12.42% 41.58% S&P: +0.23% 0.15% 8.84% 34.64% NASDAQ: +0.28% 0.26% 20.64% 60.04% Rule Maker Stocks Rec'd # Security In At Now Change 6/23/98 68 Cisco Syst 29.21 63.50 117.43% 2/3/98 54 Microsoft 45.13 84.31 86.80% 5/1/98 82 Gap Inc. 23.05 42.56 84.63% 2/13/98 52 Intel 46.93 78.56 67.41% 5/26/98 18 AmExpress 104.07 135.88 30.57% 2/3/98 66 Pfizer 27.43 34.88 27.13% 6/3/99 11 *Delphi Au 17.19 18.56 7.98% 8/21/98 44 Schering-P 47.99 49.69 3.53% 2/6/98 56 T. Rowe Pr 33.67 33.50 -0.51% 2/27/98 27 Coca-Cola 69.11 59.38 -14.08% 2/17/99 16 Yahoo Inc. 126.31 134.50 6.48% Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Exxon 64.34 81.56 26.78% 3/12/98 15 Chevron 83.34 95.88 15.04% 3/12/98 20 Eastman Ko 63.15 71.00 12.44% 3/12/98 17 *General M 61.28 61.69 0.66% Rule Maker Stocks Rec'd # Security In At Value Change 6/23/98 68 Cisco Syst 1985.95 4318.00 $2332.05 2/3/98 54 Microsoft 2437.28 4552.88 $2115.60 2/13/98 52 Intel 2440.28 4085.25 $1644.97 5/1/98 82 Gap Inc. 1890.33 3490.13 $1599.80 5/26/98 18 AmExpress 1873.20 2445.75 $572.55 2/3/98 66 Pfizer 1810.58 2301.75 $491.17 8/21/98 44 Schering-P 2111.7 2186.25 $74.55 6/3/99 11 *Delphi Au 189.09 204.19 $15.10 2/27/98 27 Coca-Cola 1865.89 1603.13 -$262.77 2/6/98 56 T. Rowe Pr 1885.70 1876.00 -$9.70 2/17/99 16 Yahoo Inc. 2020.95 2152.00 $131.05 Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 15 Chevron 1250.14 1438.13 $187.99 3/12/98 20 Eastman Ko 1262.95 1420.00 $157.05 3/12/98 20 Exxon 1286.70 1631.25 $344.55 3/12/98 17 *General M 1041.80 1048.69 $6.89 CASH $100.83 TOTAL $34854.21
Notes: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.
*Although DPH is not a Foolish Four stock, it was spun-off from GM on June 3, 1999