Gap, Inc. (NYSE: GPS) reported lackluster second-quarter operating results yesterday morning and warned of expected weakness in the retail sector that likely means a slow second half as well. The market responded by smacking our company's stock down roughly 15%.

The market often reacts to short-term earnings weakness with a Pavlovian sell reflex, but this sell-off appears to me more rational than most. After taking a closer look at Gap's numbers, our Rule Maker clothing retailer is looking as tattered and frayed as some of my old blue jeans.

Here's a run-down on the latest quarter. Total sales rung in at $2.95 billion, 19% ahead of the $2.45 billion in the second quarter of 1999. That sounds pretty good, but those additional sales came by adding 623 new stores, which increased the store count by 23% and square footage by 32%. Per-store sales dropped from $920K in the second quarter of 1999 to $897K in 2000, and sales per square foot dropped from $120/foot to under $110/foot in the same period.

Same-store sales were up slightly for the flagship Gap stores, and were flat at Banana Republic. Considering the tough environment, those are all very acceptable performances. Same-store sales at Old Navy, which is Gap's fastest-growing brand, came in at "a negative low-double-digit" rate, after posting same-store sales growth of over 20% last year. With Old Navy being counted on to drive Gap's continued growth, that big negative comp is not a good sign.

The rest of the income statement is also less than inspiring. Gross margins dropped to 37.7% from 41.1% a year ago due to what the company described as heavy promotional activity, and net earnings dropped by 6% year-over-year, resulting in a nasty drop in net margins to 6.2% from 8% a year ago. Earnings per share came in at $0.21, a penny less than last year at this time.

While the income statement results weren't pretty, it's the balance sheet that causes me the most concern. Cash and equivalents dropped to $327 million from $420 million a year ago. At the same time, short-term debt (in the form of notes payable) more than doubled to $859 million, and long-term debt also more than doubled to over $1 billion. The combination dropped Gap's cash-to-debt ratio from 0.44 in 1999 to 0.17 in the most recent quarter.

Inventories increased 38.4% year-over-year, and those bloated inventories caused the Foolish Flow Ratio to balloon as well. Since 1998, Gap's second-quarter Flow Ratio has gone from 1.10 to 1.25 to a very unsightly 1.65 in the latest quarter. While no cash flow statement is available, we already know that a higher Flow Ratio usually portends constricted cash flow.

Let's review those numbers one more time in the context of our Rule Maker statistical criteria: 
RM Criteria                  Gap Q2 
Sales growth > 10%            19.2%
Gross Profit Margin > 50%     37.7%
Net Profit Margin > 7%         6.2%
Cash-to-Debt Ratio > 1.5       0.17
Foolish Flow Ratio
While the company didn't provide cash flow data on the earnings release, I'd be surprised if the company comes anywhere close to our 10% Cash King Margin standard. In the earnings call, Gap CEO Millard Drexler was quick to point out that Gap isn't alone in its struggles during what has been a tough retail environment made tougher by the fantastic results turned in by retailers in the first half of 1999, which has made this year's lackluster performances seem even more substandard.

Many retailers, including Gap competitors Abercrombie & Fitch (NYSE: ANF) and American Eagle (Nasdaq: AEOS), have also experienced ugly first-half results, especially in the same-store sales category.

Considering that the retail environment is presumably tough for everybody, let's see how Gap's numbers compare to Abercrombie & Fitch. (Disclosure: I own shares in both companies.) 
RM Criteria                  ANF Q2
Sales growth > 10%            16.4%
Gross Profit Margin > 50%     39.5%
Net Profit Margin > 7%        12.2%
Cash-to-Debt Ratio > 1.5    No debt
Foolish Flow Ratio
Note that Abercrombie, while also suffering from sale-store sales declines to the tune of 6%, was still able to keep the net profit margin very high (almost double that of Gap), took on no debt, and kept a tight lid on inventories, turning in a very good Flow Ratio. While Abercrombie has been on a receiving end of some serious Wall Street scorn this year, Gap's stock price had weathered the retail storm quite well until today.

Although today's downward dip was unwelcome, I can't say it isn't wholly undeserved. Gap's stock price has perhaps benefited from some amount of investor perception that a company this big and stable and featuring such a dominant brand wouldn't be as negatively affected by the retail slowdown as smaller, more fashion-oriented chains like Abercrombie and American Eagle.

The last two quarters are proof that Gap is not immune to the cycles of the retailing industry, dominant brand or no. While Gap is still the Rule Maker of the retail apparel world, the second-quarter numbers reflect that this company has some chinks in the armor. This company has fought through such rough stretches before, and I will be expecting to see Gap regain some momentum in the seasonally strong third and fourth quarters.

Have a great weekend!