Our longtime readers know our aim as Rule Makers is to create a small portfolio of the best companies in the world, companies we really want to own and with which we can partner for the long-term. Perhaps even for the rest of our lives.

In fact, since the inception of this real-money portfolio on February 2, 1998, we've bought shares of 12 Rule Maker companies and sold exactly... none. (We did sell our Foolish Four companies last year to focus on Rule Makers more completely.) Our reluctance to sell is very much in keeping with our mission. We do a lot of work up front, we make sure that we are comfortable owning these companies for a long time, and then we let that time work for us. Low effort, low taxes, low commission costs, and low stress are advantages of our philosophy.

Well, today I'm proposing we sell one of our holdings. That's right. I'm suggesting that we throw back Gap (NYSE: GPS), and put the proceeds into the purchase of a company more deserving of our capital.

To make sure we aren't taking the hasty path, let's review our Rule Maker guidelines for selling. In a June 6 article, Fool writer Bill Mann provided an excellent outline, six scenarios that merit considering a sale. Of those six, only one qualifies here: deteriorating financials. Bill went on to introduce his "four for four" rule of thumb: Any current holding that fails four of our six quantitative tests for four consecutive quarters is a candidate to be sold.

"Even the best companies have down quarters, or even down cycles. But, poor performance for a full year is reason enough to question the quality of any company, even one we bought intending to hold for decades."
Before we evaluate Gap, I propose a modification to the rule. You see, there are companies in seasonal industries that would be able to dodge the four-by-four bullet with one decent quarter every year, despite the fact that total-year results are unquestionably subpar. In this case, it's important to look at the trailing 12-month period as a whole to ensure that one decent quarter isn't keeping a deteriorating Rule Maker in our portfolio for years and years, underperforming all the while. It's important to go beyond the short-term and look at the business performance over a longer time horizon.

Let's see how Gap stacks up on the six quantitative criteria that we use to evaluate all Rule Makers:
  • Minimum sales growth of 10% annually
    The Gap has grown sales 20.2% through the first six months of 2000. Unfortunately, same-store sales have been negative, and this sales growth is only coming because Gap is adding new stores at an amazing rate for a company its size. In the first quarter alone, Gap added 139 new stores and is on pace to increase selling space square footage 30% for the year. Sure, it's well above our 10% target for annual sales growth, but not in a good way.

  • Gross margin > 50%
    Gap's gross margin for the past 12 months is 40.9%, with a high of 42.8%, and the most recent quarter result of 37.7%. Gap has never exceeded 50% gross margins, and it probably never will. That's one strike.

  • Net profit margins > 10%
    We've recently raised the bar from 7% to 10%. Still, net margin for the most recent quarter was only 6.2%. For the last four quarters, it's 9.1%. As you can see, Gap doesn't measure up to our new, stronger target. At least the company will exceed our old standard, assuming normal third- and fourth-quarter results. We'll come back to this one, but for the moment let's give Gap the benefit of the doubt.

  • Cash no less than 1.5 times debt
    This one is really bad. Gap's cash-to-debt ratio has consistently deteriorated from a high of $1.57 in cash for every dollar in debt back in Q4 1998, to only 17 cents in cash for each dollar of debt in the most recent quarter. This is a direct consequence of poor free cash flow. Negative free cash flow means that Gap must borrow to keep funding that rapid store expansion we noted earlier. We like companies that can use free cash flow to fund their expansion, thereby keeping their debt moderate. Gap is fueling their expansion with debt, which is anathema to Rule Maker investors. That's two strikes.

  • Foolish Flow Ratio below 1.25
    Gap's Flow Ratio the past four quarters, from least recent to most recent, is 1.34, 1.10, 1.41, and 1.59. It's missed three of the last four quarters. The previous year, Gap only missed once, and just barely, with a Flowie of 1.35 in Q3 1998. That's called strike three.

  • Cash King Margin of 10% or better
    Gap's Cash King Margin for the 12-month period was a negative 2.4%. Ouch. In fact, Gap only generates a decent Cash King Margin one quarter of the year, during its strong Christmas season. I'll insert a quote here from fellow Fool Robert Fredeen's most recent report on Gap: "Given the negative outlook for the rest of this year, it is unlikely the company will generate enough operating cash to bring free cash flow back to positive levels." That, my friends, is strike four. And, in this game, four strikes means Gap is out. (For an in-depth look at Gap, check out Bob's report in the Motley Fool Research center.)
Gap fails four of the six Rule Maker metrics, and isn't even in the ballpark anywhere except for the Flow Ratio, which the company typically keeps under our target just two quarters of the year in the best of times. This comes at a time when we're raising the bar on net margin to 10%, a measure that Gap likely won't exceed for any full-year period going forward. That's a potential fifth strike against it.

My final argument is more simple. In the Rule Maker Portfolio, we can only own 12-15 companies, and those companies should be among the best in the world. The Gap, while a formidable company and a clear leader in retailers, isn't one of the top 20 or even 50 companies in the world, as measured by our criteria. That's just not good enough for me.

The other Rule Maker managers will be weighing in with their thoughts on Gap over the next week.

What do you think? Should the Rule Maker throw Gap back, or do we keep it?

Let us know what you think in this poll.

Related Links:
  • Gap's Big Sell-Off, Rule Maker Portfolio, 8/11/00
  • Gap Looks Winded, Rule Maker Portfolio, 8/8/00