Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
Shares of retail clothier The Gap (GPS -5.16%) are down 4% since the start of this year, and down 16% since their highs of May 10 -- a week before Gap reported its fiscal Q1 earnings results. And yet, by all accounts, Gap beat earnings pretty soundly in Q1. Is that fair?
One banker doesn't think so. This morning, analysts at Oppenheimer announced they are upgrading Gap stock from perform to outperform, and assigning the stock a $28 price target, implying 24% upside from today's stock price.
Here are three things you need to know about that.
Image source: Getty Images.
1. Gap's sad history
Gap entered into Q1 carrying a mighty burden. For three straight years, business had been going from bad to worse.
From 2014 through 2017, Gap watched 270 basis points (that's 2.7 percentage points) get sliced off of its gross profit margin. Its operating profit margin tumbled 380 basis points, and its net profit margin fell from 7.9% to 4.4% -- 350 basis points. Sales declined nearly 4% over the period, falling to $15.5 billion last year.
And profits? Those got nearly cut in half, falling to just $676 million earned in 2016.
2. Gap changes the story
And then, a miracle happened. Helped by a big 8% jump in same-store sales at its Old Navy chain in Q1 2017, Gap announced quarterly sales of $3.44 billion, edging out consensus expectations by about $60 million. More importantly, profit margin on that revenue surged higher, helping to lift profits a full $0.07 past consensus expectations, to $0.36 per share.
3. What comes next
Now, the news wasn't all good for Gap last quarter. While the company's biggest revenue producer, Old Navy, got bigger and more profitable, StreetInsider.com reports that sales tumbled 4% at both the company's eponymous Gap chain and at Banana Republic, as well. But that's not necessarily bad news.
Reiterating earnings guidance of about $2 for the year, Gap CEO Art Peck said he still hopes to translate improved results at Old Navy into similar turnarounds for the company's other brands. And he's having some success with that.
As Oppenheimer pointed out in its upgrade, gross margins improved "across all three" of Gap's main brands. What's more, summing up the parts that Gap comprises, Oppenheimer believes that Old Navy and Gap together are worth the $22 and change that the stock currently sells for. According to the analyst, at today's prices, investors are basically getting Banana Republic, and the up-and-coming Athleta brand -- which Peck called an "exceptional performer" last quarter -- for free.
The most important thing: Valuing Gap
Despite the strong Q1 report, and despite Oppenheimer's optimism, investors have sold off Gap stock to the tune of about 3% since earnings came out. (They're selling it again today, despite the upgrade.) But I think investors are making a mistake, and I'll tell you why.
At current prices, Gap stock sells for a mere 13 times trailing earnings. The fact that Gap just finished reporting 12% earnings growth -- and the low PEG ratio that this implies -- suggests to value investors that Gap stock might be cheap. (The fact that Gap pays a 4.1% dividend yield on top of its cheap stock price practically screams "bargain.") But Gap stock is even cheaper than it looks on the surface.
According to S&P Global Market Intelligence data, although Gap reported earnings of only $692 million over the past 12 months, its actual free cash flow generated during the period amounted to $1.15 billion. Yet once you factor Gap's copious cash reserves into the picture, Gap's enterprise value is only $8.7 billion -- yielding an enterprise value-to-free-cash-flow ratio of only 7.5.
That number compares favorably to the 8% long-term growth estimate that analysts have on record for Gap -- and even more favorably if Gap can replicate the 12% growth it produced in Q1. Toss in the 4.1% dividend yield for good measure, and I think Oppenheimer just may be onto something here.
Gap stock is cheap.
