Is This Stock About To Gap Up?
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
If you want a lesson in what happens when a company hits its saturation point, take a look at The Gap (NYSE: GPS). The company grew its traditional Gap stores, and repeated its successful formula over and over again as it moved across the country. However, once Gap started to saturate its traditional market, the company created the Banana Republic concept. About ten years after Banana Republic, the company introduced Old Navy. In the last six years, the company has expanded again introducing Piperlime and Athleta. Here is the problem: As the company has expanded, it stopped having one great concept, and now is just average at several concepts. Sometimes it makes more sense for a company to concentrate on its strengths, and find new places to expand, rather than to create new concepts. With this as a backdrop, let's find out where Gap is now, and what the company is doing to improve its fortunes going forward.
With five different brands, Gap is managing multiple concepts and multiple customer bases. Apparently Gap has decided, that they are going to cut down their number of stores while moving toward more francised stores. In theory, this move will initially reduce revenues, but should improve margins and profits. Take a look at the total number of company-owned stores versus franchised stores:
You can see that the company is slowly whittling down their company-owned stores and opening more franchised stores.
If you are looking for positive signs that show Gap is beginning to turn the corner on their sales problems, look at the same store sales of each of their brands in the last four months:
Of the four different major brands that Gap manages you can see that all have improved in the last four months. The two oldest chains have made the most improvement, and seem to be performing more consistently. Gap and Old Navy have seen a consistent improvement in same store sales in the last four quarters. While Banana Republic and the international division have improved, they showed a reversal between February and March. It seems that Gap needs to realize, that maybe what works in the U.S. doesn't necessarily work internationally. When the company's future growth driver (international) is showing an average of 2% same store sales growth, something is clearly wrong.
With the stock selling for $27.62 it trades at about 15.09 times 2012 estimated earnings. The company is expected to grow earnings at a 8.84% rate over the next few years. This growth rate could be low, as the company has a history of beating earnings estimates. In the last four quarters, the company beat estimates all four times. Analysts have noticed, and have raised full year 2012 and 2013 estimates by 3.98% and 5.67% respectively. When it comes to cash flow, Gap is still generating a good amount. The company generated $0.11 of free cash flow per $1 of assets over the last four quarters. A retailer that I like and competes with Gap, American Eagle Outfitters (NYSE: AEO) generated $0.07 of free cash flow per $1 of assets in the same timeframe. American Eagle has the much higher expected growth rate, but can't match Gap's cash flow generation at this point.
If there is one concern that I've noticed, it's that in the last two years Gap has spent more on share repurchases than operating cash flow. While this could be a sign that management believes very strongly that the stock is undervalued, it also could be a way to manufacture higher earnings per share. In the year ended January 2011, Gap had $1.7 billion in operating cash flow. After capital expenditures and dividends, management could have used the remaining $891 million to repurchase shares. Instead, the company drew cash off the balance sheet and repurchased $1.89 billion shares. In the year ended January 2012, the company had a net of $579 million that could have been used to repurchase shares. Instead, the company actually borrowed about $1.6 billion in new long term debt and used the proceeds to buy back over $2 billion in shares. It's admirable to make these moves if the company believes that strongly in their shares. The bad news is, the balance sheet now has $688 million less cash and $1.6 billion more debt. If I'm a shareholder, I would rather management use free cash flow to repurchase shares rather than diminish the quality of the balance sheet trying to accomplish more. This trend is something for long term shareholders to keep an eye on.
With less overall stores, but more franchised locations, shareholders should expect to see Gap revenues decline or flatten while profits improve. If the company can maintain the momentum of same store sales growth across its concepts, earnings could come in better than expected. The company generates plenty of cash flow, but to me management needs to use free cash flow for share repurchases and stop using cash and debt to finance what they can't afford. A better balance sheet is worth more than a short term earnings per share boost. Personally I would like to see a few more months of improved same store sales, before I would consider giving GPS my green thumbs-up on CAPSCall. Let me know what you think of Gap in the comments section below.
The Motley Fool has no positions in the stocks mentioned above. MHenage has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.