Specialty apparel retailer Gap (NYSE:GPS) reported third quarter earnings on Thursday after the market close that matched analyst expectations. A worrisome trend was that cash flow has dropped significantly from last year, though the all-important holiday season is just approaching. Additionally, existing store growth is still not at the levels where investors can garner steady gains from the stock.

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Third-Quarter Review
Net sales increased a modest 2% to $3.7 billion. Same-store sales were flat but Gap opened six new net stores and saw online sales jump 15% to reach almost 10% of total sales. The company breaks out comparable store sales by its three concepts in North America and also provides overall international comp data. Gap and Banana Republic each reported 1% comp growth while Old Navy fell 2%. International saw comps improve 3%. The firm ended the quarter with nearly 3,100 stores.

Gross profit fell slightly to $1.51 billion as the cost of goods grew 4% to outpace sales growth. This was attributed in part to higher cotton costs that are increasing production costs in China and adversely affecting other apparel firms including J.C. Penney (NYSE:JCP), Ralph Lauren (NYSE:RL) and even Wal-Mart (NYSE:WMT). Cost controls pushed other operating costs down more than 2% and allowed operating income to grow almost 1% to $504 million, or 13.8% of sales. Higher income taxes turned net income growth negative, with a fall of 1.3% to $303 million, or 48 cents per diluted share.

Outlook
Gap provided a general outlook for the remainder of the year and said it expects a full-year operating margin of about 13%. Analysts currently project sales growth of 2.5% for total 2010 sales of $14.6 billion and earnings of $1.82 per share. This would represent year-over-year profit growth of 15%.

Gap's Strategy
Gap continues to emphasize international growth going forward. It just opened its first namesake stores in China and Italy, as well as another store in Australia. It has found ways to wring additional cash flow out of its existing store base, though on a year-to-date basis free cash flow has fallen rather dramatically as operating cash flow has fallen and capital expenditures are almost double last year's levels. This could very well be due to inventory stocking for the all-important holiday season, but is something that should be watched closely.

Bottom Line
Gap's large existing store base will make it difficult to grow its way to higher levels of sales and profits. Efficiencies at existing stores have helped, but until it can find a way to consistently raise the performance of existing stores, the stock will likely remain a laggard in terms of total shareholder returns. Archrival Limited Brands (NYSE:LTD) is proving that a constant supply of new products can drive sales and is something that Gap is looking to emphasize going forward. (To learn more, check out Analyzing Retail Stocks.)

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Tickers in this Article: GPS, JCP, RL, WMT, LTD

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