Gap's (GPS) Q3 Earnings Meet, Soft Sales & View Hurt Stock

After delivering a positive earnings surprise in the last quarter, The Gap Inc. GPS returned to its old trend of posting in-line earnings in third-quarter fiscal 2016. Also, sales surpassed estimates for the second consecutive quarter. However, weak demand, sluggish traffic, stiff competition from other apparel chains and softness across most brands continued to weigh upon results that declined year over year. Results were also hampered by the campus fire that hit Gap’s distribution center in Fishkill, NY, in Aug 2016.

Moreover, the company’s planned store closures for fiscal 2016 reflect soft demand expectations for the holiday season, which in turn created a negative sentiment among investors, leading shares to slide 4.1% in the after-market trading session yesterday.

Q3 Highlights     

Gap’s adjusted earnings of 60 cents a share came in line with the Zacks Consensus Estimate but dropped 4.8% from the year-ago period. On a GAAP basis, earnings came in at 51 cents per share, down 16.4% from 61 cents recorded in the year-ago period.

GAP INC Price, Consensus and EPS Surprise
 

GAP INC Price, Consensus and EPS Surprise | GAP INC Quote

Net sales of $3,798 million dipped 1.6% from the year-ago figure, marking its seventh straight quarterly decline. Sales continued to be hurt by soft Banana Republic and Gap’s namesake brand performances, somewhat compensated by decent trends witnessed at its Old Navy brand. However, sales in the quarter were positively impacted by currency translations to the tune of nearly $17 million. Also, the top line surpassed the Zacks Consensus Estimate of $3,773.0 million.

Comparable-store sales (comps) for the fiscal third quarter fell 3%, compared with a 2% decline recorded in the year-ago period. As mentioned above, comps in the quarter were hurt by roughly 2% due to the Fishkill distribution center fire.

Brand Details

Comps at Gap Global declined 8% compared with a 4% drop recorded last year. Further, Banana Republic Global posted an 8% decline, compared with a 12% fall last year. Old Navy, on the other hand, reported comps growth of 3% compared with a 4% increase last year.

Also, brand-wise, the Fishkill fire hurt comps at each of the company’s brands during the quarter. Comps for Gap Global included about 4 percentage points impact from the fire, while comps for Banana Republic were hurt by nearly 2 percentage points. Further, Old Navy’s comps, though positive, bore approximately 1 percentage point impact from the fire.

Margins

Gross profit jumped 3.7% to $1,493 million, with the gross margin expanding 200 basis points (bps) to 39.3%. We believe that this is largely attributable to strong merchandise margins, which soared 220 bps in the quarter, mainly backed by strength in the Old Navy brand.

Operating income, however, declined 6% to $389 million, with the operating margin contracting about 50 bps to 10.2%, mainly owing to elevated marketing and operating expenses, with the latter also including costs related to the restructuring initiatives announced in May 2016.

Financials

Gap ended the reported quarter with cash and cash equivalents of $1,522 million, long-term debt of $1,320 million, and total shareholders’ equity of $2,726 million.

During the first three quarters of fiscal 2016, the company generated cash flow from operations of $800 million and incurred capital expenditure of $383 million. Additionally, the company’s year-to-date free cash inflow totaled $417 million. For fiscal 2016, management still projects capital expenditure of approximately $525 million.

Coming to Gap’s shareholder-friendly moves, it paid 23 cents per share as quarterly cash dividend during third-quarter fiscal 2016, and announced the same dividend for the fourth quarter.

Store Update

In the third quarter, Gap introduced 36 stores, while shuttering 28 company-operated stores. It ended the quarter with 3,742 outlets in 50 countries, of which 3,281 were company-operated and 461 were franchise. Square footage of company-operated stores declined about 2% year over year.

In fiscal 2016, Gap now expects about 65 net closures of company-operated stores, compared with 50 net closures projected earlier. Consequently, it anticipates square footage growth to drop nearly 3% year over year now, compared with 2% anticipated earlier. Per sources, the unfavorable store closure forecast is a result of soft demand expectations and a greater fall in consumer traffic during the significant holiday season. Additionally, intense competition from fast growing apparel chains and online retailers continues to pose threats to Gap.

Outlook

Expecting a tough holiday season ahead, the company is firing on all cylinders to make the most of the opportunity. This is evident from the holiday strategies announced by its best-performing Old Navy brand and its namesake brand, which remains committed toward improving its performance. Also, Gap’s Athleta brand is progressing well with its innovations and efforts toward becoming a performance and lifestyle brand, as evident from its solid footprint by the end of the third quarter.

Further, Gap has undertaken several contingency steps with regard to the Fishkill fire to minimize the adverse effects from this calamity. These include the company’s act of rerouting deliveries and increasing the staff strength at other facilities. Evidently, Gap is using its North American distribution center channel and ship-from-store capacity to curtail the impact of the fallout.

All said, management retained its fiscal 2016 earnings outlook. The company still envisions adjusted earnings for the fiscal year to range from $1.87−$1.92 per share, compared with $1.92 predicted earlier. However, the guidance compares unfavorably with the current Zacks Consensus Estimate of $1.99.

Zacks Rank

Gap carries a Zacks Rank #2 (Buy). Other well-ranked stocks in the same industry include The Children's Place, Inc. PLCE, with a Zacks Rank #1 (Strong Buy), Foot Locker, Inc. FL and Nordstrom Inc. JWN, each carrying a Zacks Rank #2.  You can see the complete list of today’s Zacks #1 Rank stocks here.

Children's Place has an average positive earnings surprise of 33.1% in the trailing four quarters. The stock, with a long-term growth rate of 10.3%, has seen positive estimate revisions in the last seven days.

Foot Locker has an average earnings beat of 3.1% in the last four quarters. Moreover, the company’s long-term growth rate of 9.9% and positive estimate revisions for the current quarter, over the past seven days bode well.

Nordstrom’s long-term EPS growth rate of 9.7% and solid positive estimate revisions for the current fiscal over the past seven days help it stand strong in the industry. Moreover, the company has delivered back-to-back earnings beat in the last two quarters.

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