Mind the Gap
Every company’s earnings can be evaluated on a quantitative and qualitative basis. Strictly speaking quantitative analysis is straightforward—is the company growing sales, profits, free cash flow, etc.? Analyzing these metrics in the context of competitive factors, sources of revenue and profit growth, and broader secular trends is a more subjective exercise but a very important one to pair with quantitative analysis. Qualitative analysis, while difficult to outline in a pithy format, is a critically important part of the research process that we believe is well illustrated by reviewing Gap, Inc. (GPS).
Gap is a specialty apparel retailer with a majority of its sales and profits generated in the United States. In eight of the last ten years the company has posted negative comparable stores sales, and it has restructured operations by shuttering underperforming domestic stores and turning its focus to e-commerce and international expansion. On a quantitative basis, Gap screens well with increasing comparable store sales and profit over the last two years. On a qualitative basis, a variety of items including comparable store sales drivers, brand perception, accounting estimates, and drivers of earnings per share growth make us question that initial quantitative assessment.
Traffic (or volume of transactions) and to a greater degree pricing have been challenging at Gap. Despite posting positive comparable store sales over the last two years, traffic at Gap has been flat or down which is telling when one considers the great promotional lengths the company goes to in order to grow sales. Based on our review of a year’s worth of promotional e-mails, a Gap customer would virtually never have paid full price. CEO Glenn Murphy corroborated this view at the most recent company investor day in lamenting, “One of the biggest weaknesses in the company…it’s [sic] how much product as a percentage of the total units…we sell at ticket price.” Of course pricing decisions are not made in isolation of competition but in light of it. On that score, Gap faces a formidable and growing competitive set including: H&M, Forever 21, Uniqlo, Topshop, Inditex (Zara), ASOS, J. Crew and Primark to name a few.
The deterioration of Gap’s namesake brand has led to discounting that undermines the company’s ability to grow profits. An example of this discounting can be seen in the namesake brand’s outlet strategy which now represents just over a quarter of the Gap’s domestic store base. One may argue that a developed outlet strategy is necessary in an age of value, but if a retailer becomes overly reliant on outlet sales, it’s the brand that suffers. As retail luminary and CEO of L Brands, Les Wexner, stated at a recent investor meeting, “The outlet business is easy money [but] discounting yourself is the beginning of the end. I can’t find an exception. It’s hard to have a dual identity. Outlet doesn’t build a brand.” Brand is the power source by which a company can determine the price it charges for its products or services, because the perceived value contributed by the brand is equal to or more likely exceeds the value exchanged by its customer. So when the brand weakens, the ability to price products at a premium does as well, such that for every $1 loss in price premium a business needs to sell an additional unit, or units, to maintain profitability. Put another way, as the initial profit lost to discounting approaches the initial product profit, the number of units needed to maintain profitability increases exponentially.
The fragility of Gap becomes more visible upon further inspection of its accounting policies as disclosed in its Forms 10-K and 10-Q filings. Disclosures provided in these documents highlight idiosyncratic factors that, in our opinion, have likely improved comparative performance and profit metrics. For example in 3Q 2009, the company changed the estimate of elapsed time for recording breakage income for unredeemed gift certificates and credit vouchers from five years to three. What makes this change interesting is twofold. First, it came just three years after the company changed the recognition of breakage income for unredeemed gift cards (distinct from gift certificates & credit vouchers) from five years to three that resulted in additional income being recognized in 2006. Second, the impact to income from the change in unredeemed gift certificates and credit vouchers was deemed immaterial, which raises the question of what prompted management to change the estimate if said changes were immaterial to results. While impossible to precisely determine the benefit from the changes in the timing of recognition of gift certificate and credit voucher income, we can confidently conclude that its impact was and remains beneficial to results.
Credit income from the store credit card purchases has also had a meaningfully positive but likely unsustainable impact on operating profit. Cost of goods sold in 1Q 2014 included credit income that was previously categorized as an offset to operating expense due to an updated credit card agreement with the underwriter. As such, the year-over-year change in gross margin appeared meaningfully stronger than it would have been absent the classification change. While the company does not disclose total credit income in its regulatory filings, management noted that the reclassification of credit income was an “immaterial portion” of total credit income. As in the case of unredeemed gift certificates and credit vouchers, clarity into the total credit income picture remains murky, but we can infer that the annual contribution of credit income adds at minimum 6-8% to earnings per share each year.
The final item of interest relates to the return allowance which is an estimated accrual for returned product. Direct or online sales have increased from $903 million in 2007 to $2.3 billion in 2013, or 155%. Over the same time period, the provision for returns has increased from $698 million to $896 million, or 28%. The difference between direct sales and the allowance accrual is striking in that as highlighted by Gap’s President of Growth, Innovation and Digital, “returns are significantly higher online”. If returns and the provision for returns were to increase by 1%, earnings per share would be negatively impacted by approximately $0.01 annually which isn’t meaningful when considered in isolation, but becomes more so when one considers that the company has exceeded consensus earnings estimates by an average of $0.014 over the last twelve quarters.
Before moving on, we think it is important to mention that the aforementioned estimates are in accordance with Generally Accepted Accounting Principles (GAAP). The inherent nature of accounting estimates—like qualitative analysis—is subjective.
Historically, the company’s share repurchase program has been a primary source of earnings per share growth and has allowed the company to consistently exceed consensus estimates. In fact, since 2007 Gap has missed about half the consensus’ revenue estimates, but never missed consensus earnings per share estimates. The company’s generous share repurchase program reduced the outstanding share count resulting in annualized earnings per share growth over the past five years that was meaningfully higher than growth in net income. Paradoxically, the more successful a share repurchase program is in levitating the company’s stock the less effective it becomes in boosting earnings per share. As a result, we believe it will be difficult for management to continue to deliver steady and increasing earnings per share given higher equity prices.
On the surface, Gap quantitatively appears appealing but, in our opinion, less so on a qualitative basis. Factors supporting our skeptical view include:
• weak traffic and pricing power due to competition and deteriorating brand perception
• accounting estimates and changes that serve to enhance gross profit and earnings per share
• thirty consecutive earnings per share reports that exceeded expectations fueled in large part by share buybacks which we believe do not add value when the price paid exceeds intrinsic value1
Investors would be well served to mind the gap between the quantitative and qualitative. We do.
1 As discussed in Rick Snowdon’s February Industry Perspective, “Value Creation through Share Repurchases: Juniper Networks”.
Originally published on July 16, 2014
The views expressed are those of the research analyst as of July 2014, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.