Gap Crosses Over to Profitability - TheStreet

Updated from 5:17 p.m. EST

Cost-cutting and modest revenue growth helped

Gap

(GPS) - Get Report

turn a loss into a profit in its fourth quarter, and to meet Wall Street's expectations.

In its quarter ended Feb. 1, Gap earned $248.7 million, or 27 cents a share, on sales of $4.65 billion. In the year-ago period, Gap lost $34.2 million, or 4 cents per share, on $4.09 billion in sales.

Analysts were expecting the company to earn 27 cents per share on $4.65 billion in revenue, according to Thomson Financial/First Call.

Gap declined to provide earnings guidance for the first quarter or for 2003 as a whole. But the company gave some troubling projections on expenses and performance in the quarter to date.

For its full 2002 fiscal year, Gap earned $477.5 million, or 54 cents per share, on $14.45 billion in sales. In fiscal 2001, Gap lost $7.8 million, or 1 cent per share, on $13.85 billion in revenue.

A turnaround in comparable-store sales helped drive the company's bottom-line improvement in the fourth quarter. Same-store sales, which compare results from shops open more than one year, grew 8% in the fourth quarter over the same period a year ago. In the year-ago quarter, comparable-store sales declined 16% over the previous year's fourth quarter.

"We're pleased with our fourth-quarter and year-end results, which reflect the hard work and progress made in our turnaround efforts across all three brands," said Paul Pressler, Gap's CEO, in a statement.

Old Navy, Gap's discount apparel chain, led the way with comparable-store sales growth of 14%, compared with a 20% decline in the year-ago period. Overall sales at Old Navy grew from $1.5 billion in the year-ago quarter to $1.9 billion in the just-completed quarter.

Banana Republic and Gap's international division also posted significant gains. The high-end Banana Republic chain posted a comparable-store sales increase of 5%, compared with a 7% decline last year. The chain's overall sales increased 7.8% to $610 million.

Meanwhile, same-store sales at the international division increased 6% after a 14% decline in the year-ago quarter. Overall international sales increased 16% to $549 million.

In contrast, Gap's eponymous core division posted more modest gains. The Gap stores division saw its comparable-store sales increase 4% in the fourth quarter, compared with a 16% same-store sales decline in the year-ago period. Overall sales at the Gap chain increased from $1.5 billion in the fourth quarter of 2001 to $1.6 billion in the just-completed quarter.

Gap also managed to lower expenses in the quarter, increasing both its gross profit and operating margins.

The company boosted its gross margin, which measures the difference between what a company charges for its products and what it pays for them, almost 10 basis points to 35% of sales. The company's cost of goods sold not only dropped as a portion of sales, but in dollars as well, falling more than $40 million to $3.02 billion.

About 8 percentage points of the gross margin increase came as a result of higher merchandise margins, said Byron Pollitt, the company's CFO, in a conference call with investors and analysts. During the quarter, Gap cut back on the breadth of its product selection, while increasing its inventory in key product categories, Pollitt said.

Decreased rent, occupancy and depreciation costs as a percentage of sales also helped to improve the company's gross margin, he said.

"Strong margin performance indicates our customers are responding to product improvements," Pressler said in the statement.

Meanwhile, the company cut its operating expenses as a percentage of sales by 20 basis points, to 25.9% of sales. Pollitt acknowledged that the improvement in operating expenses was not as much as might be expected given the company's sales growth. But Gap is "comfortable" with the increase, he said.

Included in Gap's operating expenses was a $59 million pretax charge related to excess office space that the company plans to vacate and sublease, Pollitt said. The company expects to sublease the space for less than it is obligated to pay in rent, thus the charge, he said.

Increased marketing expenses and a boost in performance bonuses paid also weighed on operating expenses, Pollitt said. In the quarter, Gap spent $134 million on advertising, up 16% from the previous year, he said. Much of the company's advertising focus was on Old Navy, which bought television ads and issued circulars in the quarter.

Although Gap declined to provide earnings guidance for 2003, the company warned that its same-store sales growth to date in February is in the high single digits, which is below its plan. The winter storms in the Northeast forced the company to temporarily close some of its stores, thus dampening sales, Pollitt said. The company has also sold more merchandise at discounted prices, with fewer customers willing to pay full price for its items, he said.

Meanwhile, Gap's inventory is above its expectations thus far. The company had about $2 billion in inventory at the end of its fiscal year, up $279 million, or 13% per square foot, Pollitt said.

Part of the inventory increase has to do with the slow sales thus far in February, Pollitt said. But the company also saw improved performance in "shrink," or inventory loss, he said. And the decline of the dollar against the euro and other currencies has meant that the company's overseas inventories are worth more now in dollar terms, he said.

Gap expects inventory per square foot to increase 10% to 15% in the first quarter and in the mid-teens in the second quarter as it invests in improving its product assortment, Pollitt said. But those levels are above what the company previously planned and the company will try to limit inventory growth in the second half of the year, he said.

"Inventory management is a huge opportunity for us," Pollitt said. "We are committed to managing it better in the future."

Despite the negative trends, it's too early to tell how the quarter will turn out, because February only typically accounts for 25% of the company's first-quarter sales, Pollitt said.

"We're still evaluating our business performance," Pollitt said. "The two strongest months of the quarter are still to come."

Gap expects to continue to boost its ad spending in 2003, planning to spend $10 million to $20 million more in the first half of the year than it did last year and $40 million more in the first quarter than it did a year ago.

Meanwhile, the company expects to spend about $350 million to $400 million in capital expenditures this year, of which only $40 million will go toward new stores, Pollitt said. The company plans to open about 30 to 40 new stores this year, but plans to cut its square footage by about 2% as it steps up store closures from last year.

Gap has a $500 million note coming due in May. The company plans to pay that off via its free cash flow, Pollitt said.

"We will take other opportunities to reduce our debt if they make economic sense," he said.

Gap shares closed regular trading on the

New York Stock Exchange

up 6 cents, or 0.4%, to $14.82. In after-hours trading, Gap shares rose 1 cent, or less than 1%, to 14.83.