managed to squeeze out fat second-quarter earnings for investors despite a decline in gross profits, the retailer's sales disappointments and shaky forecasts were prompting analysts to wonder whether the brand has lost its relevance.
With a mix of share repurchasing and accounting expertise, Gap's CEO Paul Pressler delivered a 39% jump in net income for the second quarter. The results, issued after the market closed Thursday, beat expectations, but investors were focused on the future -- which doesn't look pretty.
Management admitted on its conference call with analysts that Gap's merchandising strategies are still stumbling across all of its brands and the much-awaited sales turnaround expected this fall will likely not materialize. The discouraging words were recently driving the retailer's shares down 53 cents, or 2.6%, to $19.62 -- putting them closer to the 52-week low of $18.12.
Even with Pressler's impressive bottom-line management and a vote of confidence from legendary value investor Warren Buffett, whose
owns 15 million shares, the company and its followers are starting to acknowledge that time is running out for a top-line fix.
With negative same-store sales trends in nine out of the last 10 months, the lumbering giant of specialty apparel retailing is in danger of being torn to shreds by its smaller, hungrier rivals.
"We are acutely aware that we need to improve our top-line performance," Chief Financial Officer Byron Pollitt said on the company's conference call.
Gap earned $272 million, or 30 cents a share, in the quarter, compared with $195 million, or 21 cents a share, a year ago. The results beat Wall Street's consensus estimate, calling for earnings of 28 cents a share, but they included a pretax gain of $58 million from the reversal of a sublease loss reserve. The year-ago period had a pretax loss of $65 million from debt redemption.
Meanwhile, the company kept up its aggressive share repurchasing, buying back 45 million shares for $944 million, reducing its shares outstanding to 881 million. Also, it authorized another $500 million for repurchases in the future.
In contrast, net sales were flat at $3.7 billion on a same-store sales decline of 3%. Furthermore, Pressler told analysts on the conference call that August results are trending significantly below expectations because of a decrease in customer traffic in its stores.
"In light of our disappointing month-to-date August results, combined with concerns about the macroeconomic environment, we are lowering our 2005 guidance," Pressler said. The company cut its full-year guidance to a range of $1.30 to $1.34 a share from its old estimate of $1.44 to $1.48 a share, saying this month's results so far have been "significantly below expectations."
In response, Merrill Lynch analyst Mark Friedman cut shares of Gap to neutral from buy, citing the disappointing August results. Friedman said that since the retailer seems to have missed the mark in fashion for several seasons in a row, it's now in danger of losing its core customers permanently.
"I do believe the brand has the strength to win her back, but it is not easy," he said. Merrill has an investment banking relationship with Gap, and at least one of its analysts owns a position in the company's stock.
Goldman Sachs analyst Margaret Mager said Gap's historical valuation of 24 times earnings is "clearly no longer applicable given the company's maturity and challenges."
At its current valuation of 12 times earnings estimates through 2006, Mager said the stock is largely supported by share repurchases, large cash balances and strong cash flow. Her worst-case scenario would bring the stock down to $15. Goldman has an investment banking relationship with Gap.
"Given what we know today, we recommend investors focus on market share gainers like
Abercrombie & Fitch
American Eagle Outfitters
," Mager said.