Fooled by History: Gap (GPS) Stock as a Case Study

Gap Inc. (NYSE: GPS)

With the recent sell-off of Gap stock on underwhelming guidance issued by management for first quarter results, it sits on the market at just around $19 a share. That currently represents a price-to-earnings ratio of around 9, price-to-free-cash-flow of around 10, and a dividend yield of around 4.8%. Relative to its sector, an ownership slice of Gap today gives you much more earnings, cash flow, and dividends.

Now, when you combine this with a look at the historical per share performance of Gap, it may start tempting you to take a serious look at becoming an owner of this retailer.

Shares outstanding have shrunk from 836 million in 2007 to 413 million by 2016. This has meant earnings per share has grown from $0.93 per share to $2.23 per share. Dividends per share have also increased from $0.32 to $0.92, with a payout ratio of only 40%. This represented a dividend payout growth rate of 11% per year. Earnings per share grew at 9% per year over the previous decade.

Although Gap seems to have performed well enough over the past decade, there are three major issues to look out for.

First, revenue and net income have barely grown consistently over the past 10 years. The per share growth numbers might blind you to the fact that actual revenue and net profit growth were erratic through the past decade. It is telling that the company faces real issues with growth when the total revenue and net profit finish off the decade where it started a decade ago. These are the numbers that drive the value of the business. If revenue and profit growth are stalled, or worse in decline, the current price-to-earnings ratio of around 9 is not really all that cheap.

Second, Gap faces intense competition on multiple fronts. The apparel industry is unforgiving, both in terms of competitors and fashion trends. Fickle consumer tastes can leave yesterday’s winner a loser in the blink of an eye. With mass consumer fashion trends led by quick changes in styles throughout the season, apparent by H&M’s sales strategy, and increased online commerce, Gap has been flat footed in keeping up with consumer trends and behaviour.

Third, weak revenue and profit growth on the back of increasing competition has forced Gap into a turnaround situation. Warren Buffett is famous for stating that turnarounds rarely turn. By that, it’s meant that it’s best to avoid turnaround situations as only a small percentage of turnarounds actually succeed. Gap could be one of the exceptions. However, you would need to have some pretty big faith in the abilities of Gap’s management.

When looking at a situation such as Gap, while per share numbers can look attractive looking in the rearview window, one should think a little deeper. Companies can only borrow so much to buy back shares to prop up per share growth figures – real revenue and profit growth is ultimately needed to drive the value of the business up. The erratic revenue and profit numbers over the past decade demonstrate that this is a company that is struggling to grow any further. It is unlikely to turnaround the situation into the growth it experience in the distant past. Gap is more likely a value trap than a cheap value opportunity.

Disclosure: This author has no positions in any stocks mentioned and does not plan to open any positions in any stocks mentioned for at least 72 hours after publication of this article.