Thursday, January 20, 2011

The Gap Down

Shares of The Gap (GPS) recently fell precipitously after the company reported that December same-store sales were down 3% from the year-ago period. As such, The Gap can be added to the list of retailers that currently trade at low P/E levels (some of which are discussed here); the company now has a trailing P/E of just 10.5 (based on its current market cap and its last four quarters of earnings). Adjusted for the company's large cash balance (it has no balance sheet debt), The Gap has a trailing P/E of just 9!

But investors should avoid making purchase decisions on the basis of P/E alone. It's important to look beyond the "headline" number to understand how the business is really doing. In The Gap's case, annual sales have been in decline for several years. But at the same time, the company has actually managed to increase profits, as shown in the following chart:

This is a rare sight indeed. At this rate the gap isn't going to have worry about getting an advance from anytime soon. Usually, when sales fall (especially same-store sales), operating income falls by a larger percentage, as fixed costs (e.g. rent, administrative staff etc.) stay stable. But management of The Gap has actually been able to reduce costs at a faster rate than its reductions in revenue. As a result, The Gap's operating profit margin (which measures a company's operating profit per unit of sales) has increased steeply, as per the chart below:

While The Gap's financial performance is impressive, this is not the kind of situation a value investor wants to buy into. The cash-adjusted P/E of 9 discussed above is the result of rather high margins the company has experienced over the last year, which may not be sustainable. The last time margins were even close to this level was in 2004, as they rose to 12.8% that year. But margins tumbled for the next two years, eventually falling to 7.4% in 2006.

Perhaps The Gap's current margins are sustainable. But if an investor is willing to invest on that basis, the company had better fall well within his circle of competence, and he had better be able to point to reasons for why these margins are not subject to competitive pressures that drive down high margins in this and almost every other industry.

For value investors, it's important to look at a company's margins over several years. Otherwise, if the most recent year's margins are higher than normal (which is currently the case for The Gap), investors could be buying at a time when the company's current earnings are abnormally high. This could set the investor up for a situation where earnings (and potentially sales as well, in The Gap's case) are in decline, which makes the firm's effective P/E a few points higher than its current P/E would indicate.

Disclosure: None

1 comment:

heterocedastico said...

Really good stuff!