Gap (GPS) Bounces Back with Strong Q2 Earnings, EPS Up 9.4%

After a dismal first-quarter fiscal 2014, The Gap Inc. GPS seems to have bounced back with an improvement in sales resulting from healthy merchandise margins, tight operating cost management, by delivering earnings per share growth and returning cash to shareholders.

The company's quarterly adjusted earnings came in at 70 cents per share, up 9.4% from the year-ago comparable quarter earnings of 64 cents and a penny ahead of the Zacks Consensus Estimate of 69 cents per share. However, the company highlighted that foreign currency fluctuations reduced its earnings per share growth for the quarter by 4 percentage points.

Including a 5 cents per share gain from asset sale, the company reported earnings per share of 75 cents versus 64 cents in the prior-year quarter.

Net sales rose 3% to $3,981 million, thanks to the company's strategic initiatives, including the enhancement of omni-channel capabilities, global growth and effective inventory management. Moreover, the top-line was marginally ahead the Zacks Consensus Estimate of $3,979 million.

With continued focus on developing its omni-channel network, Gap's quarterly online sales came in at $515 million, up 11% from the prior-year quarter.

During the quarter, Gap's comparable-store sales (comps) were flat as against a 5% rise registered in the year-ago quarter. Global brand-wise, comps at Gap Global witnessed a 5% fall versus an increase of 6% in the prior-year period. Banana Republic Global's comps for the quarter were flat as against a 1% decline last year. Moreover, comps at the company's Old Navy Global stores grew 4% compared with a 6% rise in the year-ago comparable quarter.

The company reported a marginal decline in its gross profit to $1,569 million with the gross margin contracting 110 basis points (bps) to 39.4%, primarily due to a decline of 90 bps in merchandise margins.

However, operating income grew 8.8% to $567 million, leading it to expand 70 bps to 14.2%. During the quarter, the company witnessed an improvement of 180 bps in its operating expenses as a percentage of sales, primarily due to its effective cost management. Marketing expenses declined $6 million to $142 million in the second quarter.

Financials

This apparel and shoe retailer ended the quarter with cash and cash equivalents of $1,518 million, long-term debt at $1,369 million and total shareholders' equity of $2,946 million. Moreover, the company generated a free cash flow of $668 million and operating cash flow of $996 million, while it incurred $328 million as capital expenditure year-to-date.

Gap intends to spend $750 million as capital expenditures in 2014, highlighting the company's focus on investing in strategic plans.

Dividend & Share Repurchase

Focused on its policy of returning excess cash to shareholders through dividends and share repurchases the company has distributed about $802 million to shareholders so far in 2014.

During the second quarter, Gap paid its shareholders a cash dividend of 22 cents a share and bought back 9 million shares worth $364 million.

Store Update

Gap's second-quarter fiscal 2014 reflected significant progress of the company's ongoing strategy of globally expanding its brands with the opening of 5 new Gap brand stores in greater China and 3 company-operated Old Navy stores in Mainland China. Moreover, the company opened 8 new stores under the Athleta brand in the quarter.

In keeping with this strategy, the company is on track to end fiscal 2014 with a total of 110 Gap brand stores across mainland China, Hong Kong and Taiwan; 40 Old Navy stores and 100 U.S. based Athleta stores.

The company specifically plans to open about 20 company-operated Old Navy stores in Japan and about 5 franchise-operated stores in Philippines in fiscal 2014.

Further, the company is now planning to venture into the Indian market with its Gap brand, by opening franchise-operated Gap stores by 2015. To create a strong foothold in the world's second most populated country, the company has partnered with Arvind Lifestyle Brand Limited, a subsidiary of Arvind Limited. In partnership with one of India's largest textile companies, Gap plans to open its first stores in Mumbai and Delhi, launching them with the brand's summer 2015 collection for adults, kids and babies. Together, this partnership plans to open nearly 40 franchise-operated Gap stores across India.

In total, Gap opened 47 new stores, while it shut down 26 stores during the quarter. This brings the company's total store count to 3,594 across 48 countries with 3,200 company-operated and 394 franchise outlets, increasing its company operated floor space by 1.6% year over year.

In fiscal 2014, Gap intends to open 185 company-operated outlets, barring relocations, with primary focus on China, Old Navy in Japan, Athleta and global outlet stores. It also plans to shut down 70 company-operated outlets, net of relocations, primarily inclined toward Gap North America. The company reiterated its target of a 2.5% rise in net square footage in fiscal 2014.

Outlook

Gap reaffirmed its operating outlook for fiscal 2014 while it adjusted its earnings per share guidance to include the 5 cents per share gain from asset sale. The company now anticipates earnings per share in the range of $2.95–$3.00 compared with $2.90–$2.95 projected earlier.

The company retained its target of reaching operating expense leverage by the end of the fiscal year, though it anticipates the leverage to be very modest. Moreover, the company continues to forecast depreciation and amortization expense, net of amortization of lease incentives, of nearly $520 million in fiscal 2014. Effective tax rate for the fiscal is expected to be 38.5%.

Coming to the third quarter of fiscal 2014, the company expects marketing expenses to rise about $25 million year over year due to increased spending at Gap brand to support its new Fall marketing campaign. The company forecasts year-over-year inventory dollars per store to be up in the low-single digits at the close of third-quarter fiscal 2014.

Other Stocks to Consider

Gap currently holds a Zacks Rank #3 (Hold). Other better-ranked stocks in the retail sector include Citi Trends Inc. CTRN and The Men's Wearhouse Inc. MW, both holding a Zacks Rank #1 (Strong Buy), along with Foot Locker Inc. FL that carries a Zacks Rank #2 (Buy).