Gap Stores is being taken out to the woodshed today and with good reason after the retailer had some awfully dour things to say about its business through the end of the year. As such, Gap’s stock will undergo the equivalent of Tommy John surgery, meaning it will spend the next nine to twelve months on the shelf.
Ok, I admit it. I was wrong when I predicted back in November – when the stock was at $20 – that I thought Gap could “fill the gap” and trade $26. That prediction was based on some encouraging signs on the sales front and an expectation that the company would produce a $1.90 in 2011 income. Given some of the company’s success on the ecommerce front and the progress it had made on expenses, this seemed doable, particularly in light of an uptick in comps.
That analysis, however, did not account for two things. First, the sales momentum turned out to be completely illusory as the Fall uptick in comps could not be confirmed during the first quarter. And two, Gap got whacked in the face by higher sourcing costs. That all adds up to a minor tsunami where Gap can’t raise prices because its stuff is too ordinary and thus, they face huge margin compression as higher costs can’t be offset. Back to the baseball metaphor, this is the equivalent of a blown out elbow.
The damage this storm will cause to Gap’s income statement over the next year is nothing short of devastating. Heading into yesterday, the company had been guiding to about $1.90 in EPS. The Street was a bit lower and some had been trimming numbers into this event. But Gap is now guiding to $1.40-1.50 in 2011 income, which is basically a fifty-cent haircut. The cause, according to the company …. twenty percent higher unit costs in the back half of the year.
So the stock is being punked to the tune of about seventeen percent and now trades nineteen and a quarter. Assuming the company is able to hit the low end of guidance, which is debatable given high inventory and zero momentum, GPS now trades a bit under 14x earnings. And that raises the question …. Does it make some sense to buy a chunk as a long-term investment?
I will tell you … it is tempting. And that is because this is still an incredible cash flow story. I mean, is 13x an obscene multiple to pay for a company that generates Free Cash Flow returns of eight or nine percent? Plus, this company continues to buy back tons of stock. So much, in fact, that JPM mentioned this morning that the entire public float could be gone in six years.
Listen, this story is clearly a mess. And it will be rehabbing for some time as Team Gap works to improve its offerings and get through this difficult cost environment. On top of that, they need a new coach, or at least a new offensive coordinator to replace Patrick Robinson who was fired moments after this debacle came into perfect relief. But give this story a year and I think Gap will be able to pitch again. Maybe not at an elite level but the stock now has an opportunity to lift as earnings normalize down the road. With almost twenty percent of downside now in the stock, I think this is a pretty safe name to own and I wound bet some value guys will come to the same conclusion shortly.