Why There Could Be An Opportunity In The Gap

Sometimes I wonder how a major company with five major brands and no major apparent accounting scandals can lose half a billion dollars in market cap in a single trading day. Alas, unfortunately for GAP Inc GAP, that is what happened Monday, as its stock price dropped, dare I say plummeted, 6.28% on a disappointing earnings announcement.

At such moments I remind myself that stock prices are all about the future not about today. With that in mind, let’s take a look at both the present and some possible futures for the Gap.

First a look at now. Currently, the implied long-term growth rate of residual earnings for Gap is actually a shrink rate. Using a simple model that incorporates a required return of 8%, some average analysts estimates, and some fundamental accounting data, Gap’s residual earnings over the long term (i.e. the earnings above what's required for you to use your money) are expected to shrink 0.3% per year. By comparison, in the coming year Gap’s residual earnings are expected to grow around 9%.

In other words, even though the residual earnings are growing, the market believes that this growth will stop relatively soon and the shrinkage will begin. This is a simple model, and I encourage you to play with the inputs.

From the chart below, you can see that most of the Gap's value currently comes from current earnings projections (i.e. not a lot is attributed to the book or future growth).

Unfortunately, the problem is that this value depends on Gap being able to continue to hit those earnings numbers for years to come. The market doesn’t think this will happen, and not without reason. Gap’s stock dropped when it announced that its Banana Republic brand’s sales had declined 14% vs. comparable sales and its Gap brands declined 4%.

To get a better sense of future possibilities I ran a simple Monte Carlo (play with it here). Below is the value distribution if I included a possible upside where Gap’s residual earnings grow at 2%. The most-likely case in this model is that residual earnings do not grow.

What this intial analysis tells me is that there may be an opportunity in Gap. Essentially, it doesn’t need to turn around, it just needs to stop going in the wrong direction. A deeper dive would be needed to determine if there truly is an opportunity, but there is an enough in the first pass for me to justify a deeper look.

The author has no direct holding in GPS, and has no plans to trade for 24 hours.

The Morning Monte is “high-level,” and any investment requires a deeper analysis than is presented here. The comments in The Morning Monte are intended to help guide your research and ground you in the fundamentals. In no way should the comments in The Morning Monte be taken as advice to buy or sell a particular equity. Some of the statements are forward looking. As such, these statements are speculation–so beware! The comments represent the views of the author and are not necessarily the views of The Morning Monte™ or PRUDENA™.

Photo by Neff Conner