Is Gap’s Stock a Buy After Earnings?

With Gap (NYSE:GPS) releasing third quarter financial results and shares currently outperforming competitors on the year, is the clothing retailer a BUY, a WAIT and SEE, or a STAY AWAY? Let’s analyze the stock with the relevant sections of our CHEAT SHEET investing framework:

E = Earnings Are Increasing Quarter over Quarter

Gap, which also owns Old Navy and Banana Republic chains, reported crowd pleasing results for the quarter ended October 27, 2012. Net income surged 60 percent to $308 million (63 cents per share), compared to $193 million (38 cents per share) a year earlier. The results were inline with estimates, as the company recently predicted it would earn between 61 cents and 63 cents per share. The bottom line was boosted by net sales of $3.86 billion, an 8 percent increase from the same quarter last year.

“We’re very pleased with our strong third quarter financial performance, highlighted by how well customers have responded to our product,” explained Glenn Murphy, chairman and chief executive officer. “We are ready to compete and win this holiday season as we drive to build upon our top line growth.”

The company has now reported an increase in earnings for the past five quarters. Earnings came in at 49 cents per share in the second quarter, compared to 46 cents in the first quarter and 44 cents in the fourth quarter. In the past eight quarters, Gap has beaten analysts’ estimates six times, and met expectations twice.

E = Equity to Debt Ratio is Close to Zero

The debt to equity ratio is a measure of a company’s financial leverage. A high ratio generally represents that a company has been aggressive in financing its growth and operations with debt. While this may improve some metrics such as earnings in the short-term, too much debt can have disastrous effects in the longer-term.

Looking at Gap’s financials for the latest quarter, it has a debt to equity ratio of 1.53. This includes total liabilities and total stockholder equity. In comparison, Aeropostale (NYSE:ARO) and The TJX Companies (NYSE:TJX) have ratios of 0.86 and 1.65 percent, respectively. American Eagle Outfitters (NYSE:AEO) has a ratio of 0.34.

Although Gap’s ratio is higher than some in the industry, the company has repurchased $463 million in shares year-to-date. Furthermore, it has a cash position of $1.77 billion, compared to long-term debt of $1.25 billion.

T = Trends Support the Industry in which the Company Operates

Retail is a very competitive industry, which is further complicated by the global economic slowdown. On Wednesday, the Commerce Department reported a 0.3 percent drop in retail sales last month, compared to a revised 1.3 percent increase in September. October represented the first decline in retail sales since June, and the worst miss of expectations since May 2010. However, unlike J.C. Penney (NYSE:JCP), Gap’s turnaround efforts have been showing positive results.

Last year, Gap announced a recovery plan that included a top designer change and expanding its business overseas, while reducing the number of outlets in the United States. The plan appears to be working. In the third quarter, all three chains reported positive comparable sales in North America. Gap logged a 7 percent gain versus a 6 percent loss a year earlier. Banana Republic and Old Navy also posted increases of 6 percent and 9 percent, compared to losses of 1 percent and 4 percent, respectively. Overall, international comparable sales came in at a loss of 3 percent, but improved from a 10 percent loss last year. Gap’s gross margin also increased to 41.2 percent from 36.7 percent.

Conclusion:

Investors were very pleased with Gap’s latest financial results. Shares of the company jumped more than 3 percent following the report. Year-to-date, Gap has surged 80 percent. Although the quarterly numbers were strong, we find it hard to chase a stock that has outperformed to such a large degree. Furthermore, the retail industry could see a significant slowdown as consumers continue to struggle amid weak economic conditions. Based on the overall picture, we find that shares of Gap are a WAIT and SEE. Investors looking for a clothing retail play may want to consider Gap, but a pullback would make the stock much more interesting.

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