Why Gap’s Profits Likely Declined 35% In 2019

Gap Inc. (NYSE: GPS) has achieved steady growth over 2015-2018 (ending January), with the company’s revenue increasing by 5% and expenses following a similar trend resulting in stable profits for the company. However, the apparel company’s revenues should have shrunk for full-year 2019 while expenses are expected to have remained at the level seen in 2018 due to an increase in operating expenses, partially offset by a decrease in the cost of sales. We expect this to result in a 200-basis-point contraction in Gap’s earnings margin (i.e. revenues less all expenses, expressed as a percentage of revenues) from 6% in 2018 to just 4% in 2019. This, in turn, represents a 36% decline in Gap’s earnings. Trefis details Gap’s expenses and highlights trends in its various expense components in an interactive dashboard, parts of which are summarized below.

Notably, operating expenses (which represent selling, general and administrative expenses (SG&A), and other management costs) are expected to be $5 billion in FY 2019, making up one-third of Gap’s $15.5 billion in expected total costs for the year. Gap’s operating costs are half of the company’s largest expense driver – it’s manufacturing costs or the cost of sales (COGS).

• Gap’s total expenses have increased by 4.7% since 2015, going up from $14.9 billion to $15.6 billion in 2018 and are expected to remain flat in 2019. Operating expenses have been the largest contributor to this increase, with the operating expenses increasing from $4.2 billion in 2015 to nearly $5 billion in 2018.
• The company’s total expenses in absolute terms are expected to remain stable in 2019 as an increase in operating expenses is likely to be offset by an expected decrease in the cost of sales likely to be driven by a 2.2% decrease in Gap’s revenues for 2019.
• Additionally, the company’s total expenses as % revenue are projected to increase by 200 basis points, from 94% in 2018 to 96% in 2019.

Cost Of Sales & Occupancy Costs

• The cost of sales includes the expenses incurred to acquire and produce an inventory for sale, including product costs, freight-in, and rent & occupancy costs. COGS is the most significant expense driver, accounting for nearly two-thirds of the company’s total expenses in 2018.
• COGS have increased by just 1.8% over the last few years, rising from $10 billion in 2015 to $10.3 billion in 2018 driven by primarily as a result of higher revenues.
• Higher revenues, coupled with stable COGS, has helped Gap’s gross margin expand by 190 basis points over the same period. Moreover, higher margins achieved as a result of the improved average selling price per unit, coupled with lower occupancy costs, have also aided in the gross margin expansion.
• We expect COGS to marginally decline in 2019, representing a gross margin figure of 37.1%. This decline in gross margin can be attributed to merchandise margin decline at Old Navy, as well as occupancy leverage due to lower revenues.

Operating Expenses

• Gap’s operating expenses include selling, general and administrative expenses, payroll, and other costs. Operating expenses have increased by 18% from $4.2 billion in 2015 to $5 billion in 2018.
• Additionally, operating expenses as % of revenues are also on the rise, increasing from 26.6% in 2015 to nearly 30% in 2018, led by the additional costs associated with the presentation changes resulting from the adoption of new revenue recognition standard, partially offset by lower payroll and related costs.
• We expect total operating expenses to increase by 2.7% to just shy of $5.1 billion in 2019, representing 31.4% of total revenues of $16.2 billion.

Non-Operating Expense (Income)

• Gap’s non-operating expenses have decreased from $53 million in 2015 to $40 million in 2018 mainly due to higher interest income, partially offset by higher interest expense

Additional details about how Gap’s Non-Operating Expense has trended over the years are available in our interactive dashboard.

Income Taxes

• The company’s effective tax rate has been highly volatile, ranging from a high of 40.4% in 2017 to 24.1% in 2018. The company’s effective tax declined steeply in 2018 due to the enactment of the US Tax reform.
• The effective tax rate is expected to be around 26% in 2019.

Per Trefis estimates, Gap’s EPS for fiscal 2019 is likely to be $1.73. Taken together with a P/E of 10.1x, this works to a fair value of $18 for Gap’s stock, which is in line with the current market price.

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