Net sales during the quarter were $4.24 billion compared to $4.08 billion in the year-ago quarter. Comparable store sales increased 2% during the quarter compared to a year earlier. Robust earnings were primarily driven by solid sales at its low-priced Old Navy segment and the highest fourth quarter operating margins in over a decade. The Old Navy chain has benefited from the increasing preference among U.S. shoppers for lower-priced stores due to the challenging macroeconomic environment.
Gross margins increased 550 basis points to 39.5% during the quarter compared to the year-ago quarter. Operating margins increased 410 basis points to 13.9% due to effective cost-control measures and prudent inventory management policies. Gross margin in fiscal 2009 increased 280 basis points year-over-year to 40.3%, while operating margin increased 210 basis points to 12.8%.
Full-year merchandise margins were up 290 basis points.Gap is now focusing more on improving its business model by striking the right balance between its cost structure and merchandise by better aligning inventory with sales trends. Gap ended the fourth quarter with $1.5 billion in inventory, down 2% versus the prior year. Inventory per square foot at the end of the quarter was down 1% compared to 2008.
For fiscal 2009, free cash flow of the company was $1.6 billion. This provides it with an operating flexibility to protect and enhance market positions and emerge stronger once the economy fully recovers. Gap defines free cash flow as net cash generated from operating activities less expenses relating to the purchases of property and equipment.
Outlook for 2010
Management expects earnings per share in fiscal 2010 in the range of $1.70 to $1.75. Operating margin is expected to increase approximately 13%. During fiscal 2010, Gap expects to open about 65 stores and close 110 stores, including repositioning. The long-term growth investments of Gap include rolling out the new Old Navy store model to an additional 200 stores; opening its first Gap stores in China and Italy; expanding Banana Republic in Europe; and adding more outlet stores in Canada, Europe and Asia.
Gap has established quite a track record of conservative capital management and cash returns to shareholders in the form of steady dividends and share repurchases. Since 2004, Gap has returned about $8 billion through share repurchases and dividends. The company intends to continue returning excess cash to shareholders in 2010 as well.
Gap increased its annual dividend by 18% to $0.40 per share, which represents a payout of about 25% of its 2009 earnings and a yield of about 2%. The company also recently announced a $1 billion share repurchase authorization.
Estimate Revisions Trend
In concurrence with the superior performance and earnings guidance, several analysts following the stock have revised their estimates for Gap. Over the past 30 days, 27 out of the 30 analysts following the stock have raised their earnings estimates for fiscal 2010, while none has moved in the opposite direction. The current Zacks Consensus Estimate for fiscal 2010 is $1.73 per share. Estimates appear to be trending up, with a year-over-year growth of 9.6%.
The current Zacks Consensus estimate for fiscal 2010 first quarter is $0.36 per share. Quarterly estimates appear to be trending up as well, with a year-over-year growth of 16.1%. Of the 29 analysts having a first-quarter earnings estimate, 10 have raised their estimates in the last 30 days, while only 3 have reduced them.
With respect to earnings surprises, the stock has moved up moderately over the last four quarters in the range of 2%-3%. The average remained positive at 2.7%. This implies that Gap has surged ahead of the Zacks Consensus Estimate by 2.7% on average over the last four quarters.
Our Recommendation
We maintain our Outperform recommendation on Gap as we anticipate it to perform well above the market. Gap is the leading player in the highly fragmented specialty retail sector, and has a market cap which is more than double its nearest competitor. The company has improved its business model by realigning its inventory to sales trends. In addition, the company has a strong balance sheet with adequate liquidity and no outstanding debt. Gap has also been active on the share buyback front and has recently increased its dividend.
However, Gap operates in a highly fragmented market and competes with national and local department stores and discount stores that offer products at fire sale prices. With the reduction in disposable income and a cut in consumer discretionary spending due to the prolonged economic downturn, the company is under severe stress to maintain profitability.
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