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Takeaway: The Gap is up against stiff competition and needs to work on improving margins - stat.

Michael Francis has joined The Gap (GPS) as their head of marketing. This is the guy who thought it’d be a good idea to give out free haircuts at JCPenney (JCP). If that doesn’t make you nervous, a few other problems with GPS will.

Three years ago, GPS was sitting on a net cash position of $2.3 billion. Now it is down to $400mm and shrinking. The company’s been engaged in share buybacks over the past few years and while that’s fine and dandy, it has hurt their cash position. 

GPS: A Cautionary Tale - gapchart1

The Gap also needs to work on improving its margins and retaining market share. There are plenty of competitors going head-to-head with The Gap out there: Macy’s, TJ Maxx, Ross Stores and even JCPenney. Just because the company has hit on the colored jeans trend doesn’t mean it can sustain driving existing and new trends.

Retail Sector Head Brian McGough makes an excellent point in a note on GPS we’ve outlined below:

“The consensus has GPS earning $2.40 next year. Then $2.72 the year after. We’re about 10% below next year, and 20% below the year after. We’d argue that barring a disproportionately large capital investment (which would drive returns lower) GPS will never see $2.50 again – ever. And as we say at Hedgeye, ‘ever’ is a long time.

That did not matter with the stock trading at $15 a year ago. But it certainly matters today at $35.  Let’s say we’re dead wrong, and the Street is spot-on. Then you’re paying 12.9x earnings for a number that GPS will earn in FY 2014. That’s right up there with AAPL, NKE and RL. Which would you rather own?