We'll start with a question. What does it tell you about a company when financial engineering alone contributes 13 percentage points to earnings, and EPS growth is STILL down 8% y/y, and the stock is off 20% during the quarter? It tells us that owning this name as either a) a stand-alone retailer, or b) a cash-rich financial engine, are both probably #failed strategies. We generally want to be long GPS when EBIT is accelerating to the upside (even if it is ‘less bad’), and share count is accelerating to the downside. Yes, the exact inverse holds true on the short side – incrementally eroding EBIT with fewer shares having been repurchased on the margin over the preceding 3-6 months. Looking in the rear-view, EBIT has collapsed – off 21% this quarter, the worst rate in nearly 4-years. But so has the stock, down 20% since May and 25% for the year-to-date.
Looking forward – which is a heck of a lot better than looking back – we think GPS will miss both 3Q and 4Q expectations set last week. But that still only gives us a 9-10% EBIT erosion in back half, which pales in comparison to the -21% we just witnessed in 2Q. Some will argue otherwise, but this is actually an improvement on the margin. The offset is that the share count, which has been down 6% y/y over each of the past four quarters, should ease to the -4/-5% range. That’s bearish on the margin.
All in, we think those two factors are probably a push, but we still come out negative on the margin given that we think expectations are too high for this year (and next), and that GPS will miss. Is it a raging short at 11x earnings and 42% ROE? Not really. But ROE will come down over time as there’s less operating cash flow to buy back stock. But if GPS misses 2H we’re far more inclined to think it sees $27 before $35. If the research changes and leads us to another -20%+ EBIT quarter (or if the stock trades up on our current model), we’ll get much louder on the short side of this name.
