GAP INC annual report, FY2016

Business context and reporting period

The Gap, Inc. is a global apparel retailer operating Gap, Old Navy, Banana Republic, Athleta, Intermix and, following a December 2016 acquisition, Weddington Way. It sells through company-operated and franchise stores and online channels. The filing is the fiscal 2016 Form 10-K, covering the 52 weeks ended January 28, 2017; although the request metadata says “2015 Q4,” that is not the period reported here. Fiscal 2015 is the prior comparable year.

Financial performance and position

• At year-end, cash and cash equivalents were $1.783 billion, total debt was $1.313 billion, working capital was $1.862 billion and the current ratio was 1.76:1. Debt included $1.248 billion of notes and $65 million of Japanese yen term-loan borrowings.
• Inventory was $1.830 billion, versus $1.873 billion a year earlier. Total assets were $7.610 billion and stockholders’ equity was $2.904 billion.
• The company paid $367 million in dividends, or $0.92 per share. It made no share repurchases during fiscal 2016.

Material changes versus the prior comparable period

• Sales fell 2%, primarily because of lower sales at Gap and Banana Republic, partly offset by growth at Old Navy and Athleta. Foreign-exchange translation reduced sales by approximately $20 million.
• Comparable sales improved from a 4% decline to a 2% decline. By brand in fiscal 2016, Gap Global was down 3%, Banana Republic Global down 7%, and Old Navy Global up 1%.
• Gross margin edged up 0.1 percentage point, reflecting more regular-price selling and improved Old Navy product acceptance; this was partly offset by foreign exchange and occupancy deleverage.
• Operating margin declined 1.9 percentage points. Operating expenses rose to 28.7% of sales from 26.6%, including restructuring costs, store impairments and a $71 million Intermix goodwill impairment.
• Net income declined $244 million and diluted EPS declined $0.54. Fiscal 2016 EPS included approximately $0.41 of restructuring impact, $0.18 from the Intermix goodwill impairment, an $0.11 benefit from the Fishkill fire insurance gain and a $0.15 tax benefit from a legal-entity realignment.
• Operating cash flow increased $125 million, while capital spending fell $202 million. The company ended the year with $413 million more cash than at the prior year-end.

Outlook, management commentary, risks and unusual items

• Management estimated annualized pretax savings of approximately $275 million from store closures and operating-model streamlining. Fiscal 2016 restructuring costs were $197 million; the company closed 67 stores connected with the measures, including all 53 Old Navy stores in Japan.
• For fiscal 2017, management expected about 40 net company-operated store openings, primarily at Athleta and Old Navy; approximately $825 million in property and equipment spending, including an estimated $200 million to rebuild the Fishkill distribution-center campus; and an annual dividend of $0.92 per share. It also intended to restart repurchases under its $1 billion authorization.
• Management said existing cash and operating cash flows should support operations, growth initiatives, planned capital spending and debt repayment. The $500 million revolving credit facility was undrawn at year-end. Fiscal 2017 was expected to have 53 weeks.
• The August 2016 Fishkill distribution-center fire generated $133 million of identified costs. A $73 million insurance-related gain was recorded; $32 million remained receivable at year-end, and the company received an additional approximately $73 million advance in February 2017. Rebuilding was underway, with expected insurance recovery for the estimated $200 million rebuild cost.
• Key risks include changing apparel preferences, competition and markdown exposure; inventory execution; foreign exchange; sourcing and trade restrictions; consumer demand; store and lease economics; cyber and IT disruption; and dependence on revenue-sharing from Synchrony’s credit-card programs. Nearly all merchandise is sourced from third parties, with about 25% of fiscal 2016 purchases from Vietnam and 23% from China.
• Fitch and S&P downgraded the company’s ratings to BB+ in May 2016. The company reported compliance with credit-facility covenants. Contractual obligations included $6.542 billion of minimum operating-lease payments, in addition to debt and purchase commitments.
• Management reported effective disclosure controls and internal control over financial reporting; the independent auditor issued an unqualified opinion on the financial statements and internal controls. The company did not believe current legal actions would have a material effect, though outcomes remain uncertain.

Important facts for investors to verify

• Whether sales and comparable-sales trends improve, especially at Gap and Banana Republic, and whether Old Navy and Athleta sustain growth.
• Whether the estimated $275 million annual savings are realized without impairing brand performance, and how further store closures or Intermix weakness affect results.
• The ultimate Fishkill insurance settlement, recovery of remaining costs and rebuild spending and timing.
• Whether fiscal 2017 capital spending, store openings, dividend and planned share repurchases proceed as stated, given the company’s operating performance and credit ratings.
• How foreign-currency pressure, sourcing concentration, inventory markdowns and major operating-lease commitments affect margins and liquidity.