The Gap: Brand Momentum Can Carry Shares Higher (Upgrade)

seekingalpha11-23

The Gap's shares jumped 8% after strong quarterly results, with cost controls supporting margin expansion and a notable rise in online sales.Athleta showed a strong performance, while Banana Republic ...

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Old Navy remains resilient despite economic headwinds.Gap's robust cash flow and improved balance sheet, with $2.2 billion in cash, support potential future buybacks or dividends.The valuation is compelling with an 8.5% free cash flow yield; I have upgraded GAP to “buy” expecting shares to rise to $29.PaulMcKinnon  Shares of The Gap, Inc. (NYSE:GAP) jumped 8% on Friday after the company reported strong quarterly results ahead of the important holiday shopping season. Shares are now up 26% over the past year, though there has been significant volatility around past earnings releases, creating a bumpy ride for some investors. I last covered GAP in May, downgrading shares to \"hold\" from \"buy\" on valuation concerns. In hindsight, I could have downgraded shares more sharply given the fact the stock has declined 18%. With updated financials, now is a good time to revisit Gap. Seeking Alpha Cost Controls Support Margin Expansion In the company's third quarter, The Gap earned $0.72, which beat consensus by $0.14 as revenue rose by about 1% to $3.8 billion. Comparable sales rose by 1%. There was a notable bifurcation as store sales fell by 2% while online rose by 7%. Online is now 40% of total sales. The major driver of Gap's stronger earnings results though has been substantially improved cost discipline. Gross margins rose by 140bps to 42.7%, aided by 90bps of higher merchandise margin and lower rent cost. Gap over the past two years has brought inventory back to a solid level, leaving it leaner and with less pressure to engage in promotional activity to move product. In fact, even though sales are higher, its $2.33 billion of inventory is down 2% from last year. In other words, inventory productivity has improved by about 4%. Alongside this, operating expenses declined by $26 million to $1.28 billion. As a result, Gap generated an operating margin of 9.3%, up by 270bps from last year. With inventory under control and sales having improved, the vast majority of the operating margin gains have occurred, though I do see scope to ultimately get margins closer to 10% in 2025-2026, assuming modest sales growth. Athleta Shines while Banana Republic Stabilizes As you can see below, there was meaningful divergence among the brands in terms of sales momentum, with Athleta the top performer and Banana Republic the laggard. However, across the board, sales growth was similar to or better than it was last year as management's effort to reinvigorate brands with better products is starting to show results for investors. The Gap Drilling into segment results, Old Navy is actually the most important unit for the company, despite it being named Gap Inc. Old Navy accounts for the majority of sales at $2.2 billion with comps flat and total sales up 1%. Given challenging comps and unfavorable weather, this was a reasonable result. Q3 is a critical quarter, given back-to-school shopping, and sales remained healthy. I would note that Old Navy has lower-income shoppers than the other brands, and they may face more headwinds from years of elevated inflation. With annual inflation moderating, some of this pressure may ease. Gap comps rose 3% to $899 million, a fourth quarter of positive same-store sales. Total sales are growing a bit more slowly as the company has trimmed its store count to eliminate underperforming locations. This result was encouraging because the kids and baby segment remains under pressure. Across all retailers, sales are down 3%, and Gap has about 8% market share here, it disclosed on the earnings call, positive overall comps point to stronger momentum in other segments to offset this headwind. Banana Republic has been a longer-term underperformer, but efforts to modernize the brand and update merchandising have at least slowed the decline. Total sales rose by 2% to $469 million. Management is still focused on \"fixing\" the brand. Frankly, even stable sales are encouraging from an investor perspective, particularly with it less than 12% of total sales. With growth elsewhere, GAP can deliver rising profits even with a flat Banana Republic. Finally, Athleta was the standout, but it is the smallest brand with $290 million in sales. Athleta comps rose by 5%, and it sees efforts to turn around the brand \"taking hold.\" It sees the quarter as an inflection point, with unconventional marketing efforts like its TikTok channel helping to reinvigorate the brand's relevance. Last year, comps plunged as the company moved out inventory and sought to reset the brand. Athleisure is a growing category, but Athleta has struggled to truly compete with Lululemon (LULU). It is too early to declare victory, but this quarter is an optimistic sign that the turnaround is well underway. Gap's strong cash flow leads to a stellar balance sheet So far this year, Gap has generated $540 million of free cash flow, despite -$140 million in working capital headwinds. This has gone to put its balance sheet in an excellent position. It has $2.2 billion of cash and equivalents, up 64% from last year, and just $4.8 billion of debt and operating leases. I see limited need to carry even more cash on its balance sheet. It has $476 million in buyback capacity, but a large repurchase program does not appear to be an imminent priority, instead, capital allocation is something management will \"reevaluate over time.\" Shares do offer a 2.7% dividend yield. Given strong Q3 results, management did raise guidance, largely reflecting the beat seen last quarter and implying some of this momentum continues into Q4. Back in May, I was targeting $670-700 million of free cash flow and $1.65-$1.70 in EPS. I now expect Gap to deliver at least $1.92 in EPS this year, as margin improvement has been strong and its Athleta turnaround has gained traction more quickly. Depending on how much working capital it recaptures in Q4, I expect $725-$780 million of free cash flow. The Gap Gap can grow sales despite macro concerns I would note that shares have declined even as operating results have come in better than I expected, reflecting a contracting multiple. This implies more concern about the future of earnings growth. I believe some of these concerns are exaggerated. Its brands have stable to improving momentum, and management has proven an ability to increase their relevance to consumers. As such, Gap should be able to at least maintain market share, if not grow it modestly. This is not a company likely to grow sales by 5-8%, but it can grow them by 2%+. The question then becomes the macro environment. I continue to expect the US economy to expand modestly and view recession as unlikely. Apparel sales are slowly rising again. After a significant pull-forward in demand in 2021, they have essentially been flat for three years and are closer to the pre-COVID trend. In other words, spending is sustainable and can rise modestly alongside overall consumption. St. Louis Federal Reserve The primary risk would be broad-based tariffs from the new Trump Administration. This poses more of an industry risk than a Gap-specific one. Still, if broad-based tariffs do occur and cause prices to rise, that could lead consumers to pull back from spending on apparel and redirect spending elsewhere. Given the political importance of lowering inflation, I view China-specific tariffs as more likely than across-the-board increases. GAP sources less than 10% of products from China, so it is well-positioned for this potential outcome. GAP stock's valuation is compelling Assuming 0-2% topline growth next year, Gap can generate at least $800 million in 2025 free cash flow, holding working capital flat. That gives shares an 8.5% free cash flow yield, which I view as attractive. This is especially the case because its cash balance should rise towards $2.8 billion next year, which should result in a buyback or increased dividend, though I do not expect an announcement for at least six months.  I still view at least a 7% free cash flow yield as appropriate, discounting 3% long-term growth (1% real sales growth and ~2% inflation) to enable a 10% long-term return. That argues for shares rising to $29. As such, I am returning shares to a buy. The Gap, Inc. is performing well operationally, and as concerns about 2025 prove overly cautious, that should result in improving share price performance.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"1","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2485929712"}