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Stock Analyst Update

Should Gap Be On Your Shopping List?

Efforts to deliver right-sized product innovation are gaining traction.

Mentioned:

With merchandise margins that were weaker than anticipated and operating expense deleverage of 120 basis points (to 31.7%), we think investors are concerned that no-moat  Gap’s (GPS) rectification of prior inventory and operating challenges could remain ongoing. However, commentary that merchandise margin pressure should begin to alleviate in the second quarter, combined with inventory that ticked up less than 4% versus a sales increase of 10%, gives us confidence that efforts to deliver right-sized product innovation are gaining traction. Given that our prior model included 2018 earnings per share of $2.64 (in line with the company’s outlook for $2.55-$2.70), we don’t plan any material change to our $33 fair value estimate, and following a high-single-digit downdraft in shares in afterhours trading, we now view shares as modestly undervalued.

Gap increased its share in the clothing and accessories industry, with first-quarter sales growth of 10% versus an industry that has increased at a mid-single-digit pace for the year to date, thanks to strong Old Navy performance (comps of 3%). However, we don’t think the company will be able to defend its share over the long term, given that planned store closures ahead (200 Gap and BR store closures offset by 270 ON store openings) should naturally pressure the top line, and we have sales growth trending down from 2.2% in 2017 to 1.0% over the next five years, supported by flat comps at Gap, 1% comp declines at Banana Republic, and a 2% comp increases at Old Navy. Furthermore, given the slow execution in improving the supply chain and necessary investment in technology to improve the business amid an intensely competitive landscape, we forecast operating margin contraction over the next decade, falling to 8.5% from 8.9% in 2017.

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Jaime M. Katz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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