Gap Earnings: Encouraging Signs of Stability While Much Work Remains; Shares Very Undervalued

Gap’s GPS shares rallied 14% in post-market trading after it reported an unexpected (small) profit in 2023′s first quarter. We rate it as a no-moat company and acknowledge its challenges but also think consistent profitability is achievable and that its current valuation reflects an extreme level of pessimism. We do not expect to make any material change to our $23.50 per share fair value estimate.

Gap’s sales dropped 5.8% in the quarter, just below our negative 5.5% forecast. Gap Global (21% of sales) outperformed our forecast for a 3% decline with a 1% same-store sales increase. Old Navy (56% of sales) matched our estimate with same-stores sales down 1%. While spending on apparel from its low- and middle-income customer base has slowed, we think positive comparable sales are not far off after its merchandising efforts of the last few quarters. Meanwhile, Banana Republic (13% of sales) and Athleta (10% of sales) suffered same-store sales declines of 8% and 13%, respectively. While we remain skeptical of Banana Republic’s transition to upscale apparel and home goods and project sales declines, we believe Athleta should be fixable given the growth of the women’s activewear category and anticipate long-term sales growth at mid-single-digit rates.

Gap outperformed our 35% quarterly gross margin forecast by about 2 percentage points as it benefited from lower freight expenses and its improved inventory situation (down 27% at the end of the quarter) allowed for less discounting. Its operating margin was a modest 0.5%, but this was better than our negative 3% estimate as its operating costs declined more than expected. Moreover, the impact of the (previously announced) $300 million in additional expense savings will not be realized until the second half of 2023 and the first half of 2024. We forecast Gap will reach gross and operating margins of 39% and 7.5%, respectively, in 2027, below historical levels but up from the last few years.