Gap Earnings: Sales Growth Elusive but Signs of Margin Improvement Greet New CEO; Shares Undervalued

Gap GPS suffered same-store sales declines in each of its four banners in the second quarter, but cost-cutting brought a 3.4% adjusted operating margin that was 170 basis points above our forecast. As we do not think Gap can cut its way to prosperity, generating sales growth at Old Navy and Gap’s other segments will be the priority for new CEO Richard Dickson. Unfortunately, it will likely take time for progress on this front to be apparent given that inflation and other factors are depressing consumer spending on apparel this year. That said, we do not expect to make any material change to our $23.50 fair value estimate on Gap and view shares as very undervalued. Although we rate it as a no-moat company, we think Gap has strengths, including Old Navy’s historically strong sales growth and profitability and Athleta’s potential in the women’s activewear space. Moreover, despite its struggles, Gap has no near-term debt maturities and is poised for significant free cash flow improvement; its free cash flow to equity improved by more than $900 million in the first half of 2023, and we believe Gap will continue to pay its dividend (6% current yield).

Gap’s $0.34 in adjusted EPS in the quarter was $0.25 above our forecast due to margin outperformance, but its total sales fell 8%, short of our forecast for a 7% drop. The biggest problem was Old Navy (55% of total sales), which suffered a 6% comparable sales decline as its largely low-income customer base pulled back on spending. We believe Old Navy is fixable and will return to sales growth within the next year as recent merchandising efforts take hold. We are less confident in a near-term turnaround in Athleta (10% of sales) as it is clearly not keeping pace with narrow-moat Lululemon and others in its space, but a new brand leader provides some hope. Our long-term forecast for Gap to achieve 7.5% operating margins, up from the low single digits presently, is partly based on Old Navy and Athleta returning to sales growth.