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Gap Weathers Cost Pressures; Shares Attractive

We expect to raise our fair value estimate, leaving shares of the no-moat retailer as very undervalued.

No-moat Gap GPS met our forecast of a small operating profit in 2021's fourth quarter despite a gross margin of just 33.7%, down 400 basis points from last year. The firm, as previously warned, chose to use expensive air freight to overcome shipping problems and meet holiday demand, but it was able to offset some of the incremental cost by controlling other expenses. Looking ahead, Gap's 2022 guidance for low-single-digit sales growth, an adjusted operating margin of 6%-6.5%, and adjusted EPS of $1.85-$2.05 is in line with our forecast despite shipping issues continuing in the first half of the year and input inflation. We expect to lift our $26.50 per share fair value estimate by about 5% given this outlook and a rescission of our prior expectation of a higher U.S. corporate tax rate, leaving Gap's shares as very undervalued. Gap's fourth-quarter unit sales numbers were mixed but total sales met our estimate with 2% growth. Gap Global and Banana Republic recorded double-digit comparable sales growth against easy comparisons, but Old Navy (51% of total sales) suffered a 6% comparable sales decline on product shortages and a fashion shift, issues we view as transitory. We still anticipate Old Navy will reach Gap's 2023 sales target of $10 billion, up from $9.1 billion in 2021. As for Athleta, Gap continues to believe it will reach $2 billion in 2023 sales, up from $1.4 billion in 2021, but we think this may not happen until 2025 due to COVID-19 disruption. Even so, we think Athleta is poised for annual sales growth of about 6% over the next decade. Gap's 2021 adjusted gross margin came in at 39.8%, an improvement over pre-pandemic levels but likely boosted by favorable industry conditions (low markdowns, stimulus) that may subside. Its 2021 adjusted operating expenses came in at 34.3% of sales, up from (pre-pandemic) 2019's 31.2%, but we think efficiency efforts will bring this margin back down to 31% within two years, leading to stable operating margins of 8%.

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