No-Moat Gap Cuts Costs and Reorganizes as It Seeks a CEO and Stability; Shares Undervalued

Closing a painful year, Gap GPS underperformed our modest expectations in 2022′s fourth quarter. Moreover, its guidance for a mid-single-digit percentage sales decline in 2023 is disappointing. Even so, we are encouraged that the firm (even with an interim CEO) is not standing still as, in conjunction with the earnings report, it announced $300 million in cost savings in addition to the $250 million identified last year. Moreover, Gap has made major organizational and personnel changes and expects to name a permanent CEO soon.

We expect to lower our $25 fair value estimate by a mid-single-digit percentage given the dim near-term outlook, but we view Gap’s shares as attractive. We rate the firm as having no moat but believe it has strengths, including the popularity of Old Navy (53% of 2022 sales) and the potential for women’s activewear brand Athleta (9% of 2022 sales). We believe these labels will return to growth after merchandise issues are addressed, inflation cools, and consumer spending picks up. One positive is that Gap is getting its inventory under control, as it was roughly 21% lower at the end of 2022 than at the end of 2021. In addition, the company continues to pay its dividend (yield of more than 5%) and expects to be able to pay down its $350 million revolving credit line this year. The firm closed 2022 with $1.8 billion in total debt but also had $1.2 billion in cash.

Gap’s fourth-quarter comparable sales dropped 5%, shy of our negative 2% forecast, as none of its four labels managed to achieve positive sales growth. Old Navy (51% of the quarter’s sales) was affected by weak spending by lower-income customers but experienced better sales after December. Due to the poor sales, Gap’s gross and operating margins were a weak 33.6% and negative 0.7%, respectively, missing of our estimates by 90 and 170 basis points. We believe Gap can build toward gross margins in the high-30s and operating margins around 7.5%, but this may take three or more years.