Morningstar | Gap's Challenging Start to 2019 Hindered by Weather and Poor Merchandising; Shares Undervalued
No-moat Gap started 2019 with dismal results, with all segments suffering from weather and execution issues, leading to increased promotional activity. For the quarter, sales shrank 2% on 36.3% gross and 3.5% adjusted operating margins, below our estimates of 2% growth, 38%, and 8%, respectively for the year. Due to ongoing inventory issues that are set to persist in the upcoming quarter, management slashed its full-year targets, calling for comparable sales to decline in the low-single-digit range and adjusted earnings per share to fall between $2.05 and $2.15 (versus flat to up slightly comps and adjusted EPS of $2.40-$2.55 prior). These metrics are below our forecast for 0.5% comp growth and $2.58 in EPS for the year, and as a result, we intend to reduce our $31 fair value estimate by a high-single-digit percentage to account for the near-term weakness. However, we believe most of the pressures felt by Gap were largely due to unfavorable weather rather than drastic shifts in consumer tastes regarding the firm’s offerings (with management citing better performance over the quarter as weather improved). Given that long-term secular headwinds were already factored into our long-term outlook, we do not expect a large change to our 10-year projections for 1% sales growth and 39% gross and 8% operating margins on average. With the shares trading down double digits following results, we view Gap as undervalued but note that volatility in the shares may not abate until the second half of the year.By segment, Old Navy and Gap continue to pursue drastically different strategies with Old Navy pursuing store base expansion while Gap reduces its footprint to regain profitability. Both segments reported poor comparable sales for the quarter, down 1% and 10%, respectively. We think the 10% increase in inventory relative to the 2% decrease in total sales portends further merchandise margin pressure (down 140 basis points in the quarter) in the second quarter, validating our belief that Gap lacks the pricing power needed for a sustainable moat. Weakness at Old Navy (about half of sales) raises concern, and if operating performance continues to deteriorate, the firm’s plans to spin off the segment could be at risk.
The Gap is an apparel retail company. The company provides apparel, accessories, and personal care products for men, women, and children under the Old Navy, Gap, Banana Republic, Athleta, Intermix, and Hill City brands. The company has stores in the U.S., Canada, the U.K., France, Ireland, Japan, Italy, China, Hong Kong, Taiwan, and Mexico, and has franchise agreements with unaffiliated franchisees to operate Old Navy, Gap, and Banana Republic stores throughout Asia, Europe, Latin America, the Middle East, and Africa. Under these agreements, third parties operate stores that sell apparel and related products under the company's brand names.
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Morningstar provides data on approximately 530,000 investment offerings, including stocks, mutual funds, and similar vehicles, along with real-time global market data on more than 18 million equities, indexes, futures, options, commodities, and precious metals, in addition to foreign exchange and Treasury markets. Morningstar also offers investment management services through its investment advisory subsidiaries and had approximately $185 billion in assets under advisement and management as of June 30, 2016.
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