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Morningstar | Old Navy Continues to Lead in Profitability at Gap, While Namesake Brand Continues to Struggle

Old Navy remains the bright spot at no-moat Gap, marking the ninth consecutive quarter of positive same-store sales growth (4%), while Banana Republic remains on the mend, stringing together its fourth positive comp quarter (2%) after posting 11 negative quarters. Only the namesake Gap brand (about one third of sales) remains problematic, capturing just one positive comp quarter in the last 19, with comps down 7%. While the quarter’s 30.8% SG&A metric was 20 basis points better than we forecast, gains were more than offset by gross margin pressure from the Gap brand, as higher markdowns exacerbated already inflated shipping expenses in the period. With these pressures unlikely to abate ahead, Gap guided to the low end of its prior $2.55-$2.60 earnings per share range for the full year, resetting the upside at $2.60.

While the Gap attempts to pivot and innovate through assortment expansions like Hill City (men’s activewear), the fleet rollout of buy online, pickup in store, and the in stock on shelf app (to prevent stock outs), we believe most of these efforts will bring the firm up to speed with its peer set, preventing market share erosion. For reference, clothing and clothing accessories sales have risen at an average of 5% over the fiscal year to date period, while increasing an average 4% over the past three months (Census), while Gap sales have risen 8% and 7%, respectively, indicating market share losses have temporarily slowed. This doesn’t alter our long-term outlook, however, given ongoing declines in mall traffic, continued price competition to facilitate customer acquisition, and higher investment spend to remain relevant. Our forecast still includes flat same-store sales growth and 1.6% revenue growth, making expense leverage difficult and leading to around an 8.5% operating margin on average over the next decade. Given no change to our long-term thesis, we don’t plan any material change to our $34 fair value estimate and view shares as undervalued.

Total net sales decelerated sequentially in the quarter but still increased a robust 7%, bolstered by strong performance at Old Navy. Gross margin of 39.7% was about 80 basis points worse than we forecast, hindered by increased shipping expenses and elevated promotional activity at Gap brand. The shipping expense inflation was due to automation issues at a new distribution center; however, we view these in a somewhat favorable light as they stemmed from increased online sales (on track for $3.5 billion sales for the year). However, the promotional activity was driven by assortment choices (poor average top to bottom ratio) which caused sharper discount to clear inventory (merchandise margin declined 180 basis points in the quarter). Taking these impacts together highlights why we believe the firm on average will maintain flat gross margin over our 10-year forecast period (38.9% rate). Operating expenses were 20 basis points better than we expected at 30.8%, helped by expense discipline around discretionary items just as bonus favorability. Inventories grew slightly faster than sales, rising nearly 8% while payables declined at a less favorable 2.3% pace, leading to less optimal cash conversion metrics.