Is it a good time to buy Gap shares?

The holeit is (GPS 1.46%) the stock rebounded nearly 8% on November 18 in response to its third-quarter earnings report. The clothing retailer’s revenue rose 2% year-over-year to $4.04 billion, beating analysts’ expectations of $210 million, while its same-store sales increased by 1%. It posted net income of $282 million, compared with a net loss of $152 million a year ago, as its adjusted earnings per share of $0.71 easily beat consensus guidance of $0.71.

Does this earnings beat signal that it’s finally a good time to buy Gap shares, which are still down more than 40% in the past 12 months?

What happened to Gapp?

Before the onset of the pandemic, Gap was already struggling with declining mall traffic and intense competition from “fast fashion” brands – cheap, trendy clothes produced in large quantities. After four years on the job, CEO Art Peck was fired at the end of 2019 as his three main banners – Old Navy, Gap and Banana Republic – struggled with declining sales.

Image source: Gap.

Sonia Syngal, who took the helm at the start of 2020, immediately faced a trial by fire as the pandemic closed physical stores in Gap. Later that year, Syngal launched a “Power Plan 2023” turnaround strategy that aimed to grow Gap’s total sales by low to mid-single digits each year while achieving an operating margin of at least 10% by 2023.

To achieve this goal, Syngal planned to reduce the size of the slower growing Gap and Banana Republic banners while expanding the higher growing Old Navy and Athleta banners. This strategy appeared to briefly stabilize Gap’s comps growth in fiscal 2021 (which ended in January 2022), although it calculated these sales against its pre-pandemic sales in 2019.

But in the first half of fiscal 2022, those plans fell apart again as comps dwindled across the Old Navy, Gap and Athleta banners. That slowdown triggered Syngal’s layoff in July ahead of Gap’s second-quarter report.

Is Gap’s activity finally stabilizing?

But as the following chart illustrates, Gap’s compositions finally turned positive again in the third quarter of 2022, driven by the surprising growth of Gap and Banana Republic.

Segment

Q3 2021*

Q4 2021*

Q1 2022

Q2 2022

Q3 2022

Growth of Old Navy comps

(9%)

0%

(22%)

(15%)

(1%)

Spread Comp Growth

seven%

3%

(11%)

(ten%)

4%

Growth of Banana Republic compositions

28%

(2%)

27%

8%

ten%

Growth of athlete competitions

2%

42%

(seven%)

(8%)

0%

Total Comp Growth

5%

3%

(14%)

(ten%)

1%

Data source: Gap. *Compared to 2019.

Gap attributed the growth of its eponymous brand to higher sales of dresses, woven tops, sweaters and pants, which offset its weaker sales of children’s and baby clothing. Banana Republic, which was rebooted last year with new products and marketing campaigns, has attracted more customers with its workwear and wider selection of high end clothing.

However, Old Navy’s weak children’s and baby clothing sales offset its stronger women’s clothing sales. Athleta, which was once seen as the company’s most promising banner, blamed its slowdown on the weak athleisure market – even though its rival Lululemon Athletica posted 23% growth in comps in its most recent quarter.

The spread always depends on the markdowns which crush the margins

As Gap’s comps growth stabilized, its gross margin increased 290 basis points sequentially (but still decreased 470 basis points year-over-year) to 37.4%. Excluding the impairment charge related to the termination of its partnership with Yeezy, it would have generated a gross margin of 38.7%. Its operating margin finally turned positive in the third quarter (after two quarters of negative operating margins) and rose 70 basis points year over year to 4.6%. But on an adjusted basis, which excludes some one-time gains, its operating margin fell a further 40 basis points year-over-year to 3.9%.

Gap’s margins are shrinking year over year because it still relies heavily on markdowns, which have driven its comps growth and kept inventory manageable with a modest 12% year-over-year increase on the other. However, increasing sales with markdowns over the long term is not viable.

To scale its business, Gap is still largely sticking to Syngal’s original plan. The company has closed 29 Gap and Banana Republic stores so far this year, and it plans to close 30 more stores by the end of fiscal 2022. It is also on track to open 30 new Athleta stores and 10 new Old Navy stores this year.

However, I’m not convinced that expanding Old Navy and Athletica is the right move. Both brands posted near-stable composition growth in the third quarter, and both face intense competition in the fast fashion and athleisure markets. If Gap continues to try to boost sales of these banners with new store openings, their competitors’ growth could still slump in year two.

A grim short-term outlook

Gap has yet to name a new permanent CEO and expects a single-digit year-over-year decline in net sales in the fourth quarter. For now, analysts expect its revenue to fall 6% for the full year as it posts an annual net loss.

Gap shares might look reasonably valued at 15 times forward earnings, but they won’t look compelling until they stabilize growth and margins for their rivals. For now, investors should stick with better-run apparel retailers like Lululemon instead of gap.

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