Reasons to Buy Gap
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Gap (NYSE: GPS) shares have seen a tremendous 82% year to date rise and are currently trading at $33.75. Going forward, we see potential for earnings upside given multiple levers, such as improving SSS, new store contribution and leverage on fixed expenses. Gross margin should benefit from improved products and higher levels of regular price selling. Sales productivity gains should improve over time from GPS’ smaller US footprint. The following are the key reasons that make us positive on this stock.
Strong SSS Momentum
GPS posted a surprise 2Q12 sales increase of 6% to $3.58 billion, inclusive of 4% SSS growth. The company posted encouraging SSS trends with Gap NA, Banana Republic and Old Navy delivering SSS growth of 7%, 7% and 3%, respectively. The sales trend picked up a great deal towards the quarter's end with July showing a 10% year over year SSS growth, and thus we remain confident of the company’s ability to carry this momentum to the next quarter.
Part 2 of a Two-part Turnaround
GPS’ improved product and lean operating structure are components of a two-part turnaround, positioning the company to return to historical peak margins by FY15. GPS is still in the early stages of the turnaround, which we believe is gaining traction. Stage 1 was the evolution of an efficient operating structure, enabling GPS to achieve leverage with flat SSS on its rent-occupancy-depreciation (ROD). Stage 2 is improved products, which appears to be right on track as evidenced by the 4% 2Q SSS gain.
Promising new Developments in International Business
GPS opened its first international Old Navy store on 7th July in Tokyo, Japan. We view the expansion as a positive for GPS, as international opportunities provide a venue for growth at this otherwise mature company. Currently 45% of Japan's retail business is from the value segment and is showing healthy growth. Thus, the introduction of Old Navy in Japan is a good move, as this is GPS's most value-oriented brand and resonates very well with the Japanese customer. Additionally, we think the recent appointment of Stefan Larsson as Old Navy's new Global Brand President will play an incremental role in navigating the international market, given his previous experience at the successful, global fast-fashion retailer H&M.
The management at GPS has a real stake in how the company performs as large proportions of company’s shares are held by insiders. The following table summarizes insider ownership of GPS and its peer group of American Eagle (NYSE: AEO), Abercrombie & Fitch (NYSE: ANF) and Aeropostale (NYSE: ARO).
Insiders own more than a 36% share of GAP. Clearly GPS’s management appears to be more confident than struggling retailers like ANF and ARO about the company’s growth prospects.
Additionally, Asia, which represents just ~8% of total sales, holds great potential with a very long runway ahead. With significant infrastructure already in place for GPS's international expansion, we think the company should benefit from the continued rollout of stores, both under the owned and franchised models. Despite year-to-date share appreciation of more than 70%, we remain bullish and believe GPS is still in the early stages of reinvigorating its brand recognition. This turnaround appears to be supported well by meaningful improvements in merchandising and marketing; setting a platform for a multiyear progress in productivity and profitability. The company is trading at 14.67x forward earnings and appears to be undervalued. We recommend it as a buy.
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