4 More Reasons to Buy Gap

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Gap’s (NYSE: GPS) stock was among top retail-sector gainers Friday, trading higher on the strength of their quarterly earnings and positive full year outlook. Bright colored-jeans and tight inventories helped Gap post higher quarterly profit. The results contrasted with those of teen apparel retailer Aeropostale (NYSE: ARO) which had to slash prices as ho-hum merchandise failed to find favor with teens during a particularly competitive back to school shopping season.

Gap’s net income for the second quarter was $243 million, up 29% year over year. Improved product, a lean operating structure, and strong store sales (SSS) execution worked together to drive a 40% increase in 2Q EPS to $0.49, including a 200 bps gain in operating margin. I have already discussed some of the positives like SSS momentum, promising developments in the international business, and high levels of insider ownership to support my bull thesis on Gap (See: Reasons to buy Gap). In this article, I will be discussing some more reasons that make us bullish on the stock despite the recent appreciation.

Multiple initiatives to drive outsized earnings gains

We see potential for Gap to drive outsized earnings gains given multiple levers, including improving SSS, new store contribution from Athleta, smaller US footprint, growing international presence and more franchised stores.

The Company doubled Athleta stores in 2Q12, ending with 22 locations. Customers have responded positively to the expanded store presence. The Company noted that store openings are on track to reach 25 new stores in FY12 and plans to double the store count to 50 by the end of FY13. We view this as one of the first truly viable competitors to Lululemon (NASDAQ: LULU). Athleta specifically trains its staff to make recommendations based upon customer’s specific needs and pricing also undercuts Lululemon. Thus, we expect the growth to continue to accelerate.

The company is on the track to reduce North American square footage by 10% by the end of 2012 (started in 2008) through store closures, downsizes, relocations, and consolidating concepts. This will provide future cost savings and we expect sales productivity gains to improve over time from Gap’s smaller US footprint.

The company continues to invest in mobile technology and online media, among many other technological initiatives to evolve as a 21st century retailer. The launch of the Gap-operated website in additional countries over the next few years highlights Gap’s international ambition and we expect the company to touch the $2 billion mark (from $1.6 billion in FY11) and achieve a 25% operating margin on its direct business in 2013.

The company will add 50-75 more franchised stores in 2012 on top of 49 franchised stores in 2011. The company expects to double the franchised store base to more than 400 units by 2015 (from 227 in 2011), particularly in smaller or more complex markets. We believe this will be an added advantage and provide some relief from macro fluctuations.

Gross margin opportunity

Gross margin should benefit from lower cost of goods, improved product and higher levels of regular price selling. We expect that improved product in all divisions should also help improve store traffic, which should in turn drive leverage on its rent-occupancy-depreciation. Gap achieved 90bps of leverage on ROD in 2Q and we expect to see similar leverage levels in 2HFY13. Also, we see a big gross margin opportunity in 4QFY13 given the expectation of significantly lower markdowns than last year.

Lean Inventory Levels

Inventory dollar per store decreased 6% at 2Q12 end, compared to a 5% increase last year.  The ship-from-store rollout (launched in 270 stores in October 2011) allows the company to fulfill online demand with excess store inventory. Management expects 3Q12 inventory to continue to decline in the low single digits despite the plan for adding units in 2H12 as AUC lowered. Thus, we are encouraged by the ongoing improvement and anticipate that Gap will aggressively manage the inventory to ensure a fresh, clean assortment in stores.

Returning Value to Shareholders

The company repurchased 13.1 million shares for a total of $349 million during Q2. The company continues to opportunistically repurchase shares and distribute a quarterly dividend, which we believe is evidence of its continued commitment to returning value to shareholders.

Thus, we remain optimistic given leaner inventory levels, gross margin opportunities in 2H12 and strong initiates to drive earnings upside. Despite a healthy valuation (forward P/E= 15.45), we still see a room for multiple expansion. Hence, we recommend it a good buy.

TheAnalystBlog has no positions in the stocks mentioned above. The Motley Fool owns shares of Aeropostale and Lululemon Athletica. Motley Fool newsletter services recommend Lululemon Athletica. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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