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Defying concerns on fiscal cliff and economic headwinds, retailers were able to post stronger than expected December retail sales. Comparable Same Store Sales [SSS] were stronger for Off price retailers while Specialty and Department stores released mixed results. According to the National Retail Federation, the world's largest retail trade association, December retail sales (excluding automobiles, gas stations and restaurants) increased 0.8% seasonally adjusted from November and increased 2.1% unadjusted y-o-y. Post slower November SSS due to Hurricane Sandy, retailers had to resort to increased promotions in order to meet December expectations, indicating that increased sales came at the cost of lower margins. This was further corroborated by lowered 4Q guidance by few companies, especially Kohl's Corp (NYSE:KSS) which posted lower than expected SSS and lowered its 4Q EPS to $1.60 to $1.62 per share (vs. previous target of $2).

GAP Inc (NYSE:GPS), the global specialty retailer with a strong portfolio of brands - Gap, Banana Republic, Old Navy - reported strong Dec SSS of 5% (vs. -4% in Dec 11). Driven by favorable response to their product offerings and promotions, its brands posted strong positive SSS - Old Navy 13% (vs. -4% Dec 11), 1% in Banana Republic (vs. -2% in Dec 11).

GPS went through a declining SSS and profitability phase throughout recession plagued by rising cotton costs, weak product assortments, high promotional activity and a weak European economy (International sales account for 15% of FY11 sales ). Whereas its main competitor Limited Brands (LTD) - manager of Victoria's Secret, Bath and Body Works, La Senza, Pink and Henri Bendel - posted exceptionally strong SSS during the same period as it focused on managing its inventory tightly and sharpening its merchandise expertise, which caused GPS to lose market share.

Presently, GPS is focused on its turnaround strategies (closing down its oversized Old Navy stores, improved product assortments) and has seen a sharp improvement in its SSS and profitability since FY12. It had a strong 2012, with shares increasing 73% y-o-y (Current share price : $32.84 at the higher end of 52-week range 20.42-37.85) while 2013 started on a good note with the Company reporting strong December SSS, acquisition of Intermix and a new share repurchase authorization.

On the path to recovery:

Strengthening of its luxury line-up through Intermix:

On 2nd Jan, GPS announced acquisition of women's fashion boutique Intermix Inc. for $130MM. The acquisition will help it to extend its portfolio of brands. Intermix is a multi-brand specialty retailer of luxury and contemporary women's apparel (Herve Leger, Yves Saint Laurent and Rag & Bone) and operates 32 boutique stores and a website. This marks GPS' first since it paid $150MM in 2008 for women's active apparel retailer Athleta which under GPS' guidance has expanded from a catalog business to a strong e-commerce platform and brick and mortar presence.

New Share Repurchase Authorization:

On 3rd Jan, it authorized a new $1Bn share repurchase program. GPS places greater emphasis on share repurchases, purchasing ~17milion shares for ~$539MM during 4Q12.

Expansion of International Footprint:

Due to weak economic conditions in Europe coupled with a natural disaster in Japan, GPS has faced weak international performance, but has seen slight improvement in recent quarters; 3Q12 SSS were down 3% vs. -10% in 3Q11. It plans to deliberately lower its Gap North America stores to 950 by FYE13 and is aggressively expanding its international stores, mainly in China and Brazil. It aims to generate 30% of FY13 sales through international and online business.

Growing online segment:

The US apparel industry is currently being driven by the online segment, as witnessed by +23% in GPS' direct-to-consumer revenues in 3Q12. This momentum is expected to continue given the increasing popularity of online shopping and recent launch of its Japan e-commerce platform.

Competitors:

Although GPS is larger than LTD in terms of revenue, it has a lower operating margin and had lost market share due to its weak assortments and oversized Old Navy stores. GPS has a strong history of repaying its debt and has been debt free until 2011, while LTD has a long history of debt financed share repurchases and dividends. So while GPS gains on high liquidity, conservative financial policy and utilization of cash flows for share repurchase, LTD gains on its execution benefits, higher operating margin and inventory turnover, but is constrained by is financial policy which favors shareholders and high levels of debt.

Industry outlook:

The US economy is on a slow recovery with small bumps of uncertain fiscal policy and volatile gasoline prices. Nevertheless, key economic indicators remain stable with stable unemployment rates (7.8%) and a slight transitory dip in consumer confidence (71.3). Positive December SSS are an indication that shoppers are willing to spend despite lower consumer sentiment. Overall business and profit trends are expected to be flat to slightly positive as retailers benefit from lower sourcing costs and maintain conservative inventory levels.

Conclusion:

GPS is a good option for long-term investors, given strong 2013 prospects with its improving operational performance and SSS, new acquisition and continued focus on share repurchases. Further, its long-term strategic moves and disciplined cost management measures will provide it with improved financial flexibility, and its globally-recognized brands will help it to reinforce its position in the sector.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Santa Came To Town At Gap