Gap, Inc.'s Results Will Reflect Its Resilience

| About: The Gap, (GPS)

Gap, Inc. (NYSE:GPS) is one of the few apparel retailers in the U.S. that has performed well even in unfavorable market conditions. Backed by its strong market position, growing e-commerce channel, and fashion blog marketing, the company registered sturdy growth during the weak holiday season and cold-affected first quarter. Its momentum continued in the second quarter as well, when most apparel retailers were struggling to match their previous year's performance.

Gap will report comparable-store sales growth of 5% when it releases its Q2 fiscal 2013 earnings on Aug. 22. The figure is significantly higher than that for its peers and reflects its strong product offerings, firm inventory control, and growth in its online sales. This growth comes despite a slowdown in the company's business in July due to heavy promotions and the weakness in the U.S. apparel industry.

Apparel Industry Remained Weak During the Quarter

The spring season in the U.S. this year was reportedly the coldest since 1996, with average temperatures around 50.5 degrees Fahrenheit. Moreover, the season turned out quite wet, with average precipitation 0.21 inches above the 20th century average. These weather conditions translated into low demand for clothing suiting warmer and drier climates, which impacted the industry-wide apparel sales during March through May. Moreover, consumer spending remained weak during the quarter due to high unemployment rate as U.S. employers slowed their hiring pace outside the farming sector. The worst affected was the teenage segment, where the unemployment rate rose to 23.7% in July.

As a result, the beginning of the back-to-school season (July), which is the second-most important season for apparel retailers, was quite weak. According to the National Retail Federation, average spending per family on apparel, shoes, supplies, and electronics will decline by almost 8% during this season, as compared to 2012. This can be attributed to last year's record back-to-school season spending and cautious consumer spending this year on the account of payroll tax increases. Overall, the rough quarter impacted the sales of a number of retailers, including Aeropostale (NYSE:ARO) and American Eagle Outfitters (NYSE:AEO).

Gap Showed Resilience With Strong Product Offerings

Gap has been on the top of its game in managing its inventory since it started losing touch with emerging fashion trends toward the end of last decade. The company has managed to keep its products in line with the prevailing trends. During the second quarter, Gap's core products, such as denims and woven tops, along with its seasonal offerings such as summer dresses and shorts, delivered good performance. For Banana Republic, categories such as suitings, pants, and woven tops were among the strongest growth drivers. However, the weakness in women's merchandise and knit tops dragged the brand's growth lower. The company's youngest brand, Old Navy, was the strongest during the quarter with healthy growth coming from kids and baby products, summer collections, flip-flops, active shorts, and dresses.

As a result, the company registered comparable-store sales growth of 7% during May and June. However, the figure fell to 1% during July as the start of back-to-school season was marked by industry-wide promotional activities. This can also be attributed to the company preparing itself for low inventory carryover for the third quarter.

The launch of new products and campaigns also assisted Gap's growth during the second quarter. In July, Old Navy launched a vintage tee collection under the tag "Mickey Through The Decades" featuring Disney's most iconic character, Mickey Mouse. The collection included t-shirts for all age groups depicting Mickey Mouse's evolution over the years. The appealing product combined with attractive pricing supported the brand's growth to some extent. Moreover, Banana Republic was selected as formal attire supplier for Oracle Team USA, the sailboat racing syndicate and current defenders of the 34th America's cup. We believe that this partnership had a slightly positive impact on the brand's results.

Growth in E-Commerce Will Help

Online shopping in the U.S. has been growing rapidly and Gap has been at its forefront. The company's direct-to-consumer (mainly includes the e-commerce channel) revenues have jumped by almost 60% the last two years, which is impressive given the size of its online business. Even during the first quarter when the apparel market slipped, Gap's online sales grew by a staggering 27%. Apart from the growth in the online apparel industry, the retailer's mobile apps and mobile-optimized websites have played a vital role in strengthening its direct-to-consumer business.

Additionally, its ship-from-stores services, which allow the fulfilling of online orders through store inventories, have enabled it to offer a greater variety over the Internet, maintain delivery responsiveness, and drive store traffic. Gap is concerned that it might lose customers if they do not find products, fits, and colors according to their likings over the Internet, and assume that even stores will not have these products. Since the retailer's merchandise offerings remained strong during the second quarter, we expect the strong growth in e-commerce channel to continue. The direct-to-consumer channel accounts for about 25% of the company's value, according to our estimates.

Our price estimate for Gap at $47 implies a premium of about 5% to the market price.

Disclosure: No positions.