Gap: Short-Term Headwinds But Bull Case Still Intact

| About: The Gap, (GPS)

Gap (NYSE: GPS) reported another impressive quarter of margin and comps growth last month. Third quarter earnings per share came in at $0.72 and the company reaffirmed its guidance for the full year of $2.57-$2.65. Despite this impressive performance investors have begun to question whether the company can continue this hot streak.

Two years ago, any kind of hot streak seemed a distant hope. Mall retailers suffered under competition from "fast fashion", off-price, and online retailers. Overall, according to Euromonitor, mall-based retailers as a group lost 450bps of market between 2007 and 2012 (I can't publish a link as the source is a PDF on my computer which I received from JPMorgan as part of paid research. My understanding is that either distributing this piece or putting it up on the internet and linking it here would be illegal). Cotton prices were rising strongly too cutting into Gap's margins.

In early 2012, Gap began to beat these trends. The launch of the "Be Bright" campaign, focused on brightly colored denims and bottoms, was the headline success. Gap began to win share back at the expense of other mall-based apparel retailers and department stores. Cotton prices also reversed most of the huge price gains seen in 2010/11 by early 2012, adding 318 bps to gross margins through 2012.

Keeping Pace
Unfortunately for Gap, success breeds its own set of questions. As we begin to lap these trends, investors are asking whether Gap can keep up this performance. Gap has moved ahead of other mall-based retailers but permanent shifts towards a certain retailer are rare in this industry. Moreover, the poor performance of mall-based competitors will surely mean that Xmas season will be highly promotional. Gap has staked out a very attractive segment of the market in contrast to some of the struggling retailers but the high level of promotional activity will affect results going forward.

Margins are a particular cause for concern. In the third quarter, a falling merchandise margin was offset by cuts in SG&A. Going forward, Gap will struggle to keep making numbers this way. Building inventory and the pressure of a promotional Xmas period suggest that Gap's margins will come under pressure in the near future.

Bull case

Gap's operating margin averages 13%, well above the peer average of 6.6%. Reversion to the mean might seem inevitable. If we look to other global apparel retailers though we can see the direction the company should be heading in. Both H&M and Inditex average margins in the high teens.

Making this comparison is easier than proving that Gap can achieve this goal. Management does have a plan though.

The headline figures are for 1,000 incremental stores and $1 billion in online sales by 2016. Online sales will naturally be accretive to margins. Gap plans to enter Asia with Old Navy, expand Gap and Banana Republic internationally with franchises, and grow the high-end (and high margin) Piperlime, Intermix, and Athleta brands. Gap is also investing in inventory management systems which should further improve inventory turns and margins simultaneously. The route to higher margins comes from this realignment in regions, brands, and channels.

Bulls are also sure to mention Gap's excellent record of capital returns. Over the past five years, the company has bought back 30% of shares outstanding which has contributed 8 percentage points to annual earnings-per-share growth. In this quarter alone Gap has returned $880m through share repurchases and dividends. In the future, this should lead to mid-single digit growth.

Gap is coming off a very hot streak but there is still a great deal of potential for further improvements. Management has a clear plan to achieve these goals and it is doing this with shareholder-friendly capital allocation.

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.