Like Our Khakis, The Gap Has More Room To Run

Aug.24.14 | About: The Gap, (GPS)


Despite new highs, The Gap looks undervalued vs. peers and the market.

Going where the young people are: Indian growth initiative looks savvy.

Merchandise discounts a risk.

We recently retired our well-worn Gap (NYSE:GPS) khakis due to -- ahem -- size issues. They were good soldiers and we will miss their buttery soft familiarity and much admired drape, but an inch or two extra around the middle was needed. With the purchase of several new pair from Banana Republic, we are comfortable once again.

The shares remain in our comfort zone as well, though they are trading near their 52-week high after word Friday of the fiscal second quarter earnings beat and more robust guidance. Using a forward price-to-earnings multiple equal to that of the S&P 500, we arrive at a price target of $54, about 20% higher than recent levels. Throw in a 2% dividend yield, and we think The Gap can be a mainstay for investors in retail stocks.

Old Navy stores were The Gap's strength in the second quarter, with comparable-store sales up 4%, outweighing a decline at The Gap and a flat performance at Banana Republic. Total sales were $3.98 billion, up about 3% from the year-ago period. Adjusted earnings per share were $0.70, excluding a five-cent benefit from the sale of a building. The company said foreign currency fluctuations reduced the second quarter fiscal year 2014 earnings per share growth rate by approximately four percentage points.

Going forward, The GAP now expects full year EPS of $2.95-3.00, up five cents to reflect the gain on sale of the building.

The case for owning shares of The Gap comes down to relative valuation, in our view. Sporting a forward PE of about 13, the stock is cheaper than that of competitors Abercrombie & Fitch (NYSE:ANF), American Eagle Outfitters (NYSE:AEO) and Urban Outfitters (NASDAQ:URBN). It also lags the S&P 500 forward PE of about 16.25 as calculated by Birinyi Associates. A market multiple is appropriate for this solid performer, in our view.

Meanwhile, international growth continues. Along with second quarter results, the company announced it was planning on opening 40 new stores in India, partnering with Arvind Lifestyle Brand Limited, a subsidiary of Arvind Limited, an Indian textile company. Bringing American casual style to Asia, which has more young people than anyone, is a necessary, if not pivotal strategy for a company the size of The Gap.

That's because risks certainly are apparent on the home front. Apparel sellers have been forced to discount merchandise to move it, and The Gap has been no exception. Despite declines in input costs, the company's gross margin fell to 39.4% from 40.5% a year earlier. (Indeed, our new khakis were a bargain). But a 4.2% decline in operating expenses enabled the company to post a 14.2% operating margin versus 13.5% last year.

If the consumer holds up, clearly a concern, though somewhat ameliorated by falling gasoline prices, The Gap should outperform peers, in our view.

The Gap, Inc. operates as an apparel retail company worldwide. It provides apparel, accessories, and personal care products for men, women, and children under the Gap, Banana Republic, Old Navy, Piperlime, Athleta, and Intermix brands. It was founded in 1969 and is based in San Francisco.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.