The Gap Is Back... But We're Not Chasing It Here

| About: The Gap, (GPS)

With Gap (NYSE:GPS) on a tremendous run as of late, we thought it important to provide a perspective on the firm's valuation. At Valuentum, valuation is the first and foremost consideration in our process -- and not just simple multiple work, but an extensive DCF process. Though the firm has been good to investors this year, we value its shares just below the $30 mark, suggesting a pullback is in order. Let's take a read on how its fundamentals are doing and what the company scores on the Valuentum Buying Index, our stock-selection methodology.

Last Thursday, retailer Gap shrugged off sluggish international demand to post another strong quarter. For its second quarter, the retailer grew sales 6% from the same period a year ago, to $3.6 billion, north of consensus expectations. Earnings per share increased 40% to $0.49, which was also better than consensus estimates. The firm hiked its 2012 bottom-line earnings per share guidance range to $1.95-$2.00, a meaningful increase from its previous range of $1.78-$1.83.

Other than its international segment, Gap is firing on all cylinders. Systemwide same-store sales grew 4% year-over-year, despite a 5% decline in the international division. Though Gap North America and Banana Republic lapped negative comparisons, both segments grew 7%. Management noted trends regarding color and fit as the main growth drivers. Many retailers have revealed that colored jeans have become a big hit in recent months, and Gap covers essentially the entire rainbow.

The firm's consistent fit across products helped boost online sales 24% at Gap Direct during the second quarter. Old Navy wasn't quite as strong as Banana Republic or Gap, posting 3% same-store sales growth. However, h&m executive Stefan Larsson, who is seen as one of the best, young retail executives in the world, was recently hired as Old Navy's president. Coming from h&m, one of the more disruptive retailers in recent memory, we think Larsson certainly has the experience to transform the Old Navy business, which many thought the firm should close.

Although same-store sales are truly driving growth, pricing is also stronger, reflecting better product across the board. The company's gross margin increased 300 basis points from the mark posted in the same period a year ago, to 39.9%, though 90 basis points of the gain came from improved rent and occupancy costs. By extension, Gap boosted its operating-margin outlook for 2012 to 11% from 10%. We think better gross margins, improvement at Old Navy, and ongoing closing of unproductive stores will drive even higher operating margins in coming periods--though it may take some time to manifest.

Ultimately, Gap posted a very strong quarter and issued excellent guidance, underscoring the broader trend regarding the preference of brand names in the retail and apparel space. In a low/no growth environment, there will be winners, i.e. Ross Stores (NASDAQ:ROST), Nordstrom (NYSE:JWN), Gap and TJ Maxx (NYSE:TJX). And there will be losers, i.e. Kohl's (NYSE:KSS), J.C. Penney (NYSE:JCP), Abercrombie & Fitch (NYSE:ANF) and Sears (NASDAQ:SHLD). Consumers want brand names, and they want value.

All of the winners have a nice combination of both. Gap is clearly a winner at this time, but it scores just a 3 on the Valuentum Buying Index, so we aren't wild about its return potential (especially given its recent run higher). A 3 on our indicates translates to a 'less exciting' rating.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.