Let's Not Get Too Excited On Gap's Strong Monthly Sales

| About: The Gap, (GPS)
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Gap’s June sales beat expectations thanks to the strength at Old Navy.

I am cautious on Gap’s sales growth because I do not believe that it can compete effectively against fast-fashion brands such as Zara and H&M.

I would avoid this stock in the near-term until I see consistent execution on monthly sales.

Gap Inc. (NYSE:GPS) posted a surprising 2% increase in June comp sales compared with the average analyst estimate of a 3.6% decline. All the brands delivered strong results with Gap Global saw comps decline only 1% compared with a 2.7% estimated decline. Banana Republic saw a 4% decline compared with a 10.3% expected decline and Old Navy saw a 5% increase compared with a 3.3% decline. Gap's stock went up 5% today on this news and investors were clearly happy that Gap posted the first monthly increase since March 2015. However, I will be cautious on Gap because I don't think the company is out of the woods yet. The stock has been down 22% for the past three months and so far down 12% for the year compared with a 3.4% decline in the S&P. The recent sell-off seems to show that investors still lack faith in a viable turnaround plan. Speculators are also on the stock with short-interest at 18% of the float, which is at the high end of the 8.6% - 22% range. I would avoid Gap in the near-term and buy into L Brand (NYSE:LB) which I have a positive view on.

I believe that Gap Inc. continues to experience the structural challenge in the rising popularity of fast-fashion retailers such as H&M and Zara and the growth in ecommerce. Unlike LB, Gap's ecommerce has yet to catch on and it will likely to take several more quarters of investments for Gap to scale up its digital business.

I give credit where its due and would like to point out that Gap did a good job in expense reduction with the expected $275m in annual savings and exiting non-core markets such as Japan where it could generate another $250m in savings. However, the issue lies in Gap's supply chain and price structure, both of which will remain pressured in the near-term.

First, Old Navy's one-time jump in monthly sales is not indicative of a broader trend. I need to see several months of consistent execution to be comfortable with the stock. Specifically speaking, Old Navy does not seems to be a focused brand with the recent departure of its President, lack of marketing, aggressive in-store promotion and small-fashion oriented products. Such strategy is unsustainable because fast retailers can compete on value so it is difficult to see how Old can provide a higher quality apparel at a lower price.

Second, the cost cutting on international and Banana Republic were good but they only represented 3% of the company's total square footage, meaning more needs to be done to address the overall weakness. Gap simply has too many stores across North America (estimated at 2,660 or so units) and needs to scale down its retail locations especially when traditional specialty retailers are placing greater emphasis on ecommerce. The current store locations can only cause a drag to Gap's total productivity.

Finally, deleveraging and cost saving at the corporate level is also a positive only when Gap can achieve consistent comps sales. If not, the positive savings could be negatively impacted by the weak comps sales and it will ultimately hurt the bottom line.

In the near-term, investors should avoid Gap due to the challenges that I have highlighted above. Unless, I see the company to re-energize Old Navy in terms of marketing and branding, this segment is likely to continue to face structural demand challenges. As for Banana Republic, I would like to see further cost cuts and a more focused branding given that product differential between the Gap and Banana Republic needs to improve so that Banana Republic consumers can feel that they are buying a quality BR outfit rather than a Gap outfit that is slightly modified and rebranded as BR (This shirt from BR is very similar to that from the Gap but there is a $30 price difference). Finally, Gap should double down on its investment in ecommerce, improve store-level efficiency and streamline the products for the mass market to better compete against the fast-fashion retailers.

Disclosure: I/we 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.