Gap Pinned to Neutral

Zacks

We are maintaining our long-term Neutral recommendation on Gap Inc. (GPS), with a target price of $28.00. However, based on Gap’s considerable recovery in its comparable and total sales performance so far in fiscal 2012, the company holds Zacks #2 Rank, implying a short-term Buy rating.

Monthly sales data for Gap inducates a decent performance. Within the period from February to May 2012, the company registered a minimum year-over-year flat sales growth and a maximum growth of 10%, reflecting an average growth of approximately 5% for the period. The company registered sales growth of 6% in February, 10% in March, flat in April and 4% in May.

Moreover, despite a consistent weak performance in all four quarters of fiscal 2011, the company reported a strong first-quarter 2012 result with net sales increasing 5.8%. The robust performance was primarily driven by a 4% growth in comparable store sales. On the back of increased top line, the company’s earnings climbed 17.5% year over year to 40 cents per share.

Further, better-than-expected quarterly performance has prompted management to raise its fiscal 2012 earnings guidance. The company now expects earnings in the range of $1.78 to $1.83 per share for fiscal 2012, up from $1.75 to $1.80 forecasted earlier, reflecting an increase of 14% to 17% from fiscal 2011. The current Zacks Consensus Estimate stands at $1.91 per share. Gap still anticipates an increase of 10% in operating margin during fiscal 2012.

In addition, Gap has been making significant progress in its long-term plan by reducing dependency on North American specialty business while increasing its online presence as well as expanding its international operations.

During first-quarter 2012, the company closed net 20 stores domestically and opened net 9 stores globally, thereby growing its international presence. Going forward, Gap is aiming to generate 30% of total sales from overseas operations and online business by 2013, which is expected to further strengthen its top and bottom lines.

Besides, in an effort to improve customer experience and enhance productivity per square footage, the company intends to strategically close and consolidate square footage at Gap and Old Navy brands. Gap plans to strategically reduce its Gap North America store counts to 950 by the end of fiscal 2013, including 700 specialty stores and approximately 250 outlets.

Contrary to this, the company continues to aggressively expand internationally through both company-operated and franchise stores. Gap intends to triple its store count in China from 15 to approximately 45 during fiscal 2012. Additionally, the company aims to grow its Athleta stores count 5 times from 10 to 50 by the end of fiscal 2013.

However, Gap’s business is seasonal in nature and generates a high proportion of sales during the fourth quarter, the crucial holiday season. Furthermore, the company ramps up its merchandise levels in anticipation of the season, exposing itself to significant risks, if the season fails to deliver expected operating performance.

Moreover, due to its exposure to the international market, Gap remains prone to currency fluctuation. The weakening of foreign currencies against the U.S. dollar may require the company to either raise prices or contract profit margins in locations outside the U.S. An increase in product prices may have a direct impact on consumer demand.

Above all, Gap operates in a highly fragmented market and competes with national and local department stores and discount stores, American Eagle Outfitters Inc. (AEO) and The TJX Companies Inc. (TJX), which offer products at fire sale prices. To retain the existing market share, the company may have to reduce its sales prices, which could affect its margins.

However, we believe that the company’s long-term strategic moves along with disciplined cost management measures will not only provide financial flexibility, but will also help to drive value proposition. Moreover, Gap’s globally recognized brands complement one another, enabling it to leverage its position in the sector.

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