Gap Makes Progress on Sales, Gross Margin Performance

No-moat Gap’s (GPS) second-quarter results delivered a third consecutive quarter of comparable sales growth (up 1%) and a fourth consecutive quarter of adjusted gross margin expansion (up 120 basis points to 38.9%). That said, the company is not out of the woods yet, with two of the three major brands still posting comparable sales declines (Gap Global comparable sales, contributing 32% of sales, were down 1%, while Banana Republic Global comps, contributing 15% of sales, were down 5%). Additionally, the company is still short of its leverage point (which we estimate to be low- to mid-single-digit comparable sales). Furthermore, we still think the company lacks a sustainable competitive advantage and that performance will be volatile as it hits or misses fashion trends. Therefore, we expect to increase our $26 fair value estimate by just 1%-2% to reflect performance through the second quarter tracking ahead of our expectations (our full-year estimate currently calls for flat comparable sales), but we still think average annual revenue growth over the next five years will be flat to up 1% and that adjusted operating margin will decline from 9% in 2016 to under 8% in 2021 on deleverage, as the firm faces intense competition in an industry where switching costs are nonexistent.

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