Turnaround Continues at Gap
No-moat Gap’s (GPS) third-quarter 3% comparable sales growth and 60 basis point increase in adjusted gross margin (to 39.7%) leave us to conclude that efforts to focus on profitable and higher growth vehicles (value, active, and digital), while reducing exposure to traffic-challenged real estate and increasing productivity, are hitting home. We expect to increase our $27 fair value estimate by $1-$2 as we now have greater visibility into holiday positioning and expect these improved performance levels to continue (we are currently modeling fiscal 2017 adjusted earnings per share of $2.07 versus updated management guidance for $2.08-$2.12). That said, improved top-line performance is coming at a price. We had expected a significant increase in marketing spend to drive traffic and that was the case in the third quarter with adjusted operating margin falling 120 basis points to 9.8%. With more work needing to be done at Gap, and Banana Republic and Old Navy facing difficult comps, we remain comfortable with our long-term estimates calling for 1% average annual top-line growth over the next five years and adjusted operating margin continuing to decline to under 8% (from 9% in fiscal 2016).
By division, Old Navy posted 4% comparable sales growth, Gap achieved 1% comparable sales growth, and Banana Republic's comparable sales declined 1%. Overall, this was the fourth consecutive quarter of positive comparable sales growth. We attribute some of this success to a more responsive supply chain, which we view as key to modern retailing. On that note, denim was particularly strong at Old Navy with sales comps in the high teens and capabilities to replenish the category in nine to 14 weeks. 50% of Athleta is on a pipeline of six to 11 weeks. That said, goal levels and timeline for achievement in responsiveness by brand or for the company as a whole remain opaque, in our view.
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