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Gap’s ‘biggest issue right now’ is Old Navy, analyst says

Morningstar Equity Analyst David Swartz joins Yahoo Finance Live to weigh in on Gap's most recent earnings report and where the company's biggest weakness lies.

Video Transcript

RACHELLE AKUFFO: All right. Well, let's dive deeper into this Gap report with David Swartz, Morningstar equity analyst. So David, obviously with these beats here, what are your takeaways?

DAVID SWARTZ: Expectations are very low. So really, it's actually quite positive that Gap was able to report numbers such that were actually within line of what people expected. Because after the pre-announcement last month, people probably thought that Gap's earnings report would just be abysmal. And really, it's not that much different than we thought three months ago.

DAVE BRIGGS: What's the biggest issue plaguing Gap?

DAVID SWARTZ: Well, the biggest issue right now is Old Navy. Old Navy has had a terrible year. And Old Navy generates most of Gap's revenue and profit. So if Gap can't fix Old Navy, then the whole business is in trouble. So that's why this year, Gap has fired the CEO of Old Navy, that was back six months ago, and then most recently fired CEO of the entire company. And they've brought in a new CEO of Old Navy. And they will soon, I presume, bring in a new CEO for the company. And the first priority will be to fix Old Navy.

SEANA SMITH: David, despite all of these challenges, you mentioned Old Navy weakness there. Sales off, comp sales off 15%, worse than what the street was looking for. A drop of 13.7%. But despite this, you actually think Gap is undervalued. Why are you positive on this name?

DAVID SWARTZ: I think that Gap is undervalued. The company is in no danger that I can see of falling into financial distress. The balance sheet is fine. I mean, clearly, this has been a terrible year. And really, the last few quarters have been pretty bad. But Gap has a lot of strengths. This is a company that has Athleta that is still growing and has legitimate prospects to get a lot bigger. Old Navy is still one of the biggest discount apparel retailers out there.

And its other two brands, they're struggling. But they do have some positives. Banana Republic's results have gotten better. It's actually been posting positive sales numbers, which is quite a change from past years when it was mostly negative. And the Gap brand is downsizing, but it does have the partnership with Yeezy, which could potentially turn into something. So I think if Gap can really stabilize Old Navy, then people will realize that this is really an undervalued stock and that it probably shouldn't be at $10 a share. Because this is generally a financially stable company that right now is going through a very difficult period.

RACHELLE AKUFFO: And David, as we look at how changing consumer attitudes are really sort of having a lot of these retailers scrambling here, when you look at things like the glut of inventory that's still at play here, how do you see Gap handling that?

DAVID SWARTZ: Yeah, inventories are up across the board for most apparel retailers. Gap specifically has had a lot of trouble this year with managing inventory in all of its chains. It's really been affected by the shipping issues in the industry, probably more than any other retailer that I cover. So they're going to have to do a lot of discounting. And how that affects my numbers, I'm going to have to revisit that when I update my model and write my note tonight and see what they say on the earnings call.

But I think that the inventory can be fixed. Generally, Old Navy sells a lot of stuff that sells all the time like shirts, and pants, t-shirts, and basic blue jeans. And it's not really a lot of fashion risk usually with Old Navy. And so I think if Old Navy can sell some of the stuff that it's not selling well, it can replace it with really more basics that do sell at Old Navy consistently.

DAVE BRIGGS: We saw some of the names there struggling with the retail inventory issue. Who's been the star? Now that we kind of have all the retail earnings in the rear view mirror, who's been the one that you hold up there and say, they got it right?

DAVID SWARTZ: Well, I think some retailers are doing pretty well. Ralph Lauren would be one, for example. Ralph Lauren reported strong numbers a couple weeks ago. And that was even with a big impact in China from store closures. I think a lot of upscale retailers that sell to higher middle income and higher income consumers are still doing well. So Ulta just reported this afternoon, and I'll need to revise my fair value estimate on that one, but Ulta did beat my estimates.

And it's generally been doing well. Next week, we have a report from Lululemon. I think Lululemon's stock is overvalued. But Lululemon itself has really been doing well too. So there have been some retailers that have been standouts. And I think it really depends on the customers that they target. I think if they target customers that really are being affected by inflation right now, like lower income people, I think they're struggling. But if they target upper middle income and upper income people, they're still doing pretty well.

SEANA SMITH: David, you certainly have had a busy afternoon here. You mentioned Ulta very briefly. And I just want to quickly dive into those results. Because they raised their full year outlook, they beat on the top and bottom line. EPS coming in at $5.70, net sales up 17% year over year. From your perspective, you closely track the stock. What's Ulta doing right?

DAVID SWARTZ: Well, there's been a big resurgence in makeup. Makeup had been challenged during the pandemic because, of course, people were wearing masks and not going out so much. So women have gone back to buying a lot of makeup. And Ulta's mix of prestige cosmetics and discount cosmetics really, I think, puts it in a great market position. It really only has one significant competitor besides the department stores. And that would be Sephora.

And I think Ulta does even better than Sephora because Ulta really focuses on a wide range of consumers, both people that like to buy the more expensive cosmetics and people that are looking for more discount stuff. And Ulta really has a very strong loyalty program, I think very strong online sales. And so Ulta has really come back big this year. And that was even with a CEO change last year.

SEANA SMITH: David Swartz, thanks so much for joining us again. Ulta shares moving higher after hours, up just about 2%.