Gap Inc’s Earnings Stumble But Recovery Is Imminent

Even as Gap Inc (NYSE:GPS) managed to register positive comparable sales growth in Q1 fiscal 2014 amid an unconducive retail environment, its earnings were very disappointing. Weighed down by unfavorable foreign currency fluctuations as well as high COGS (cost of goods sold) and occupancy expenses, the retailer’s earnings per share slumped 18.3% to $0.58, marking the first instance of EPS decline in the last three years. However, Gap Inc’s EPS was still better than the consensus estimate of $0.57. ^[1] But the results were far from satisfactory and the company will be looking to rectify its shortcomings to bring its profitability back on track. During the earnings call, Glenn Murphy, Chairman and CEO, stated that the company could have done better on several facets, such as customer communication, inventory management and the timing of product launchs. ^[2] However, given Gap Inc’s rich history of strong company-customer connection, it appears to be well equipped to recover from this fumble in the near future.

Being one of the oldest and biggest apparel companies in the U.S., Gap Inc enjoys strong footing in the highly competitive and promotional apparel industry. Over the years, the retailer has leveraged its position effectively to build a strong image for itself. Customers have exhibited strong affinity towards Gap, Old Navy and Banana Republic products due to the company’s deep understanding of consumer needs and tastes. Gap Inc’s strong rebound in April following lackluster February and March somewhat confirms this factor. Although the retailer is known for its sturdy supply chain structure, it had some trouble in managing its inventory in Q1 as the early launch of the spring collection and persistent cold temperatures in February resulted in weak demand. However, with well planned and equally well executed promotional strategies, Gap Inc was able to end Q1 with a clean inventory position. This should allow it to launch new collections on schedule and operate with fewer markdowns, that will ultimately help its comparable sales and margins.

Our price estimate for Gap Inc is at $51.20, implying a premium of about 25% to the market price. However, we are in the process of updating our model in light of the recent earnings release.

See our complete analysis for Gap Inc.

Gap Inc Knows Its Customers Well

Lately, U.S. buyers have shown low brand loyalty, as they have been readily moving to brands that offer desirable and current fashion at affordable prices. As a result, there has been a gradual shift of customers from retailers such as American Eagle Outfitters (NYSE:AEO), Aeroposatle (NYSE:ARO) and Abercrombie & Fitch (NYSE:ANF), to fast-fashion brands such as Gap Inc, Zara, Forever 21 and H&M. The reason why Gap Inc has enjoyed this trend is because it caters to a large demographic, knows what its customers want and connects with them in strategic ways. The retailer offers its three main brands — Old Navy, Gap and Banana Republic — at different price points and creates separate shopping experiences for  each of these brands.

Old Navy mainly offers casual clothing at affordable prices for value and trend conscious high school and college students. The website reflects an array of vibrant colors and features different products under discounts every week. It shuffles between categories such as women’s dresses, jeans for the entire family, swim suits, flip flops, etc. That way it covers a wider customer base while maintaining interest in the brand. At Gap, the company offers its products at higher prices than Old Navy and targets working professionals along with teenagers. The brand’s website is more subtle, with products such as polos, jeans, khakis and cardigans. Banana Republic is Gap Inc’s affordable luxury brand, which has an organized website reflecting a sense of expensiveness. It offers versatile workwear for men and women for all occasions, ranging from desk to dinner. Occasionally, the brand partners with leading designers to offer an exclusive and limited addition collection. Banana Republic serves as a viable shopping option for affluent buyers who are looking to add some class to their workplace attire. Although Gap Inc is a casual apparel retailer, it has created different markets for itself with each brand targeting distinct groups of buyers. This has worked well for the company so far and is likely to continue the same way.

Additionally, Gap Inc. is leveraging fashion blogs to promote its brand image among U.S. buyers. About a couple of years back, the retailer introduced a website Styld.by in partnership with popular fashion and lifestyle blogs such as Lookbook, PopSugar, etc. From time-to-time, Gap Inc. features its collections on these blogs as they serve as a valuable medium for company-customer interaction. According to a 2011 Technorati report, while consumer trust on traditional media had declined by 46% since 2006, around 35% consumers trusted blogs to be credible sources of information. Interestingly, 19% agreed with the idea that they are better written than traditional media sources. ^[3]

Inventory Management To Improve

Gap Inc’s inventory management was a little off balance after unusual cold weather in February subdued the sales of spring clothing. However, inventory management progressed very well thereafter and is expected to improve further going forward. The retailer stated that its inventory is under control and also assured good progress on several supply chain initiatives, that will help its operating margins towards the latter half of the year. While the company’s gross margins fell by 260 basis points in Q1 fiscal 2014 due to heavy promotions, it allowed the company to attain a desirable inventory position for the second quarter. Inventory dollars per store increased by 7% at the end of the quarter which was in line with Gap Inc’s guidance. The company expects to maintain a tight control over its inventory in Q2 as well with inventory dollars per store likely to rise only few points year over year versus the year-over-year increase in Q1. ^[2] Gap Inc also stated that the ongoing supply chain initiatives will begin yielding fruitful results soon. As the company optimizes its inventory levels, it will be better positioned to deliver trend- and season-relevant merchandise, which will help it attract customers and dilute the need for promotional activities.

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1. Gap Inc Q1 Earnings Beat Ests, Fall Y/Y, Zacks, May 23 2014 [↩]
2. Gap Inc’s Q1 fiscal 2014 earnings transcript, May 22 2014 [↩] [↩]
3. State of the Blogoshpere 2011, Technorati, Nov 4 2011 [↩]