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Is Gap a Good Buy Right Now?

Apparel retailers are difficult investments to make in uncertain economic times. The Gap Inc. (NYSE:GPS) operates a number of different stores with different objectives, including the eponymous Gap, Banana Republic, Old Navy, and Athleta. Old Navy, Gap, and Banana Republic cater to different price points and styles, with Old Navy and Gap comprising the greater part of total sales. With its combination of intelligent branding and excellent execution, Gap is among the best investment ideas among apparel companies.

Stephen Mandel’s multibillion-dollar hedge fund Lone Pine Capital holds 21.5 million shares of Gap as of June 30, according to 13F filings (you can view his portfolio here). The fund is also long on Ralph Lauren Corp (NYSE:RL). A number of other major funds have small positions in Gap.


Valuation. The company’s shares are trading at about 19 times earnings, which is within the inner three quartiles for the sector. However, the company’s valuation is compatible with its growth ambitions. The company’s global outlet business added 10 stores in the second quarter, and Athleta—a women’s athletic apparel store—opened 11 new locations. The company actually looks undervalued on a price/sales basis; shares are trading at 1.2 times sales, whereas Ross Stores, Inc. (NASDAQ:ROST) and American Eagle Outfitters (NYSE:AEO) have multiples of 1.8 and 1.3, respectively. I mention these two because they have had solid performance year-to-date.

Gap’s second-quarter performance. The company had a positive second quarter, spearheaded by a 29 percent increase in net income and a 4 percent comp. Despite a negative comp abroad, the company still managed a 7 percent increase in sales internationally. Finally, the company reported earnings of $0.49 per share, up 40 percent year-over-year from $0.35. Gap CEO Glenn Murphy remarked in the second quarter conference call that “overall people feel energized” in the wake of the company’s solid performance.

Color and consistency of fit matter. Sure, customers want to be able to come into a store and not have to spend hours in the dressing room. However, online sales benefit tremendously when all of the garments in a store fit consistently, an aspect of its merchandise that, for instance, J.C. Penney Company, Inc. (NYSE:JCP) has had trouble with. Management’s recent push for “best fit” has paid off: Gap’s online sales were up 24 percent domestically and 25 percent internationally in the second quarter. Additionally, the company has tweaked its color palate, which is one of the most important motivations behind every sale.

The brand. Though J.C. Penney CEO Ron Johnson has been criticized for his “everyday pricing” initiative, Gap is already executing this sort of plan rather nicely. Murphy noted in the second quarter conference call that “we are working aggressively on ticket integrity, selling product at full regular price. I think that’s been helpful to us. That doesn’t just happen through great product[s] although that’s the initial first driver. It happens through where it’s in the store, how our store associates sell it, what goes in the window.” This goes to show that a well thought-out branding strategy, with high-quality merchandise, allows for a higher margin business.

Economic data. The U.S. Census Bureau estimates that there was a total of $19.9 billion in sales at clothing retail stores in July, up from $18.9 billion in July 2011. The forward sustainability of improvement is the fly in the ointment of equities in general, though a negative economic outlook is particularly deleterious for apparel retailers. Markdowns and price deflation hurt margins, while dwindling traffic hurts volume. So the broader economy is the single largest risk in an investment in Gap.

We like a retail company that can combine strong sales with steady margin achievements to yield impressive earnings. In the event of an economic turndown, these are the facets of an apparel retailer that will save the day.