Stock of the week - Gap (06.06.2024)

Gap Inc (GPS.US), one of the largest US fashion retailers, has been taking a hit this week and is trading 8% week-to-date lower. However, this drop comes after an almost 30% surge on Friday, which was triggered in response to solid fiscal-Q1 earnings release. Let's take a quick look at company's most recent earnings release as well as its valuation.

Gap rallies almost 30% after fiscal-Q1 2024 earnings

Gap released its fiscal-Q1 2024 earnings report on Friday, May 31 before the opening of the Wall Street session. Results were better-than-expected all across the board. Company reported higher net sales as well as much faster growth in comparable sales than expected. Moreover, company achieved positive comparable sales growth in each of four brands. While sales grew, cost of revenue declined, paving the way for a big jump in gross profit. Moreover, operating expenses were also lower year-over-year, allowing the company to report high operating income, compared to a small operating loss a year ago. This, in turn, has led to a big jump in net income and EPS. 

Fiscal-Q1 2024 results

• Net sales: $3.388 billion vs $3.285 billion expected (+3.4% YoY)
• Comparable sales: +3% vs +0.9% expected (-3% a year ago)
  • Old Navy: +3% vs +2.5% expected (-1% a year ago)
  • Gap Global: +3% vs +2.5% expected (+1% a year ago)
  • Banana Republic: +1% vs -3.3% expected (-8% a year ago)
  • Athleta: +5% vs -4.7% expected (-13% a year ago)
• Cost of revenue: $1.991 billion vs $2.014 billion expected (-3.4% YoY)
• Gross profit: $1.397 billion vs $1.266 billion expected (+15.1% YoY)
  • Gross margin: 41.2% vs 38.5% expected (37.1% a year ago)
• Operating expenses: $1.192 billion vs $1.198 billion expected (-2.6% YoY)
• Operating income: $205 million vs $64.2 million expected ($10 million loss a year ago)
  • Operating margin: 6.1% vs 2.0% expected (-0.3% a year ago)
• Pre-tax income: $208 million vs $66.1 million expected ($8 million a year ago)
• Net income: $158 million vs $44.1 million expected ($18 million loss a year ago)
  • Net margin: 4.7% vs 1.5% expected (-0.6% a year ago)
• Diluted EPS: $0.41 vs $0.12 expected (-$0.05 a year ago)
• Total location count: 3,571 vs 3,554 expected (+3.4% YoY)

Gap rallied almost 30% after stellar fiscal-Q1 2024 earnings, marking the biggest single-day jump since mid-November 2023. Source: xStation5

Company boost full-year forecasts

Gap said that solid fiscal-Q1 2025 results gave the company confidence to boost full-year sales and operating income guidance. Company noted that it has achieved positive comparable sales growth at all brands, and that it has managed to increase its market share for the fifth consecutive quarter.

New set of forecasts call for a continuation of positive sales growth in fiscal-Q2 as well as in full fiscal-2024. Margin are also expected to improve, with company seeing gross margin of around 40.50% in fiscal-Q2 2024 and of at least 40% on in full-year. Operating income is also expected to increase significantly.

Fiscal-Q2 2024 forecast

• Net sales: 'low-single-digit' growth
• Gross margin: 'about 300 basis points' expansion
• Operating expense: 'about 5% growth'

Fiscal-2024 forecast

• Net sales: 'slightly higher on 52-week basis', compared to 'roughly unchanged' previously
• Gross margin: 'at least 150 basis points expansion', compared to 'roughly 50 basis points expansion' previously
• Operating income: 'mid-40% growth range', compared to 'low-to-mid teens growth'
• Capital expenditure: 'about $500 million', unchanged compared to previous forecast

Source: Bloomberg Finance LP, XTB Research

Source: Bloomberg Finance LP, XTB Research

A look at valuation

Let's take a quick look at Gap's valuation with 2 often used valuation methods - DCF and multiples. We want to stress that those valuations are for presentation purposes only and should not be viewed as recommendations or target prices. 

As Gap is a dividend paying company, it could be valued with Gordon Growth Model, which we often use in our Stock of the Week posts. However, company does not have a clearly defined dividend policy and recent changes to dividends may it hard to make assumptions about the next move. Gap has cut its dividend by 75% in fiscal-2021, then increased it by 50% and 66% in fiscal-2022 and fiscal-2023, respectively. Dividend was left unchanged in fiscal-2024. Having said that, we have decided to omit Gordon Growth Model in our Gap's valuation.

DCF

Firstly, let's take a look at Gap's valuation based on one of the most popular fundamental models - Discounted Cash Flow method (DCF). This model relias on a number of assumptions and we have decided to base those around 5-year averages. However, in order to capture recent improvement in company's financials, we have decided to base revenue and operating margin assumptions on expectations for this year - 4% sales growth and around 7% operating margin. Forecasts for 10 years were made and terminal value forecast was based on 3% revenue growth assumption and 8% weighted average cost of capital. Such a set of assumptions provides us with an intrinsic value per Gap share of $55.02 - or around 100% above current market price!

A point to note is that the intrinsic value obtained via the DCF method is highly sensitive to assumptions made. Two sensitivity matrices are provided below - one for different sets of Operating Margin and Revenue Growth assumptions and the other for different sets of Terminal WACC and Terminal Revenue Growth assumptions.

Source: Bloomberg Finance LP, XTB Research

Source: Bloomberg Finance LP, XTB Research

Multiples

Next, let's take a look at Gap's valuation compares to its competitors. We have constructed a peer group consisting of 7 companies - Abercrombie & Fitch, American Eagle Outfitters, Urban Outfitters, Boot Barn Holdings, Burlington Stores, Levi Strauss and Deckers Outdoors. We have taken a look at 9 different multiples, based on trailing and forward data.

As one can see in the table below, there is quite significant volatility in multiples for Gap peers. However, a key point to note is that in each case analysed, be it trailing or forward, Gap's multiples are lower than mean, median or cap-weighted multiples for the group. According to multiples valuation, Gap is undervalued compared to its competitors.

Source: Bloomberg Finance LP, XTB Research

A look at the chart

Taking a look at Gap Inc chart (GPS.US) at D1 interval, we can see that stock launched Friday's trading with a big bullish price gap and continued to move higher afterwards. However, while the stock attempted to extend those gains on Monday, bulls failed to maintain a breakout above the $29.00 resistance zone, marked with previous local high, and a bearish pin bar candlestick pattern was painted. As a result, stock pulled back from 3-year highs and trimmed part of post-earnings price jump.

Taking a look at weekly chart (W1), we can see that stock pulled back to a long-term support zone in the $26.50 area. Breaking below this hurdle could signal that a deeper plunge is coming. However, should we see pullback halted there, it could be a good be an opportunity for buyers, given that fundamental picture for the stock is rather positive.

Gap (GPS.US) at D1 interval. Source: xStation5

Gap (GPS.US) at W1 interval. Source: xStation5