Specialty retailer Gap Inc.’s (NYSE:GPS) stock gained roughly 11% Thursday after the disclosure of January sales results.^[1] Though Gap reported a January sales decline of 1% and a comp sales decline of 4% compared to previous year, the apparent reason behind the increase was Gap’s earnings guidance for Q4 of $0.41 – $0.42, which was well above market consensus of $0.35. For the complete quarter, Gap reported a decline of 1% in net sales and a decline of 4% in its comps, slightly better than its Q3 results of 2% decline in net sales and 5% decline in comps. Banana Republic was the bright spot for Gap in January, up 6% compared to 5% last year. We expect the increase in sales of Banana Republic to benefit Gap’s net margins for the quarter, as Banana Republic EBITDA margins are higher than those of Gap and Old Navy, two of the company’s most well known brands. Gap competes with other specialty retailers like Aeropostale (NYSE:ARO), American Eagle (NYSE:AEO), Abercrombie & Fitch(NYSE:ANF) and Urban Outfitters (NASDAQ:URBN).

We have a Trefis price estimate of $24.98 for Gap’s stock — a premium of around 15% to the current market price.

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Increase in Banana Republic sales should improve Gap’s margins

In the recent three quarters Gap has been plagued with the shrinking margins. The situation had exacerbated during the holidays as Gap had been forced to increase the depth of its promotions in order to woo holiday shoppers. Banana Republic is the most high-end brand for the company under the affordable luxury.

We believe that the increase in Banana Republic sales will help Gap to fight the margin woes because luxury brands can pass the cost pressures to customers more easily compared to value-based brands. Additionally we also take the statement of Mr. Glenn Murphy, chairman and chief executive officer of Gap Inc., regarding inventory levels on a positive note. He stated, “January was largely clearance-based, and we’re pleased we successfully cleared holiday inventory.” This reduces our concern that there could be an inventory overhang for many of the retailers following the holiday season.

Lower inventory levels will essentially mean that Gap might be able to realize the benefit of declining cotton costs, which contributes a major portion of Gap’s Average Unit Cost (AUC).

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