Gap Inc (NYSE:GPS) reported steady results for its Q3 fiscal 2013, with 5% growth in revenues and 1% rise in comparable store sales. Although its gross margins declined by 120 basis points, due to heavy promotions, its operating margins expanded by 100 basis points, benefiting from better expense leverage. Along with its counterpart Urban Outfitters‘ (NASDAQ:URBN), Gap Inc is among the few companies in the U.S., who have performed relatively well in the current challenging retail environment.
One of the main factors behind the retailer’s success has been its ability to respond quickly and effectively to changing fashion trends. We believe that the company can leverage this factor to sustain a steady growth momentum in the future. Gap Inc’s sales growth can also be attributed to strong sales in foreign markets and growth in online revenues. As the company continues to expand in lucrative markets and invest in its direct channel, its results can improve in the coming years.
Our price estimate for Gap Inc. at $50 implies a premium of about 20% to the market price. However, we’re in the process of updating our model in light of the recent earnings.
Fashion Trends Continue To Attract Customers
Possessing a vast and flexible supply chain that enables strong inventory management, Gap Inc has remained on top of changing fashion trends. This has allowed the company to attract customers amid a highly competitive and promotional retail environment. U.S. buyers have shown low brand loyalty as they have been readily shifting to competitors that provide latest fashion products at affordable prices. This trend has become more profound this year as discretionary consumer spending has come under pressure from slow job growth, increased taxes and higher healthcare costs. While players such as American Eagle Outfitters (NYSE:AEO), Abercrombie & Fitch (NYSE:ANF) and Aeropostale (NYSE:ARO) have lost customers to fast fashion brands such as Forever 21, H&M, Zara and Gap Inc.
During the back-to-school season, Gap Inc launched several products that resonated well with its customers, including skinny jeans, ruffle shirts, bootcut pants, and capri pants. Also, its line of colored jeans, launched last year, continued to perform well.  The retailer maintained this product strength in previous quarters as well, with the success of its denims, woven tops, dresses, shorts and seasonal products. Given this track record, we believe that Gap Inc is both well positioned and properly stocked to do well in this holiday season.
Direct Channel Likely To Remain The Key Growth Driver
During the third quarter, Gap Inc’s direct-to-consumer revenues increased by 20%, which was significantly more than what its counterpart Abercrombie & Fitch experienced.  Moreover, with continuous growth, this channel has been boosting the company’s results for some time now. Direct-to-consumer business accounted for 9% of the company’s revenues back in 2009, which increased to 14% in 2012. While the revenue contribution might seem insignificant, this segment constitutes close to 28% of the company’s value due to its high margins.
Going forward, we expect the channel’s revenue contribution to reach 22% by the end of our forecast period, backed by industry growth and Gap Inc’s individual efforts. The retailer’s mobile apps and mobile-optimized websites have played a vital role in strengthening its Direct business. Its ship-from-stores service, which allows the fulfillment of online orders through store inventories, has enabled the company to not only offer a greater variety of merchandise over the Internet, but to enhance delivery responsiveness and increase store traffic as well. During the third quarter, Gap Inc launched its “Reserve in Store” service in all Banana Republic stores and more than 200 Gap stores.  This service allows a customer to reserve up to five items online to try in stores. Since buying clothes is a personal experience and online shopping provides convenience, this new program offers customers the best of both channels. We believe that this too will help the company drive greater store and web traffic as well. 
Continued International Expansion Should Help The Company In Long Term
International expansion allows a retailer to reduce its dependence on the U.S., where economic growth right now is sluggish and competition is high. During the quarter, Gap Inc’s international operations outgrew their domestic counterparts. Indeed, the company is continuing to expand abroad. Gap Inc opened about 18 stores in mainland China in Q3, which brought its total there to 73 stores. Although this market is currently struggling with weak consumer spending, it does hold huge potential from long term perspective. Also, the retailer continued expanding its Old Navy brand in Japan, which is a lucrative market for value focused brands. Gap Inc ended the quarter with 14 Old Navy stores and plans to take this count up to 20 by the year end. The company also carried on its franchise expansion and entered four new markets – Brazil, Costa Rica, Hungary and Peru. It now operates more than 350 franchise stores in over 40 nations.  Franchise operations allow the company to spread its brand awareness in different markets, with lower levels of investment, leveraging the capital of its franchisees.Notes:
- The Gap Inc. : Gap Profit Rises On Strong Sales Abroad, 4 Traders, Nov 21 2013 [↩]
- Gap Inc Reports Third Quarter Results, Gap Inc, Nov 21 2013 [↩] [↩]
- Gap Inc’s Q3 fiscal 2013 earnings transcript, Nov 21 2013 [↩]
- Gap Executive Reveals How Retailer Struck Gold With ‘Game Changing’ Reserve In Store Program, Forbes, Nov 22 2013 [↩]