Old Navy To Be A Key Growth Driver For Gap Inc. In The Third Quarter

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Gap Inc. (NYSE:GPS) is scheduled to report its third quarter results on November 20, wherein a 4% increase in revenue and a 17% improvement in the EPS is expected, with the metrics reaching $4 billion and $0.68 respectively. Strong growth by Old Navy and Athleta, as well as digital sales is expected to drive revenue growth. Meanwhile, a lower tax rate and productivity saving should result in a significant increase in the earnings per share. After a poor first quarter, the company managed to beat consensus expectations in Q2; however, the performance of its namesake brand leaves much to be desired. Gap Inc.’s comparable sales increased 2%, versus 1.5% expected, and by brand, the growth was led by Old Navy, which posted a comps growth of 5% (4% consensus), followed by 2% improvement at Banana Republic (in-line with estimates), while comparable sales fell 5% at its Gap brand, as compared to 2.3% decline anticipated. While the company reaffirmed its full year EPS guidance of $2.55 to $2.70, the poor performance of its Gap brand in the first half of the year has made the ability of the company to reach the high end of its guidance even more challenging.

We have a $33 price estimate for Gap Inc., which is higher than the current market price. The charts have been made using our new, interactive platform. You can modify the different driver assumptions by clicking here for the interactive dashboard Estimating Gap Inc.’s Performance In Q3 and Its Fair Price to gauge their impact on the revenues, earnings, and price estimate for the company.

Factors That May Impact Future Performance

1. Continued Strength of Old Navy: The brand was able to deliver comps growth of 5% in Q2, against a tough comparison of 5% last year. The brand grew market share again in the quarter, and was the eighth largest apparel retailer, and the second largest apparel brand in the United States.  The fact that the brand’s merchandise tends to be skewed towards the affordable segment has worked in its favor. Seeing its impressive performance, Gap has accelerated Old Navy store openings, with over 30 opened in FY 2017, and 28 in H1 2018, along with 85 remodels. The management noted that new store performance is beating expectations and remodels are outperforming the fleet by an average spread of five comp points. The company feels the brand remains under-penetrated when compared with its peers, and hence, plans to double the store openings as compared to FY 2017, which should help to increase the revenues.

2. Introduction Of Plus Collection: The company announced that Old Navy will be launching its plus collection, previously only available online, in 75 select stores. The women’s plus-size market is north of $20 billion and is growing at a higher rate than the overall apparel market. According to NPD, even with just the online business, Old Navy falls within the top 10 women’s plus-size brands and the expansion of the category in the stores represents a significant growth opportunity.

3. Popularity Of Athleta: According to the NPD group, the activewear industry is the “primary driver of growth opportunity” for the apparel industry. Sales in this category increased 2%, valuing the market at roughly $48 billion in 2017. Hence, it is no surprise that Gap’s Athleta brand has been performing well, in fact, at a much faster rate than that of the industry. The brand had another strong second quarter, with double-digit growth, despite some softness, and we expect the momentum to continue through FY 2018. In line with its growth strategy detailed during FY 2017, the company expects store openings to be focused on Athleta and Old Navy, with closures weighted toward Gap and the Banana Republic. Given the strength of its athletic wear business, GAP CEO Art Peck has also stated that the company is looking for an acquisition in the space.

4. Margin Pressure at the Gap Brand: The operating model improvement process at the company’s namesake brand has been fraught with inventory problems. As a result, the company was saddled with excess inventory coming into the first quarter, which consequently impacted the company’s sales from this brand as well as its ability to optimize its margins, since it forced the brand to be more promotional. The overall gross margins of the company fell 10 basis points in Q2, after a 20 basis point decline in Q1.  Looking ahead, the company has cut 30% of styles heading into the second half of the financial year, which should help to improve the performance.

5. Improvement In Online Business: The online and mobile business is the place to be these days, and Gap has ensured its presence is felt in the space. The company has one platform for all of its brands, ensuring customers can purchase items for any of them in one place. This has also ensured its new brands get the recognition that would not have been possible if they had had a separate web presence. An upshot of this is that the company was able to deliver strong growth from its online and mobile channels in the second quarter, and is on track to garner over $3.5 billion in digital sales this year. The company has also focused its investment into the native mobile apps and on improving site speed. These factors should ensure the growth of this segment in the future.

6. Optimizing Store Fleet: Gap Inc. has continued the process of optimizing its store count, including reducing its exposure to low productivity stores. The company has also seen an opportunity for increasing the store count of Athleta, Old Navy, and the factory and outlet expressions at the Banana Republic and Gap. Consequently, in the first half, the company opened 60 stores, largely Old Navy and Athleta, and closed 38 stores, primarily Gap and Banana Republic.

7. Productivity Savings: At the start of 2018, the management set a goal to deliver $200 million in productivity savings, marking a key step in its target to reach a total of $500 million in savings. The company remains on track to exceed that goal, with savings to-date being enabled by strategic sourcing negotiation with vendors to deliver lower non-product costs, optimizing the organizational structure by reducing the non-working marketing dollars focusing on in-store waste and inefficiency, and tightening controls over discretionary spending. These savings will be used to fund the company’s investments into the digital space.

8. Lower Tax Rate: As a result of the lowering of the corporate tax, from 35% to 21%, the effective tax rate for Gap Inc. is expected to be 26% for FY 2018. This is a significant drop from the roughly 40% rate the company has been averaging for the past couple of years. This should help to boost the net income margin, and consequently, the earnings.

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