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Intro
Gap, Inc. (NYSE:GPS), parent to Old Navy, Gap, Banana Republic, and Athleta, is one in all the biggest apparel retailers on this planet. With stubborn inflation and low visibility on future demand, it isn’t any surprise that Gap’s management has struggled to navigate the corporate through a heap of economic, industry, and company-related headwinds. The results of those headwinds have caused Gap shares to plummet YTD.
Data by YCharts
A number of months ago, I noticed that a few of these headwinds were starting to dissipate. Actually, I ended up publishing an article discussing how certain cost trends indicated a high upside for Gap’s shares. Sure enough, my thesis panned out as Gap shares outperformed the S&P 500 during that point span.
Rating History of Gap Article (Looking for Alpha)
Although my thesis happened to work out, current and potential investors are actually wondering if Gap shares are still a buy. As I analyzed recent developments in cost trends, management’s expectations, and sector valuation, I arrived on the conclusion that Gap shares are still undervalued. Industry and company-specific headwinds that caused problems on the apparel retailer appear to be vanishing quickly. On top of that, economic outlook will not be as pessimistic because it was in the summertime. I’ll walk you thru why Gap shares appear to still be undervalued.
Margin Expansion Drivers
Less Discounting Ahead
It isn’t any secret that Gap’s largest income is Old Navy. Subsequently, any problems at Old Navy affect Gap’s earnings greater than problems at Gap, Banana Republic, and Athleta. The explanation Old Navy has led the pack in sales decline these past two quarters is since it had issues with each supply and demand. By overestimating the demand for its BODEQUALITY sizes and underestimating the demand for its core sizes, management set Old Navy up for poor financial performance. This mixture of lost potential sales and heavy discounting deleveraged gross margins by 370 bps in Q2. To make matters worse, $58 million in unproductive inventory needed to be written off resulting in an extra 150 bps hit to Gap’s gross margin.
Fortunately, inventory mismanagement will not be exclusive to only Gap. Actually, there appear to be only a few retailers who are usually not significantly impacted by this industry challenge. Gap’s management seems to concentrate on this problem and is expecting Q3 inventories to moderate.
As discussed earlier, we have taken motion to put in writing off unproductive inventory within the second quarter and cut receipts across the assortment starting in late fall and into holiday, positioning our brands to have the opportunity to reap the benefits of our reinstated responsive capabilities and chase into demand as we enter fiscal 2023. These actions are a part of our focused approach to inventory planning for the rest of fiscal 2022 and beyond.
As we glance to the rest of the 12 months, we imagine that third quarter ending inventory growth will moderate substantially and are targeting negative inventories versus last 12 months by the top of the fiscal 12 months. (Katrina O’Connell, CFO, Q2 EC)
Currently, Gap’s management has implemented the pack-and-hold strategy where excess inventories are tucked away right into a warehouse and held until the subsequent fiscal 12 months. This excess inventory consists of mostly core seasonal items which reduce the danger of one other inventory write-down. As indicated by the quote above, Gap’s management plans to in the reduction of on inventory purchases starting in Q4 of this fiscal 12 months. If executed successfully, this plan should prevent further inventory buildup and result in less discounting in upcoming quarters. Essentially, lower Q4 receipts coupled with a previously successful pack-and-hold strategy will result in less discounting going forward.
As it’s possible you’ll recall, we have now utilized pack and hold strategies as a list management tool up to now, which has proven to achieve success. While the usage of money within the short term, we’re capable of optimize our margin within the near term and profit working capital next 12 months as we buy lower receipts and sell through the pack and hold inventory. (Katrina O’Connell, CFO, Q2 EC)
Airfreight Expense No Longer Obligatory
As emphasized in my previous article, Sonia Syngal’s decision, made during Q3 of last fiscal 12 months, to move 35% of inventory via air was a really costly decision. How costly, you ask? Take a have a look at management’s statements regarding air freight costs on past earnings calls:
Merchandise margins were down just 10 basis points despite nearly 2 basis points of upper online shipping costs and about 250 basis points in short-term headwinds related to airfreight. (Q3 ’21 EC)
On an adjusted basis, gross margin deleveraged 260 basis points versus 2019, on account of nearly 600 basis points in estimated air costs. (Q4 ’21 EC)
As we communicated last quarter, greater than half of our fiscal 2022 air freight was expected to be realized in the primary quarter. We realized roughly 170 million of incremental air freight through the quarter, which resulted in roughly 480 basis points of gross margin deleverage. (Q1 ’22 EC)
Second, consistent with our expectations, we expectations, we realized an estimated $50 million of incremental airfreight through the quarter, which resulted in roughly 130 basis points of margin deleverage. (Q2 ’22 EC)
As indicated by the above quotes, increased air freight has compressed gross margins significantly. On the intense side, the recent decline in ocean freight volume is predicted to proceed; together with a pointy drop in ocean freight rates. Gap’s priorities appear to have shifted from “punctual deliveries regardless of the fee” to “less purchases in order that we are able to match future inventory levels with future demand”. Subsequently, one could confidently assume that importing high levels of inventory via air freight isn’t any longer mandatory going forward. Don’t just take my word for it:
I feel the one lever we all know is that, we do not plan to be using airfreight going forward. I feel that is the one thing we all know that it’s an expensive lever, and we have created responsive levers back within the business so we shouldn’t have to try this again. (Katrina O’Connell, CFO, 2Q EC Q&A)
This decision will likely expand gross margins enough to realize operational profitability in Q3 and beyond. The one query is: how much gross margin leveraging can investors expect?
As we glance to the second half of the 12 months, airfreight expense is predicted to normalize, and we shall be anniversarying last 12 months’s investments, leading to roughly 400 basis points of leverage. (Katrina O’Connell, CFO, 2Q EC Q&A)
*This 400 bps of air freight leverage estimate is utilized in Gross Margin FCT*
Cotton Prices Normalizing but Inflation Persists
While cotton will not be as significant as other expenses, it’s still an expense. Small changes are arbitrary, but cotton had risen from ~$0.70/lbs to $1.60/lbs in under a 12 months. That extra $0.50/lbs (assuming the 1yr avg from Q2 ’21 to Q2 ’22 was $1.20/lbs) adds up. Fortunately, cotton prices have fallen back to pre-pandemic levels on account of rapidly decreasing demand. For an organization like Gap, that has struggled to be operationally profitable these past few quarters, lower raw material costs are promising and may expand merchandising margins, albeit barely.
Cotton (USD/Lbs) (Trading Economics)
Unfortunately, management still expects inflationary headwinds to proceed compressing margins. In accordance with management’s statements regarding expectations for the second half of the 12 months, the 200 bps inflationary deleverage reported within the previous two quarters is predicted to proceed. As well as, they expect ROD deleveraging to be flat to barely delevered.
*This 200 bps of inflationary deleverage estimate and the ROD deleverage estimate is utilized in Gross Margin FCT*
Reduced Workforce and SG&A
If sales are growing at an adequate rate and the economy seems healthy, above-average SG&A spending is justifiable. Nevertheless, Gap’s financial performance these previous few quarters indicates an opposite reality. Management is expecting $5.6B in operating expenses for the total fiscal 12 months. As Gap is barely profitable recently, reducing future operating expenses would appear to be the logical decision. Sure enough, management commented on this dilemma during Gap’s second quarter earnings call:
While we made significant SG&A investments over the previous couple of years to assist fuel our future growth opportunities, the present operating environment does dictate a moderation of those investments in addition to the implementation of distinct expense savings actions within the near term.
We are going to begin implementing later within the third quarter a discount in overhead investments, including a pause on planned hiring and open positions amongst other actions. As well as, we’re reevaluating our investments in marketing and technology. (Katrina O’Connell, CFO)
A month and a half after the earnings call, Gap declared that they were cutting 500 corporate jobs in an effort to cut back expenses. While this alone doesn’t have a big impact on the corporate’s operating margin, it’s a step in the precise direction. Management’s tone implies SG&A spending cuts within the near future. Investors should control upcoming headlines about Gap cutting unnecessary costs and the way the market reacts to the knowledge.
Gross Margin FCT
Through the use of the above trends and management’s expectations from last quarter’s earnings call, we are able to get an idea of how much margin expansion we are able to expect in the subsequent 4 quarters. I break down each quarter and provides a rough estimate of gross margin expectations based on what has modified y/y. These assumptions shall be utilized in my FWD P/E valuation model.
Q3 ’21: 42.1% gm Air freight leverage (+150 bps) Inflationary cost headwinds (-200 bps) More discounting considering y/y demand change and better inventory levels (-300 bps) Slight ROD deleveraging stemming from reduced demand (-25 bps) Q3 ’22 estimate: 38.4% Q4 ’21: 33.7% gm Air freight leverage (+250 bps) Inflationary cost headwinds (-200 bps) Less discounting on account of lower inventory levels and expected sales growth (+100 bps) Slight ROD deleveraging stemming from higher rent (-25 bps) Q4 ’22 estimate: 35% Q1 ’22: 31.5% gm Air freight leverage (+450 bps) Inflationary headwinds (-100 bps) Manageable inventory levels and the lapping of last 12 months’s Old Navy assortment imbalance (+200 bps) Q1 ’23 estimate: 37% Q2 ’22: 34.5% gm Air freight leverage (+130 bps) Inflationary headwinds (-100 bps) Lapping inventory impairment charge of $58M (+150 bps) Lapping Old Navy’s high inventory levels that forced higher discounting (+300 bps) Q2 ’23 estimate: 39.3%
With lower inventory levels starting within the fourth quarter together with an improved (or at the least not as bad as the primary half of 2022) assortment balance, I find it highly unlikely that Gap is forced to resort to heavy discounting. As mentioned earlier, management’s top priority appears to be rightsizing inventory. Subsequently, it will not be unreasonable to expect sizeable margin expansion just from improved inventory management alone. As well as, discontinued air freight will provide significant leverage through 2023.
Valuation
What assumptions are reflected in the present share price? Are these assumptions realistic or overly pessimistic? Specializing in an FWD P/E valuation methodology, I reverse-engineered the stock price to know market expectations. It led to me discover two potential overly-pessimistic assumptions which are priced in: no cuts to SG&A spending or flat/negative sales growth.
No SG&A Reduction Scenario Reverse P/E Model (Creator using historical data and quarterly gross margin forecasts)
Assuming negative sales growth in Q3 but modest sales growth in the next quarters, I kept SG&A spending unaltered. I used reasonable sales growth rates (which I’ll explain later) in addition to the gross margin forecasts discussed within the previous section. Sure enough, using a 12x to 13x FWD P/E multiple results in the present share price of ~$10.50. This poses the query: how likely is it that Gap’s management continues to chop operational expenses?
Before announcing 500 corporate job cuts, Gap’s management indicated that the $5.6B expected SG&A expense for the total 12 months is “just too high of a value structure for the present operating environment”. Motion is best than empty words. I get it. Nevertheless, seeing as other firms within the sector are shedding employees, it could not be surprising to see management proceed to chop spending. A 5% reduction in SG&A spend for the primary half of next fiscal 12 months can be a reasonably conservative projection that might significantly move the needle in operating and net profitability. Remember, we’re leaving SG&A unchanged for the remaining of this fiscal 12 months; which can be a conservative assumption.
Okay but what if this scenario will not be what investors are pricing in? Possibly Mr. Market is the truth is accounting for a big reduction in SG&A spend. In that case, the opposite scenario possibly being priced in is: little to no sales growth.
Creator using historical data and quarterly gross margin forecasts
The model above shows a 5% reduction in SG&A spend (blue font color), but negative sales growth in Q3, no sales growth in Q4 ’22 and Q2 ’23, and a minor jump for Q1 ’23 (these revenue growth projections are also marked with the blue font color). This mixture of lower SG&A but mostly flat growth gives us a good value of ~$10.50/sh (12x/13x fwd multiple). This poses an analogous query to scenario 1: how realistic is the above sales growth forecast?
The Rationale For Modest Sales Growth
As I’ve stated multiple times in this text and my previous one, Old Navy’s massive mistake of overshooting BODEQUALITY demand while concurrently not meeting demand for his or her core sizes led to a big decline in sales. The image below shows TTM revenue growth and NTM revenue projections for Gap and its peer group.
Screenshot of TTM Revenue Growth and NTM Revenue Forecasts for Gap and Competitors (Looking for Alpha)
As indicated by the chart, this assortment imbalance has caused higher than expected sales decline for Q1 (-13%) and Q2(-8%) of this fiscal 12 months. Subsequently, reported sales growth for Q1 ’23 and Q2 ’23 ought to be positive as Old Navy readjusts and so they lap last 12 months’s hiccup.
As for Q3 and Q4 of this 12 months, I expect a sales growth trend reversal to begin in Q4. My source? Well, the National Retail Federation expects holiday retail sales to grow between 6% and eight% in comparison with 2021. As well as, a Mastercard SpendingPulse report estimates 7.1% holiday spending growth, but that report is less recent than the NFR’s. Inflationary challenges may dampen demand, but it surely seems consumers are still expected to spend. Because of Gap’s reduction in Q4 purchases, I set a conservative 2% sales growth assumption.
Using the evaluation above, we are able to confidently expect positive low to mid single-digit growth rates for 3 of the 4 upcoming quarters. This proves that Scenario 2’s growth assumptions are overly pessimistic given the available information.
Valuation Part 2
Now that we have now analyzed why Gap should see modest sales growth and fewer SG&A going forward, we are able to confidently arrive at a price goal. As a reality check, the FWD P/E multiples for the sector are shown below:
Cons Desc Sector Median FWD P/E (Looking for Alpha)
Without further ado, assuming conservative sales growth rates and a 5% reduction in SG&A for H1 ’23, the outcomes of the P/E model are highlighted in yellow:
Fwd P/E Model for GPS (Creator using historical data and the above assumptions)
Because the model illustrates, Gap shares have an upside between ~33% and ~55%, depending on the FWD P/E multiple. The diluted EPS estimates are also adjusted for an estimated 27% effective tax rate (forecasted by management in Q1 ’22 ECP). Again, this upside was derived using conservative assumptions for the aim of assessing whether or not Gap shares have an adequate margin of safety. Based on the above evaluation, they do.
Risks
Management doesn’t at all times accomplish what they set out to perform. Although significant damage to profitability has already been done, there is no such thing as a guarantee that management will learn from these mistakes and reverse course. They could miscalculate future demand again leading to higher inventory levels and more discounting. They could fail to cut back SG&A significantly leading to negative operating profit margins. Not having a long-term CEO in place only increases the probability of those risks. This will not be to say I don’t have any confidence in Bob Martin. In my view, he deserves more credit for rising to the occasion and taking mandatory motion to make sure Gap’s stability. Nevertheless, electing an industry veteran with a proven track record will ease investors’ concerns concerning the way forward for Gap.
One other risk is a possible collapse in consumer spending. The unemployment rate rose to three.7% in October from 3.5% in September. As well as, recent CPI data are showing no signs of cooling. If this mixture of rising unemployment and lower disposable income persists, it could prevent revenue growth and margin expansion. Obviously, this risk is not exclusive to Gap, but it surely is one price considering for risk-averse investors.
Final Thoughts
One among the toughest tasks in analyzing an organization’s recent underperformance is determining whether the problems stem from a short-term hiccup, or slightly a fundamental problem within the business model. After looking deeper into Gap’s current situation, I’m confident that what we’re seeing here is the previous, a short-term hiccup. The shortcoming to match inventory purchases with demand and sacrificing profitability for punctuality has compressed Gap’s valuation as uncertainty still looms.
As contrarian because it seems, Gap has a big upside from its current valuation. The expectations for near-term sales growth and operating margins which are priced in by the market are unreasonably pessimistic. Subsequently, I’m assigning a “buy” rating given a 1-year investment horizon.
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