The Gap Inc. and L Brands Are Still in Fashion

Even mediocre companies can do well when the wind is on their back, but thriving in a challenging environment says a lot about a company and its management team. In times when most apparel retailers are reporting lackluster performance, The Gap,  (NYSE: GPS  ) and Limited Brands (NYSE: LB  ) are doing considerably better than the competition, and that deserves some serious attention from investors.

Blame it on the economy
Many apparel retailers are facing tough times lately, especially those focused on a young customer base. Abercrombie & Fitch (NYSE: ANF  ) recently released some really negative financial data for the quarter ended Nov. 2, the company said third-quarter sales fell 12% to $1.03 billion, below the $1.07 billion expected on average by Wall Street analysts.

Total same-store sales for the quarter declined by 14% and management is now expecting full-year adjusted earnings between $1.40 and $1.50 per share, materially below its May guidance of $3.15 to $3.25. CEO Mike Jeffries said in the press release that a weak consumer environment is the main factor behind the company´s performance.

"Our results for the third quarter reflect continued top-line challenges, with overall spending among younger consumers remaining weak. Until we have seen a clear trend improvement, we are continuing to take a cautious approach into the fourth quarter and are working to end the year with appropriate levels of fall carryover inventory."

Abercrombie's problems go well beyond economic factors, but the fact remains that many other apparel retailers have been complaining about a weak economy lately. Except for the best companies in the industry, that is.

Mind the Gap
Gap is going through a successful transformation over the last years; the company has materially improved its merchandising strategy and streamlined its operations by closing unprofitable stores and focusing on eficiency. In response, customers are staying loyal to Gap in times when most apparel retailers are finding it hard to sustain sales growth.

Through its widely recognized brands: Gap, Banana Republic, Old Navy, Piperlime, Athleta, and Intermix the company has more than 3,100 company-operated stores and over 300 franchised stores and e-commerce sites in more than 90 countries. The company sells affordable fashion and basic apparel to a broad audience and its combination of wide reach and brand recognition are proving to be valuable qualities under challenging conditions.

Gap reported net sales growth of 6% for October versus the same month in the previous year on the back of a strong increase of 4% in comparable sales during the period. Comparable sales at its namesake Gap segment increased by 5% in October, while Banana Republic and Old Navy delivered increases of 1% and 2% respectively in comparable revenues.

The company will be reporting earnings on Nov. 21, but management provided a positive guidance for earnings per share when it announced sales data for October. Earnings are now expected to be in the range of $0.7 to $0.71 per share, which is above the previous estimate of $0.66 per share by Wall Street analysts in average.

Even if margins remain under pressure in a heavily promotional environment, the company is proving that it has what it needs to succeed under challenging conditions for the sector and both customers and shareholders have reasons to cheer.

Gap is trading at a P/E ratio near 15 versus an industry average around 22 according to data from Morningstar, so the company is attractively valued in spite of a stock price rising by more than 24% over the last year due to Gap´s strong financial performance.

Victoria´s profitable secret
Through brands like Victoria's Secret, Pink, Bath & Body Works, La Senza and Henri Bendel, Limited Brands operates more than 2,600 specialty stores in the U.S. and the company´s products are sold in about 800 company-operated and franchised additional locations worldwide.

The company reported a strong increase of 11.3% in sales during October to $680.5 million from $611 million a year earlier; this was fuelled by big jump of 8% in same store sales during the month. Limited brands reports earnings on Nov. 20 and management is feeling optimistic about the coming earnings report since it said in the press release that it expects earnings per share at the high end of its previous guidance of $0.23 to $0.28 per share.

While La Senza delivered a drop of 2% in comparable store sales during October and the Bath and the Body Works segment produced a moderate increase of 4% during the month, a whopping increase of 10% in comparable store sales at Victoria´s Secret stores was the main growth driver for the Limited Brands in October.

Victoria´s Secret generates more than 60% of total revenues for the company, and the brand is sustaining its market leadership in the intimate apparel business even under challenging conditions and when facing increased competition from American Eagle's Aerie brand and Abercrombie's Gilly Hicks in addition to other competitors that are increasingly focusing on intimate apparel.

Limited Brands trades at a P/E ratio roughly in line with industry average in the area 23 times earnings over the last year. Considering the company´s competitive strength in intimate apparel and its above-average financial performance, valuation doesn´t look excessive at all for such a high quality company.

Bottom line
Warren Buffett wrote in his 2001 letter to Berkshire Hathaway shareholders: "you only find out who is swimming naked when the tide goes out." The tide has not been very helpful for most apparel retailers recently, yet Gap and Limited Brands are proving to be well dressed to successfully navigate the current environment. 


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