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What happened

Shares of apparel retailer Gap Inc. (NYSE:GPS) dropped on Friday after its third-quarter report proved disappointing to investors. While Gap beat estimates for revenue, the company's namesake stores continued to struggle, and its full-year earnings guidance remained unchanged despite improved merchandise margins during the third quarter. At 11:30 a.m. EST, the stock was down about 13.5%.

So what

Gap reported third-quarter revenue of $3.8 billion, down 2% year over year but about $60 million above the average analyst estimate. Comparable sales dropped by 3%, although 2 percentage points of that decline was blamed on a fire in a distribution center building during the quarter.

Gap's namesake brand suffered an 8% decline in comparable sales, with the fire responsible for half of that decline. Banana Republic posted an 8% comparable sales decline as well, with the fire accounting for 2 percentage points of decline. Old Navy, the company's largest brand, managed to grow comparable sales by 3%, with the fire knocking off 1 percentage point of growth.

Non-GAAP EPS came in at $0.60, down from $0.63 during the prior-year period and in line with analyst expectations. One thing helping the bottom line during the quarter was a 220-basis-point improvement in merchandise margin, mostly due to Old Navy. Gross profit increased compared to the third quarter of last year despite the drop in sales, and inventory declined by about 4%.

Now what

"As we move into the holiday season, our teams are sharply focused on execution and delivering great experiences across the portfolio," said CEO Art Peck. "Looking forward, we remain dedicated to utilizing our scale advantage in supply chain, as well as through knowledge sharing, in order to drive product innovation across brands and categories."

Gap left its full-year non-GAAP earnings guidance unchanged at $1.87 to $1.92. With merchandise margins improving during the third quarter, investors may be disappointed that the company isn't expecting a stronger performance during the holiday season.

The Gap and Banana Republic brands continue to struggle, and there has been little indication that either is on the verge of returning to growth. Old Navy saved the day for the company during the third quarter, allowing it to meet expectations. But investors still knocked the stock down, with the lack of an optimistic outlook likely playing a role.

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