Gap Stock Plunged on Wednesday: Can It Recover?

Gap (GPS -0.05%) shares fell precipitously earlier this year, as the COVID-19 pandemic wreaked havoc on the apparel market. Sales plunged 43% in the first quarter of fiscal 2020, and the company recorded a massive operating loss of $1.2 billion (including a $484 million impairment charge). Gap stock bottomed on April 2 at just $5.26.

A funny thing happened next. Gap stock quintupled between its early April low and the beginning of this week, surpassing $26. An earnings miss on Tuesday finally halted the stock's momentum, though. Gap shares plummeted 20% to $21.60 on Wednesday.

Gap stock performance. Data by YCharts.

Let's take a look at why the stock dropped and whether Gap is likely to get back on a positive trajectory for investors in the years ahead.

Solid sales results come at a cost

Gap's third-quarter sales were flat year over year at approximately $4 billion. Comparable sales increased 5%, though, reflecting store closures over the past year.

These results masked a sharp divergence in trends across the company's brands and channels. Two of Gap's major brands achieved double-digit sales gains last quarter (Old Navy and Athleta), while the other two (Gap and Banana Republic) posted significant declines. Meanwhile, online sales surged 61%, offsetting a 20% drop in store sales. This boosted e-commerce to 40% of the apparel retailer's sales mix. While the pandemic drove the bulk of this shift, Gap's ability to meet customer demand via e-commerce reinforces its plan to close unproductive Gap and Banana Republic stores.

Data source: Gap Q3 2020 earnings release. Table by author.

Gross margin increased to 40.6% in the third quarter from 39% a year earlier. Lower occupancy costs from closing underperforming Gap and Banana Republic stores -- as well as a handful of city-center stores with expensive rents -- drove this strong performance, more than offsetting the headwind from higher shipping costs.

Nevertheless, operating income fell 21% to $175 million. A big increase in marketing spending and pandemic-related costs drove this decline. Higher interest expense caused an even bigger drop in earnings per share, which plunged to $0.25 from $0.37 a year earlier. This fell short of the average analyst EPS estimate of $0.32.

Management expects more of the same

Gap didn't provide guidance for the fourth quarter, given the uncertainty of the current environment. However, it did lay out some broad expectations -- and they aren't very different from last quarter's.

Management expects total sales to be flat or up slightly on a year-over-year basis in Q4. Higher shipping costs will fully offset the benefit from store closures, keeping gross margin roughly flat. Finally, pandemic-related safety costs and increased marketing investments will continue to weigh on Gap's margins, boosting operating expenses to between 33% and 34% of sales (compared to just 30.3% of sales in the year-ago period, excluding special items). This informal guidance implies that earnings could fall by 50% or more in Q4, despite Gap's potential return to sales growth.

Image source: Gap Inc.

Can Gap rebuild its profitability?

Gap certainly has a lot of potential thanks to the strength of Old Navy and Athleta. Those two brands generated approximately $8 billion and $1 billion of sales last year, respectively. At Gap's investor day last month, management set a goal of growing Old Navy's annual sales to $10 billion and Athleta's annual sales to $2 billion by fiscal 2023. If these brands hit their growth targets, they'll account for about 70% of Gap's sales by 2023, up from 55% last year.

Historically, these brands have been very profitable. Whether they can be equally profitable in the future depends on whether the company's current marketing investments allow Old Navy to gain new customers who can subsequently be retained more cheaply. Conversely, if marketing costs stay permanently elevated, the combination of higher operating expenses and higher shipping costs will make it hard for Gap to expand its operating margin to 10% or more by fiscal 2023 as it intends.

On the flip side, the declining Gap and Banana Republic brands will remain a thorn in Gap's side. Store closures may provide some margin relief in the near term, but they don't represent a permanent fix. The Gap brand has failed to resonate with customers for years. Meanwhile, Banana Republic is fighting an uphill battle to pivot toward casual styles, as demand for workwear may never fully recover.

If Gap achieves its 2023 sales and margin targets, its net income could surge to well over $1 billion. That would make Gap stock a bargain based on its current market cap of $8 billion (down from $10 billion earlier this week). At the moment, it's far from certain that management can turn around Gap and Banana Republic, or that Old Navy will return to its pre-2019 margin profile. Gap stock needed a breather after its wild 2020 rally, and that's what it's getting.