Is Now the Right Time to Buy Gap Stock?

The Gap's (GPS -3.83%) stock rallied nearly 8% on Nov. 18 in response to its third-quarter earnings report. The apparel retailer's revenue rose 2% year over year to $4.04 billion, beating analysts' expectations by $210 million, while its comparable store sales improved 1%. It posted a net profit of $282 million, versus a net loss of $152 million a year ago, as its adjusted earnings per share of $0.71 easily cleared the consensus forecast by $0.71.

Does that earnings beat indicate it's finally the right time to buy Gap's stock, which still remains down more than 40% over the past 12 months?

What happened to Gap?

Before the pandemic started, Gap had already been struggling with declining mall traffic and intense competition from "fast fashion" brands -- cheap, trendy clothes produced in high volume. After four years on the job, CEO Art Peck was fired in late 2019 as all three of its core banners -- Old Navy, Gap, and Banana Republic -- struggled with declining sales.

Image source: Gap.

Sonia Syngal, who took the helm in early 2020, immediately faced a trial by fire as the pandemic shut down Gap's brick-and-mortar stores. Later that year, Syngal launched a "Power Plan 2023" turnaround strategy that aimed to grow Gap's total sales by the low- to mid-single digits annually while achieving an operating margin of at least 10% by 2023.

To accomplish that goal, Syngal planned to downsize the slower-growth Gap and Banana Republic banners while expanding the higher-growth Old Navy and Athleta banners. That strategy seemed to briefly stabilize Gap's comps growth in fiscal 2021 (which ended in Jan. 2022), although it calculated those sales in comparison to its pre-pandemic sales in 2019.

But in the first half of fiscal 2022, those plans collapsed again as comps declined across the Old Navy, Gap, and Athleta banners. That slowdown triggered Syngal's dismissal in July ahead of Gap's second-quarter report.

Is Gap's business finally stabilizing?

But as the following table illustrates, Gap's comps finally turned positive again in the third quarter of 2022, driven by the surprising growth of Gap and Banana Republic.

Data source: Gap. *Relative to 2019.

Gap attributed the growth of its namesake brand to stronger sales of dresses, woven tops, sweaters, and pants -- which offset its weaker sales of kids and baby apparel. Banana Republic, which was rebooted last year with new products and marketing campaigns, attracted more shoppers with its workwear and a broader selection of premium apparel.

However, Old Navy's soft sales of kids and baby apparel offset its stronger sales of women's apparel. Athleta, which was once considered the company's most promising banner, blamed its slowdown on the softness of the athleisure market -- even though its rival Lululemon Athletica posted 23% comps growth in its latest quarter.

Gap still depends on margin-crushing markdowns

As Gap's comps growth stabilized, its gross margin rose 290 basis points sequentially (but still declined 470 basis points year over year) to 37.4%. Excluding an impairment charge related to the discontinuation of its partnership with Yeezy, it would have posted a gross margin of 38.7%. Its operating margin finally turned positive in the third quarter (after two quarters of negative operating margins) and rose 70 basis points year over year to 4.6%. But on an adjusted basis, which excludes some one-time gains, its operating margin still shrank 40 basis points year over year to 3.9%.

Gap's margins are declining year over year because it's still relying heavily on markdowns, which buoyed its comps growth and kept its inventories manageable with a modest year-over-year increase of 12%. However, boosting its sales with markdowns over the long term is unsustainable.

To right-size its business, Gap is still largely sticking with Syngal's original plan. The company shuttered 29 Gap and Banana Republic stores so far this year, and it plans to close an additional 30 stores by the end of fiscal 2022. It's also on track to open 30 new Athleta stores and 10 new Old Navy stores this year.

However, I'm not convinced that expanding Old Navy and Athleta is the right play. Both brands posted nearly flat comps growth in the third quarter, and they both face intense competition in the fast fashion and athleisure markets. If Gap keeps trying to boost those banners' sales with new store openings, their comps growth could still collapse in the second year.

A murky near-term outlook

Gap still hasn't appointed a new permanent CEO yet, and it anticipates a mid-single-digit year-over-year decline in net sales in the fourth quarter. For now, analysts expect its revenue to decline 6% for the full year as it posts an annual net loss.

Gap's stock might look reasonably valued at 15 times forward earnings, but it won't look compelling until it stabilizes its comps growth and margins. For now, investors should stick with better-run apparel retailers like Lululemon instead of Gap.