With a cloud of uncertainty hanging over the global economy, investors might be concerned that retail stocks -- which depend heavily on mainstream consumers -- could tumble. Despite those challenges, the U.S. retail industry is expected to post its highest annual growth this year since 2011, according to the National Retail Federation. The NRF estimates that retail sales will climb 4.1% annually in 2015, compared to 3.5% growth in 2014.
However, not all retail stocks are created equal, and two well-known companies -- Michael Kors (CPRI -0.47%) and Gap (GPS 1.89%) -- have fallen out of favor over the past year. Let's take a closer look and see if these two stocks are now cheap enough to buy.
Michael Kors: The curse of "affordable luxury"
Last quarter, fashion house Michael Kors posted 18% annual sales growth and 13% net income growth. Those numbers looked decent, but Kors posted wildly uneven comparable store sales. Comps in North America, its largest market, fell 5.8% annually (excluding the currency impact) during the quarter against analyst expectations for 3% growth. On a constant currency basis, comps in Europe and Japan respectively rose 11% and 12.4%, but those two markets only accounted for 22% of the top line.
Meanwhile, its retail operating margin dropped from 22% in the prior year quarter to 15.4%, indicating that weaker demand was forcing the company to lower its prices. Kors also slashed its full-year earnings forecast to $4.40 to $4.50 per share, missing the average estimate of $4.72.
Kors basically fell into the same trap as its chief competitor Coach -- it cheapened its own brand by offering its products in too many outlets and department stores. Once a brand becomes associated with clearance sales, it is tough to raise prices again and recover its premium appeal. Looking ahead, Kors expects new omni-channel initiatives and retail expansion to generate double-digit sales growth in its retail segment in fiscal 2016. It is also expanding its men's business, footwear, and licensing businesses to boost brand visibility.
After plunging more than 50% over the past 12 months, shares of Kors now trade at less than 10 times trailing earnings, versus the industry average of 19 times for the textile/apparel clothing industry. That is the cheapest Kors stock has been since its IPO in late 2011.
Gap: Disrupted by "cheap chic" rivals
Shares of apparel retailer Gap have slipped 8% over the past 12 months and currently trade at 13.5 times earnings. That is considerably lower than the industry average of 22 times for apparel stores, as well as the S&P 500 benchmark of 20 times.
In the past, Gap fared better than rivals like Abercrombie & Fitch and Aeropostale during economic downturns, because it used a tiered pricing strategy. Old Navy was its low-end brand, Gap was its midrange play, and Banana Republic was aimed at more affluent customers. But in recent years, "cheap chic" retailers like H&M, Forever 21, and Zara dramatically lowered price expectations with inexpensive, briskly rotated apparel.
Due to lowered price expectations, customers kept visiting Old Navy, but avoided Gap and Banana Republic. Last quarter, Gap reported a 10% annual drop in comparable store sales, which caused earnings to decline by 8%. Old Navy was the only one of its three chains to post positive comps growth. That trend continued in May, when Old Navy's global comps rose 6% annually, while Gap and Banana Republic's respectively slipped 6% and 5%. In June, Gap announced that it would close 175 of its 675 Gap stores in North America and focus more on its e-commerce business, which accounted for 43% of its top line last quarter.
In addition to cutting costs, Gap needs to get its fashion designs back on track. In late 2012, it hired former H&M designer Rebekka Bay to launch new styles but fired her earlier this year due to creative conflicts. Over the past few years, Gap expanded into other markets by acquiring yoga apparel maker Athleta and high-end boutique chain Intermix, which represent potential ways to diversify its top line beyond its three core brands.
The key takeaway
Michael Kors and Gap are both companies in transition. Kors is trying to build its brand without cheapening it, while Gap is trying to adapt to changing tastes and sliding price expectations. Neither stock will likely rally in the near future, but both are considerably undervalued compared to their market peers. Therefore, if Kors and Gap's tough turnaround efforts pay off over the next few years, their current prices might be a bargain.