The Gap Inc. (GPS, Financial), one of the largest clothing retailers, has had a strong start to the new fiscal year. The company nearly doubled its revenue as compared to the corresponding quarter of the previous fiscal year as malls and other retail locations start to see more and more footfall in the post-pandemic environment. Online sales have been a key driver with respect to Gap’s growth and management expects the momentum to sustain even as store traffic returns.
As a result of the work-from-home mandates, people continue to spend on refurbishing their homes, giving momentum to Gap Home. The company is on track to get into the home decorating business in a partnership with Walmart Inc. (WMT, Financial). Overall, Gap is at an interesting juncture today and deserves an in-depth analysis.
Recent financial performance
Gap reported excellent first-quarter results on May 27, surpassing Wall Street's expectation on all counts. The company reported a top line of $3.99 billion, which was a staggering 89.42% growth as compared to the $2.11 billion number reported in the prior-year quarter. The company breezed past the analyst consensus estimate of $3.44 billion. The revenue translated into a gross margin of 40.84% and an operating margin of 6.14%, which was higher than a year ago. Gap reported net income of $166 million and adjusted earnings per share of 48 cents, which was a contrast to the average Wall Street expectation of a 5 cent loss per share. In terms of cash flows, Gap generated $340 million in the form of operating cash flows and spent $161 million in investing activities, leaving management with positive free cash flow.
Digital upside and other key factors
Gap operates one of North America's largest e-commerce sites and its online channel was among the top performers in terms of U.S. apparel e-commerce sales. As more sales took place online due to the pandemic, the company’s first-quarter online sales grew 82% versus 2019. Gap’s data indicates that a staggering 40% of the company’s total sales are taking place online as compared to about 25% in 2019. This is an indicator of the dramatic shift in consumer behavior taking place as a result of the pandemic.
Apart from this, the company’s fleet rationalization is on track and continues to drive significant economic value. Gap remains on track to closing 350 Gap and Banana Republic stores in North America by the end of 2023. It is worth highlighting that higher online sales and store closures, both in the quarter and last year, along with lease negotiations and abatement settlements contributed 430 basis points of ROD leverage in the first quarter versus 2019. Since last year's low, management has worked to revive the company's brands through celebrity partnerships, including those with rapper Kanye West's Yeezy and Olympic gymnast Simone Biles. While the company has not witnessed any significant growth in the Banana Republic brand, management remains optimistic about the new changes, which include updated product design, realigned pricing architecture, in-store experience and updated brand creative.
Partnership with Walmart
In May, Gap announced it is launching a new brand of home products, consisting of home decor, tabletop, bedding and bath, that will be sold exclusively on Walmart’s website. The home goods market has been booming over the past year since the pandemic drove people into isolation, leading to them spending more on their living spaces. As per a report by Euromonitor, the U.S. home furnishings market constitutes about $163 billion, and Gap is well-positioned to leverage its partnership with Walmart to amplify its offerings in this space, which should be available beginning June 24. New seasonal and special collections at Gap Home are expected to be introduced year-round, which will be developed in collaboration with IMG, the company’s licensing agency. The prices are expected to range from $15.88 for a pillow to $64.98 for a comforter. It is interesting to note this development makes Gap the first fashion retailer to enter into a multiyear partnership with Walmart in the home space.
Final thoughts
As illustrated in the chart above, the share price of Gap has more than doubled after its low in 2020 on account of the pandemic. The company continues to benefit from businesses reopening as well as economic recovery and is trading at a price-earnings multiple close to 27.5, which appears to be a bit pricey. The collaboration with Walmart comes in line with the company’s progress on leveraging partnerships as a capital-efficient way to raise its iconic brands and drive profitable sales, particularly at the Gap brand. Moreover, the management is still seeing strength on the digital side of the business, which acts as a positive sign going forward. Overall, I believe Gap has a number of green flags, such as strong sales growth, rent reductions and low markdowns, making it a compelling "hold" for the long term, but, at the same time, the current valuation does not look like a good entry point for new investors.
