Gap: Lack Of Growth And Unstable Profitability Indicate A Hold (NYSE:GPS)

Thesis

Despite recent inflationary pressures and weakening sentiment, the global apparel industry remains at the forefront of discretionary spending for consumers. The Gap, Inc. (NYSE:GPS) is a well-known retailer in the apparel industry, familiar to consumers in the United States and across the world.

While Gap has established a reputable brand, with a wide target customer group, failure to capture sales growth momentum over the past five years has led to underperformance. Currently, GPS trades at $19.06 ($7.07B market cap) and pays a 3.15% dividend yield. Over the past year, however, the stock has surged +50%, following some more optimistic recent results and raised expectations.

Key Business Attributes

Diversification is an attribute that the company embraces across different aspects of its business model. Gap offers a diverse product range, marketed under five different brand names. Old Navy is a value apparel brand offering clothing essentials, while the Gap brand markets a more modern style of clothing, still at affordable prices, while also offering kids’, maternity clothing, and more. Banana Republic aims at a more work-focused style customer base and Athleta dips into fitness and lifestyle clothing.

For the last quarter reported (Q3 2023), the Old Navy brand remained the top performer of the company, accounting for over 50% of total net sales. The Gap brand is responsible for approximately 24% of revenue, with Banana Republic following at 12%. Athleta has yet to make significant headway in sales.

When it comes to distribution, Gap follows an omni-channel approach, with sales directed towards both retail stores and online shopping. Gap operates company-owned stores, primarily in North America and Asia, while also utilizing a franchise model. The company also operates outlet stores across many different countries.

Clothing Industry Prospects

The global apparel market is currently valued at around $1.4T, representing one of the largest industries in the consumer discretionary sector. The industry displays moderate-to-low growth prospects going forward, expected to grow at a 4.63% CAGR through 2029, to reach a total $1.8T in market value. Currently, Europe remains the industry’s largest market, while Asia-Pacific is presenting itself as the fastest-growing one.

The moderate growth prospects that the industry displays are also paired with a very high degree of fragmentation across many different geographic locations, product ranges, and marketing strategies. From global fast-fashion giants like Zara and H&M to up-and-coming Chinese retailers or marketplaces like Amazon, to more niche luxury brands, the competition is fierce across the board. As a result, the high degree of saturation leads to narrower profitability margins.

Cyclicality Signs

The consumer discretionary sector and even more so the apparel industry is highly cyclical and dependent on consumer spending which is in turn associated with consumer confidence. While consumer confidence in the U.S. has recovered from the Covid-19 pandemic lows, still confidence levels remain at lower levels compared to 2018 or 2019.

In February 2024, the Consumer Confidence Index fell to 106.7, compared to the 110.9 level in January, indicating weakening sentiment in the short term. Additionally, the percentage of consumers who view current market conditions as “good” fell slightly from 21.3% to 21.2% in February.

Financial Performance

Gap has been on a revenue stagnation path for many years now, as sales have failed to pick up any noticeable momentum. Specifically, the company recorded revenue of $15.8B in 2015 which has only slightly increased to $15.6B for the 2022 fiscal year. In 2023, sales are expected to decrease below $15B. Over the course of the same period, gross profits have increased from $5.8 to $6.8B, which notes an uptick in profitability, especially considering the revenue stagnation. Earnings have been particularly volatile, ranging from $0.9B in 2015 to -$0.7B in 2020 and -$0.2B in 2022.

Balance sheet-wise, Gap holds a $1.4B in cash & equivalents (more than 20% of market cap) and a 1.4x current ratio, which indicates strong liquidity. Leverage remains at, more or less, reasonable levels, at $1.5B, but seems rather elevated when also considering $3.5B in capital lease obligations.

Profitability Provides Mixed Signals

Given the industry’s intensity of the competition and lack of attractive growth performance in market size, the ability of a company to maintain or even more preferably expand its profitability metrics is a key attribute investors should consider.

In this context, unfortunately, Gap offers some contradicting evidence around profitability performance. While gross margins have somewhat improved from 39% in 2019 to almost 46% in 2023, both EBITDA and EBIT margins have decreased rather significantly over the same period. If anything, this trend indicates efficiency improvements are long overdue in the firm’s operations. On a more positive note, GPS’s FCF margin has increased by over 10% in 2023, as the company is improving inventory and working capital management.

What might prove to be relevant to profitability performance is that in April 2023, management announced a restructuring plan, primarily aiming to cut costs and improve operating efficiency. The plan included an 1,800-employee workforce reduction.

Expectations Fail to Inspire Confidence

Over the current fiscal period, Gap is expected to reach $1.16 in EPS, which will increase to $1.33 by 2026. Growth performance for revenue is expected to fluctuate going forward, with sales actually forecasted to decrease for the 2023 fiscal year and then only slightly increase going forward. Overall, Gap’s trajectory causes some concern for its lack of a clear path toward growth.

Valuation

With earnings being particularly volatile, it is preferable to examine valuation multiples like Price/Sales and EV/EBITDA to determine the sock’s valuation attractiveness. Currently, GAP trades at a 12x EV/EBITDA (on a TTM basis and 11x on a FWD basis). Both EV/EBITDA multiple values are on par with sector averages, indicating, that, especially concerning the lack of solid growth prospects and the struggling bottom-line profitability of the business.

On the other hand, the 0.5x P/S ratio that GPS trades at, appears much more attractive, considering that the consumer discretionary sector currently stands at approximately 1.0x.

Final Thoughts

After all things are considered, while Gap has managed to establish a well-regarded and diversified brand in the apparel industry over a multi-year presence, the company’s financial performance does not provide much optimism in terms of the stock’s current risk/return prospects, even at current valuation levels.