Still Bullish on Gap

We retain our long-term Outperform recommendation on leading apparel retail chain, Gap Inc. (GPS - Analyst Report), based on the company’s strong quarterly performance and an upbeat outlook. Moreover, the company’s continued efforts to remain on the growth path are paying off well. Additionally, the company is exhibiting significant progress on its international expansion strategy, making its presence felt globally.

Gap, which competes with Ross Stores Inc. (ROST - Snapshot Report), posted third-quarter earnings of 63 cents a share, in line with the Zacks Consensus Estimate and surged 66.0% from the year-ago quarter earnings of 38 cents. Strong earnings performance was mainly driven by an increase in sales along with improved margins and a lower share count. Net sales increased 8.0% year over year to $3.864 billion from $3.585 billion in the comparable prior-year quarter and surpassed the Zacks Consensus Estimate of $3.841 billion.

Moreover, the company registered growth of 6% in its comps against a 5% decline in the prior-year period. Third-quarter comps mainly benefited from the continued positive trend in its North American business, Gap, Banana Republic, and Old Navy. Further, management’s cost cutting initiatives are helping the company reduce costs and boost profitability.

Healthy quarterly performance prompted management to raise its fiscal 2012 earnings guidance. The company now expects earnings in the range of $2.20–$2.25 per share for fiscal 2012, an increase of 41%–44.2% from fiscal 2011. Earlier, Gap was expecting earnings in the range of $1.95–$2.00 per share for fiscal 2012, an increase of 25%–28.2% from fiscal 2011.

We believe that the company’s relentless focus on turnaround strategies such as lowering domestic store counts while enhancing international stores for improvising the top line is paying off, which is evident from its solid comps and sales performance in the recent months. The company posted positive comps for five consecutive months (July, August, September, October and November) this year.

As part of its strategy, the company is planning to deliberately reduce its Gap North America store count to 950 by the end of fiscal 2013, by shuttering 700 specialty stores and approximately 250 outlets. Contrary to this, the company continues to aggressively expand on the international front through both company-operated and franchise stores. Further, it is aiming to generate 30% of total sales from overseas operations and online business by 2013.

Gap has established a track record of conservative capital management while maintaining a strong balance sheet. The company also generates strong free cash flow, which allows it to grow earnings per share through large stock repurchases and further enhance shareholder value by consistently raising its dividend.

Gap’s long-term strategic moves, along with its disciplined cost management measures have not only provided it with financial flexibility, but also helped reduce operating expenses. Moreover, Gap’s globally recognized brands complement one another, enabling it to leverage its position in the sector. Currently, Gap’s shares maintain a Zacks #2 Rank, which translates into a short-term Buy rating.