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We have downgraded our long-term recommendation on Gap Inc. (GPS - Analyst Report) to Neutral in anticipation of a possible rise in input costs and increasing inventory level, which may slow down the company’s sales and margin growth trends. This Zacks Rank #3 (Hold) company has a target price of $38.00.

Why Downgrade?

Despite reporting strong quarterly results, we remain apprehensive about the stock’s future performance as margins are likely to remain pressured by several headwinds. Going forward, management stated that increased input costs and rising inventory level are likely to take a toll on its margins.

We remain concerned about the company’s rising inventory per store level, which is facing a tough comparison from last year. Overall, inventory is anticipated to increase in the mid single-digit range at the end of first quarter of fiscal 2013. We believe that these factors may limit the company’s margin growth.

Although its franchise business has performed impressively, the international retail business remains weak, as evident from its continual negative comps performance.

In addition, the company operates in a competitive environment and strives to maintain its market share, actively competing with numerous manufacturers and distributors of apparel and related products. The company primarily competes on the basis of brand recognition, fashion, price, service, store location, and quality. Failure to offer high-quality differentiated products at a competitive price may hamper Gap’s market share, and thereby its top and bottom-line performances.

However, we consider that the company may return on the growth track in the long term with the help of its relentless endeavors on turnaround strategies. We believe that the company’s efforts have paid off well over the past one year, resulting in improved comps and sales performance.

Further, we believe that the company’s acquisition of INTERMIX Holdco Inc. during fiscal 2012 will not only help Gap in expanding its brand offerings, but will regain its fashion leadership status as well. Moreover, from a valuation perspective, the stock looks attractive as it trades at a discount to the industry average, based on forward earnings estimates. Gap currently trades at a forward P/E of 13.64x, lower than the industry average of 19.82x.

Other Stocks Worth Considering

Other stocks worth considering in the apparel retail industry are PVH Corporation (PVH - Snapshot Report), Hanesbrands Inc. (HBI - Analyst Report) and Ralph Lauren Corp (RL - Analyst Report). All these companies carry a Zacks Rank #2 (Buy).

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