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Gap Increases Y/Y, Raises Outlook

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Driven by continued increase in sales along with improved margins and a lower share count, Gap Inc.’s (GPS - Free Report) earnings of 63 cents a share for the third quarter of fiscal 2012 soared 66.0% from 38 cents reported in the comparable prior-year quarter. Further, the quarterly earnings came in line with the Zacks Consensus Estimate.

Quarter in Detail

During third-quarter, Gap’s net sales increased 8.0% year over year to $3,864.0 million from $3,585.0 million in the previous-year quarter. Moreover, the company registered a growth of 6% in its comps against a 5% decline in the prior-year period. However, quarterly sales missed the Zacks Consensus Estimate of $3,841.0 million.

The company’s third-quarter comps mainly benefited from the continued positive trend in its North American business, Gap, Banana Republic, and Old Navy. During the quarter, comps at the company’s Gap North America, Banana Republic North America and Old Navy North America improved 7%, 6% and 9%, respectively. Whereas the company’s International business comps declined 3% year over year.

Quarterly gross profit jumped 21.2% year over year to $1,593.0 million, primarily due to lower input costs. Consequently, gross margin expanded 450 basis points (bps) to 41.2%.

Gap’s operating income for the quarter came at $520.0 million, up from the prior-year quarter operating income of $346.0 million. Moreover, operating margin expanded 380 bps to 13.5% due to an expansion in gross margin. Operating expenses increased $105.0 million from the previous-year quarter due to increased marketing expenses for promoting Gap brand and enhancing customer relationships.

Moreover, with efficient inventory management, the company’s inventories were down 4.0% from the prior-year quarter level. Further, Gap is expecting inventory levels to increase in the low single-digit range at the end of fiscal 2012 on a year-over-year basis.

Balance Sheet, Share Repurchases and Dividend

At the end of the third quarter of fiscal 2012, the company has cash and cash equivalents and short-term investments of $1,770.0 million, compared with $1,417.0 million in the year-ago period. The company’s shareholders equity was $3,161.0 million.

Gap’s total number of outstanding shares declined about 3.4% to 488.0 million from 505.0 million reported in the prior-year quarter. Lower share count in the quarter contributed about 2 cents to earnings per share in the quarter.

Free cash flow during the first nine months of fiscal 2012 was $776.0 million compared with $222.0 million in the last year period. During these nine months, the company has made a capital expenditure of $449.0 million and expects to expend $675.0 million in fiscal 2012. During the quarter, the company deployed $96.0 million of cash toward share buybacks.

In the quarter, Gap paid a quarterly dividend of 12.5 cents per share, an increase of 11% from the prior-year quarter. Further, Board of Directors sanctioned a quarterly dividend of 12.5 cents to be payable on January 30, 2013, to the stockholders of record as on January 2, 2013.

Store Count

In the third quarter, Gap opened 46 company-operated stores and shuttered 13 locations, bringing the total company-operated store counts to 3,068. Moreover, in the same quarter, the company opened 25 stores and closed 4 stores in franchise business, bringing the total franchise store counts to 271.

In an effort to improve productivity per square footage, the company plans to strategically close and consolidate square footage at Gap and Old Navy brands. In 2012, Gap continues to anticipate net openings of 15 company-operated stores and 50 – 75 franchise stores in different locations.

Moreover, it expects to decrease its net square footage by 1% in fiscal 2012. In the third quarter, the company’s net square footage decreased 2% to 36.9 million from 37.6 million in the previous-year quarter.

Fiscal 2012 Earnings Outlook Up

Healthy quarterly performance has 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. The current Zacks Consensus Estimate stands at $2.25 per share, in line with the company’s new guidance range. Moreover, Gap is now anticipating an increase of 12.0% in operating margin during fiscal 2012, up from previous guidance of 11.0%.

Peer Performance

One of the company’s peers Ross Stores Inc. (ROST - Free Report) recently reported earnings of 72 cents per share for third-quarter 2012, in line with the Zacks Consensus Estimate. The quarterly results grew 14% from the prior-year level of 63 cents a share.

Our Recommendation

We believe the company’s relentless focus on turnaround strategies for improvising the top line are paying off, which is reflected in its solid comps and sales performance in the recent months. The company has now posted positive comps for four consecutive months (July, August, September and October).

Further, Gap’s long-term strategic moves, along with disciplined cost management measures will not only provide it financial flexibility, but will also help 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. Our long-term recommendation on the stock remains Outperform.

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