The Gap, Inc.: Turnaround Efforts Slowly Coming To Fruition

Description

4Q22 results were disappointing across the board, but I remain optimistic about Gap Inc.'s (NYSE:GPS) ongoing restructuring efforts. I agree that GPS's recent mixed results have not been as promising as they could have been, especially given the company's weaker-than-expected earnings for the fourth quarter and the weak guide for 2023. My opinion, however, is that the 4Q22 report did provide some promising early indicators of the turnaround that GPS is starting to implement. One example is Old Navy, where sales trends of new spring merchandise have been improving after a weak fourth quarter. Importantly, inventory numbers are a lot better now with stocks down 21% compared to last year, giving GPS the opportunity to load up fresh in-demand goods. Additionally, management guided to an increase in gross margin, estimating a recoupable amount of over 200bps. Finally, SG&A is now better under control than ever before thanks to recent restructuring actions.

Thus, I continue to see GPS as a place where things can and will turn around. But I will admit that the fourth-quarter report card included a number of discouraging changes. With Athleta's comps falling in the fourth quarter, GPS decided to part ways with the brand's president in an effort to find someone with better execution. Also, after a disappointing holiday season, GPS took a more reserved stance on Banana Republic, saying it expects muted delivery in the first quarter due to tough comps last year and shifting consumer behaviour. All in all, I now recognize a more protracted road to recovery, but am still maintaining my Buy rating on GPS stock in light of signs of improvement.

Old Navy improving

In the most recent quarter, Old Navy's sales were hurt by stale merchandise, a lack of novelty, and poor demand from shoppers with lower incomes. However, I was heartened to hear that the women's business showed strength, which I consider to be an essential part of Old Navy's performance, despite the fact that categories like kids and baby underperformed. Management has also noted better quarter-to-date trends and product acceptance since introducing its Spring lineup in January, following substantial inventory clearing actions in the fourth quarter. However, with the crucial selling months of March and April still ahead of them, I believe it is wise for management to exercise caution regarding the outlook.

Athleta and Banana Republic

Athleta and Banana Republic's weaker-than-anticipated 4Q22 results were attributed by management to product misses. As much as I was let down by Athleta's executional lapses, I think some of the blame lies with the overall sluggishness of the women's athletic apparel market. The search for a new brand president and the subsequent hiring of Athleta's newest Head of Brand Creative does indicate that a turning point may soon arrive.

Inventory management

In my opinion, the 21% Y/Y decrease in inventory at GPS's end of the year presents an opening for more novelty and a rebalancing of the company's selection. Importantly, management specifically cited Old Navy as a reason for the uptick - which suggests Old Navy could see positive traction with new in-demand delivery. Going forward, management anticipates inventory reductions that outpace sales in FY23, which I believe will give GPS the flexibility to pursue more in-demand products while cutting back on promotional activities and thereby boosting margins.

Margins

In 4Q22, there was a 10bps decrease in gross margin, bringing it to 33.6%. Management indicated that the decrease in airfreight expense from the previous year provided a 540bps advantage, but this was mostly negated by a 200bps increase in inflationary costs and a 320bps increase in discounting. Looking ahead in FY23, management anticipates a 200bps boost from airfreight, but a 100bps drop from ongoing product cost increases. Aside the tailwinds affecting gross margin, I like management's efforts to reduce expenses even further. To achieve the additional $300 million in savings, management has introduced plans to restructure leadership and the organization as a whole with the goal of streamlining decision-making processes and increasing overall productivity. This is on top of the annualized $250 million in savings thanks to the implementation of cost-cutting measures last year. Of course, the immediate result will be a higher profit margin, but I think the reorganization will have a more far-reaching, positive impact by enhancing the underlying operations, thereby increasing productivity and, hopefully, fostering a more positive company culture.

Summary

While the 4Q22 results for GPS were disappointing, there are some promising early indicators of the ongoing restructuring efforts. Old Navy's sales trends have been improving with better product acceptance, while inventory management presents an opening for more novelty and a rebalancing of the company's selection. Along the expected increase in gross margin, management efforts to further cut cost should lead to improve EBIT margins. Overall, while there may be a more protracted road to recovery, the signs of improvement justify maintaining a Buy rating.