Clothing and accessories retailer The Gap (NYSE:GPS) reported Q3 FY2023 results topping analysts' expectations, with revenue down 6.7% year on year to $3.77 billion. Turning to EPS, Gap made a GAAP profit of $0.58 per share, down from its profit of $0.77 per share in the same quarter last year.
Gap (GPS) Q3 FY2023 Highlights:
- Revenue: $3.77 billion vs analyst estimates of $3.61 billion (4.4% beat)
- EPS: $0.58 vs analyst estimates of $0.21 (170% beat)
- Free Cash Flow of $113 million is up from -$689 million in the same quarter last year
- Gross Margin (GAAP): 41.3%, up from 37.4% in the same quarter last year
- Same-Store Sales were down 2% year on year
- Store Locations: 3,533 at quarter end, increasing by 153 over the last 12 months
Operating under The Gap, Old Navy, Banana Republic, and Athleta brands, The Gap (NYSE:GPS) is an apparel and accessories retailer that sells its own brand of casual clothing to men, women, and children.
The core customer is therefore broad, and the aesthetic is a mix of timeless and trendy Americana. For example, The Gap will has always been a good place to find a classic pair of khakis for work. It can also be a destination for a jacket that is a bit more trendy and fashion forward. Prices tend to be towards the affordable end of the spectrum, with frequent sales further enticing customers.
Old Navy features the lowest prices and is the most casual in style. Banana Republic is the most upscale and this is reflected in its prices. The Gap brand sits in the middle with regards to price and style. Athleta, acquired in 2008, offers women’s athleisure clothing such as yoga pants and sports bras.
The Gap’s stores, regardless of brand, are roughly 5,000 square feet and located in malls or shopping centers. They are organized in a similar manner to other clothing retailers, with sections for men, women, and children as well as centralized displays for promoted or seasonal items. The Gap has an ecommerce presence for each of its brands that gives customers various shopping options.
Apparel Retailer
Apparel sales are not driven so much by personal needs but by seasons, trends, and innovation, and over the last few decades, the category has shifted meaningfully online. Retailers that once only had brick-and-mortar stores are responding with omnichannel presences. The online shopping experience continues to improve and retail foot traffic in places like shopping malls continues to stall, so the evolution of clothing sellers marches on.
Retailers offering casual yet trendy apparel for men, women, and children include H&M (OM:HMB), Inditex (BME:ITX) which owns Zara, Abercrombie & Fitch (NYSE:ANF), and American Eagle Outfitters (NYSE:AEO).Sales Growth
Gap is larger than most consumer retail companies and benefits from economies of scale, giving it an edge over its competitors.
As you can see below, the company's revenue has declined over the last four years, dropping 2.4% annually as its store count and sales at existing, established stores have both shrunk.
This quarter, Gap's revenue fell 6.7% year on year to $3.77 billion but beat Wall Street's estimates by 4.4%. Looking ahead, analysts expect revenue to remain relatively flat over the next 12 months.
Number of Stores
A retailer's store count is a crucial factor influencing how much it can sell, and store growth is a critical driver of how quickly its sales can grow.
When a retailer like Gap is shuttering stores, it usually means that brick-and-mortar demand is less than supply, and the company is responding by closing underperforming locations and possibly shifting sales online. Gap's store count increased by 153 locations, or 4.5%, over the last 12 months to 3,533 total retail locations in the most recently reported quarter.
Taking a step back, the company has generally closed its stores over the last two years, averaging a 1.5% annual decline in its physical footprint. A smaller store base means that the company must rely on higher foot traffic and sales per customer at its remaining stores as well as e-commerce sales to fuel revenue growth.
Same-Store Sales
Gap's demand has been shrinking over the last eight quarters, and on average, its same-store sales have declined by 0.8% year on year. The company has been reducing its store count as fewer locations sometimes lead to higher same-store sales, but that hasn't been the case here.
In the latest quarter, Gap's same-store sales fell 2% year on year. This decline was a reversal from the 1% year-on-year increase it posted 12 months ago. We'll be keeping a close eye on the company to see if this turns into a longer-term trend.
Gross Margin & Pricing Power
We prefer higher gross margins because they make it easier to generate more operating profits.
Gap has great unit economics for a retailer, giving it ample room to invest in areas such as marketing and talent to grow its brand. As you can see below, it's averaged an impressive 43.4% gross margin over the last eight quarters. This means the company makes $0.43 for every $1 in revenue before accounting for its operating expenses. 
Gap's gross profit margin came in at 41.3% this quarter, marking a 3.9 percentage point increase from 37.4% in the same quarter last year. This margin expansion is a good sign in the near term. It shows the company increased its pricing power, and if this trend continues, it could signal a less competitive environment where it has more negotiating leverage and stable input costs (such as distribution expenses to move goods).
Operating Margin
Operating margin is an important measure of profitability for retailers as it accounts for all expenses keeping the lights on, including wages, rent, advertising, and other administrative costs.
In Q3, Gap generated an operating profit margin of 6.6%, up 2 percentage points year on year. This increase was encouraging and driven by stronger pricing power, as indicated by the company's larger rise in gross margin.
Zooming out, Gap over the last eight quarters but held back by its large expense base. Its average operating margin of 1% has been among the worst in consumer retail. However, Gap's margin has improved, on average, by 2.3 percentage points year on year, an encouraging sign for shareholders. The tide could be turning.EPS
These days, some companies issue new shares like there's no tomorrow. That's why we like to track earnings per share (EPS) because it accounts for shareholder dilution and share buybacks.
In Q3, Gap reported EPS at $0.58, down from $0.77 in the same quarter a year ago. This print easily cleared Wall Street's estimates, and shareholders should be content with the results.
Between FY2019 and FY2023, Gap's adjusted diluted EPS dropped 213%, translating into 53.3% average annual declines. In a mature sector such as consumer retail, we tend to steer our readers away from companies with multiple years of falling EPS. If there's no earnings growth, it's difficult to build confidence in a business's underlying fundamentals, leaving a low margin of safety around the company's valuation (making the stock susceptible to large downward swings).
Wall Street expects Gap to continue performing poorly over the next 12 months, with analysts projecting year-on-year declines in EPS.
Cash Is King
Although earnings are undoubtedly valuable for assessing company performance, we believe cash is king because you can't use accounting profits to pay the bills.
Gap's free cash flow came in at $113 million in Q3, representing a 3% margin and flipping from negative in the same quarter last year to positive this quarter. Seasonal factors aside, this was great for the business.
While Gap posted positive free cash flow this quarter, the broader story hasn't been so clean. Over the last two years, Gap's capital-intensive business model and demanding reinvestments to stay relevant with consumers in an increasingly competitive market have drained company resources. Its free cash flow margin has been among the worst in the consumer retail sector, averaging negative 5.2%. However, its margin has averaged year-on-year increases of 15.5 percentage points, showing the company is taking action to improve its situation.
Return on Invested Capital (ROIC)
We like to track a company's long-term return on invested capital (ROIC) in addition to its recent results because it gives a big-picture view of a business's past performance. It also sheds light on its management team's decision-making prowess and is a helpful tool for benchmarking against peers.
Gap's subpar returns on capital may signal a need for future capital raising or borrowing to fund growth. Its five-year average ROIC is 5.1%, somewhat low compared to the best retail companies that consistently pump out 25%+ returns.
Key Takeaways from Gap's Q3 Results
Sporting a market capitalization of $5.20 billion, Gap is among smaller companies, but its more than $1.35 billion in cash on hand and positive free cash flow over the last 12 months puts it in an attractive position to invest in growth.
Although its revenue and EPS declined, we were still impressed by how significantly Gap blew past analysts' expectations this quarter. These beats were driven by better-than-expected same-store sales performance (analysts forecasted a 7% decline and Gap posted a 2% decline). We were also excited its gross margin and free cash flow outperformed Wall Street's estimates - many were expecting Gap to post negative free cash flow. Zooming out, we think this was an impressive quarter that should delight shareholders. The stock is up 8% after reporting and currently trades at $14.75 per share.
Is Now The Time?
Gap may have had a good quarter, but investors should also consider its valuation and business qualities when assessing the investment opportunity.
We cheer for all companies serving consumers, but in the case of Gap, we'll be cheering from the sidelines. Its revenue growth has been weak over the last four years, but at least growth is expected to increase in the short term. And while its gross margins are a strong starting point for the overall profitability of the business, the downside is that its declining same-store sales suggests it'll need to change its strategy to succeed. On top of that, its relatively low ROIC suggests it has struggled to grow profits historically.
Gap's price-to-earnings ratio based on the next 12 months is 14.9x. While we think the price is reasonable and there are some things to like about Gap, we think there are better opportunities elsewhere in the market right now.
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