Wall Street Falls In Love With Gap Again as Clothes Sell

Wall Street loves Gap Inc. (GPS) Again.

The largest U.S. apparel chain has surged 37 percent to $25.48 this year through yesterday and on March 26 hit a 10-year closing high. Analysts are raising their price targets to levels -- $28 and higher -- not seen since one of the best-performing companies of the 1990s began to lose its footing in 2001.

The euphoria is being driven in part by February and March same-store sales that beat analysts’ estimates and were the best back-to-back results since 2010. After shunning Gap for the likes of Hennes & Mauritz AB (HMB) and Forever 21 Inc., U.S. consumers have been snapping up brightly colored denim at Gap’s namesake stores and 1960s-inspired dresses from Banana Republic’s “Mad Men” collection. Items from the chain’s Diane von Furstenberg children’s collection are popping up on EBay Inc.’s website for about twice the original retail price.

Even analysts who earlier this year were less bullish on Gap have changed their tune. Two months of robust same-store sales will compel more people to “join in the positive chorus” on Gap, Dorothy Lakner, of Caris & Co. in New York, wrote in a April 5 note. For the first time since May, she has changed her recommendation to “above average,” raising her price target to $32 from $27.

The big question is whether Gap’s gains are sustainable, said Dave Weiner, an analyst at Deutsche Bank AG in New York.

“It’s too early to say,” said Weiner, who has a $19 price target and hold rating on Gap’s stock. “What the brand needs to do is prove it can sell product at full price. They are still a very promotional brand.”

Fewer Markdowns

A measure of Gap’s revenue per product is up this year, driven by “improved customer response to women’s assortment, especially at Gap and Banana Republic, which has translated to fewer promotions and markdowns,” Edie Kissko, a company spokeswoman, said in an e-mail yesterday.

Gap’s gains come as Americans continue to spend judiciously. U.S. same-store sales rose 3.9 percent last month, beating the estimate for a 3.3 percent gain, as many chains used discounts to woo shoppers. Though Gap sales climbed 8 percent, unseasonably warm weather and an early Easter may have prompted shoppers to stock up early on spring gear.

When Glenn Murphy, 50, became Gap’s chief executive officer in 2007, he focused on international and online sales while shrinking or closing stores at home. Since 2007, sales in the U.S. and Canada have fallen 6.6 percent, and some investors began looking overseas for growth. In the past 12 months, Murphy has been re-emphasizing North America, which last year generated 85 percent of the company’s $14.5 billion in revenue.

Jade Green

He has moved the creative operation to New York from hometown San Francisco, bringing together for the first time the design, marketing and production teams. He poached former Gap executive Tracy Gardner from J. Crew Group Inc. to advise on ways of making the women’s clothes more appealing. The spring line, which features denim and khakis in colors from red to jade green, is the new team’s first outing.

“With more confidence in our product assortments at Gap and Banana Republic, we feel this is a good time to invest more in marketing,” Kissko said. “The ultimate pacing and amount will in part be determined by the brands’ continued momentum.”

Murphy, who ran Canada’s Shoppers Drug Mart Corp. (SC) chain before becoming CEO, has assembled and disassembled several creative teams at Gap. It was as though he was throwing “spaghetti up against the wall until it sticks,” according to Connor Browne, who oversees more than $3 billion as co-manager of the Thornburg Value Fund in Santa Fe, New Mexico. His firm owned 10.6 million Gap shares as of December.

Finally Hitting

“It would be great if the move of the design team to New York, bringing on the adviser from J. Crew, if all of that was finally hitting and they were designing product that resonates with customers,” he said.

Browne said when his firm invested in Gap last year it was lured by the prospect of higher margins over time from online sales and franchisees overseas -- not potential improvements in North America. Boosting sales in the U.S. would “be a really nice outcome for shareholders,” he said.

Investors won’t see how improving sales will affect operating margins and profit until Gap reports quarterly earnings on May 17. The company said in February that operating margins at Gap would be relatively flat this year, as it invests in the business, buys back shares and returns cash to shareholders in the form of higher dividends.

“Analysts have been taking up estimates on expectation they have improved operating margins,” Browne said.

Cotton Prices

Gap’s operating income was 9.9 percent of its sales last year, the lowest since fiscal 2008, and down from 13.4 percent in the year-earlier period, as it struggled to pass along higher cotton prices and was forced to discount clothing that failed to resonate with consumers, such as women’s tops.

Randal Konik of Jefferies & Co., who boosted his recommendation on Gap shares to buy from hold in July and is calling for a $37 price target, is the most bullish analyst. Gap last reached that price in August 2000, when J. Crew CEO and Chairman Mickey Drexler was still running the show.

“We continue to hear positive feedback on the new spring product at Gap,” Konik wrote in a March 19 note. “There is a clear and noticeable improvement in style with better designs and bright colors that are on trend with the fashion, and we have seen more customers buying the merchandise.”

Still, a sustainable turnaround will depend largely on whether Gap can get full price for its clothes.

Too Early

Although the company has “seen some real traction in its business and has been able to pull back on promotions at Gap Brand and Banana Republic,” it’s too early to say this is the start of a “long-awaited turnaround,” Paul Lejuez, an analyst at Nomura Securities International Inc. in New York, wrote in a note on April 5. He has a neutral rating on the stock.

April same-store sales will offer a clearer picture of Gap’s success this year than the past two months, according to Deutsche’s Weiner. It will be a tough comparison; sales rose 8 percent last year partly because the Easter holiday fell late in April.

“The appeal for people who like the stock is the product turns meaningfully better into the back half of the year,” he said. “My own view is it’s just too early to say.”

To contact the reporter on this story: Sapna Maheshwari in New York at sapnam@bloomberg.net

To contact the editor responsible for this story: Robin Ajello at rajello@bloomberg.net

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