Inflation Pressures Gap Profitability, but Stock Remains Undervalued

By Trefis Team,

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Gap's ( GPS ) operates its namesake Gap brand in addition to Old Navy and Banana Republic, and competes with other specialty retailers like Aeropostale ( ARO ), American Eagle ( AEO ), Abercrombie & Fitch ( ANF ) and Urban Outfitters ( URBN ). We estimate that Gap and Old Navy stores each constitute a little over a quarter of the company's stock value. Banana Republic stores, while still significant, add a smaller 17%.

Our price estimate for Gap stock, at $35.51, is about 50% above market price.

The Cost of Living is Increasing in the U.S.

The consumer price index (a measure of inflation) increased by 0.5% in February, the highest for any month in nearly two years and above analyst forecasts. In total, consumer prices have increased just over 2% during the 12 months ended February 2011. The inflationary pressure affects profit margins of retailers like Gap that face increasing raw material costs, with global cotton prices rising over the last year. While raising prices on goods can offset these added costs, retailers might be hesitant to do so as consumer spending and employment levels remain pressured.

Gap Looking to Consolidate U.S. Store Count

Gap is aiming to improve its operational efficiency by eliminating a few underperforming stores. The company is looking to consolidate its U.S. store count, while expanding internationally. As a result, Gap could end up closing 200 stores in the U.S. over the next two years.

The company has been gradually reducing the number of Gap stores since 2001, due in part to declining demand. Going forward, we expect the decreasing store count in the U.S. to be offset by international store openings in locations like Europe and Asia Pacific.

Gap Profit Margin Outlook

Gap stores' EBITDA margin has been trending upwards since 2006, hitting an estimated 15.5% in 2010. We anticipate continued, albeit moderate, growth going forward towards 17% by the end of our forecast period. However, inflation could pressure profit margin growth and create downside to our base case forecast.

To illustrate this affect, we estimate that a 300 basis point drop-off from our base case by the end of our forecast period (in other words, a slight decline towards 14%) would suggest 4% downside to our $35.51 price estimate for Gap stock. While this does add risk, investors should consider the greater picture - this scenario would still leave our price estimate well ahead of market price.

See our full analysis for Gap stock

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Investing Ideas , Stocks , US Markets
Referenced Stocks: AEO , ANF , ARO , GPS , URBN

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