THE HEDGEYE EDGE
Gap (GPS) is often called a “Lazy Person’s Short”, because it's relatively well-known that the business has problems. However, we think the full extent of these problems is not fully appreciated and we’re happy to be short it if it's heading lower.
The consensus short call is Gap's mall exposure and dying brand, but there’s much more risk. The comparisons are very hard in upcoming quarters, the business model faces significant long term structural pressures, and the stock is not cheap on the right numbers. FCF yield is only at 8% with comparable retailers trading at 9-13%. That is a set-up we like with the U.S. macro environment inflecting to growth slowing.
INTERMEDIATE TERM (TREND)
The 4th quarter comparison is going to be very difficult for GPS. The company is up against its toughest comparable sales growth in 5 years, and expectations are for a big 2 year acceleration and a positive 4Q comp. Gross margin comparisons are even harder, with the company up 292 bps last year as it recognized a 1 time benefit for insurance payment on its Fishkill DC fire that it did not adjust for in earnings.
The calendar shift from the 53rd week is a headwind for all of the 2nd half with a material hit in 4Q. We don’t think this is properly in numbers.
On its last call GPS CEO Art Peck signaled that the company would likely announce some Gap brand store closures in the future as specialty mall locations have been struggling. At face value the closures could be viewed as positive as it helps operating profit and should mean better comp optics for a year. However, in this cycle, closing stores at retail almost always means more store closures soon after. The comments from the CEO are basically an admission that the business model is structurally flawed. Gap can’t sell clothes well in specialty mall locations... well that’s what GPS does. P&L may look better on the margin, but the value of the enterprise should be viewed as lower.
Lastly, as the Trump battle with China rages on, any tariffs on apparel are a real risk for GPS. 22% of purchases come from China and there is likely no room to pass that inflation along to customers.
LONG TERM (TAIL)
GPS has some of the highest exposure to private label credit cards in all of retail. It accounts for about 40% of EBIT. We think this risk is underappreciated. Whenever the credit cycle rolls over, GPS will see massive pressure on EBIT from the credit exposure. Also, we think Synchrony (GPS’s credit partner) is scaling back card issuance to low quality customers, which could mean some comp pressure on the margin for GPS.
Like much of retail GPS faces structural margin pressure from growing ecommerce, which comes at much lower gross margins due to shipping and return costs vs store sales.
GPS has significant exposure to dying malls. It sometimes has multiple banners in these malls and its locations span all classes (ABC) of mall properties. Even if the GPS could get its banners operating better there is traffic risk from co-tenancy closures as Anchors look to exit weak malls.
Lastly, there is a perception among some investors that Old Navy is comparable to off price names like TJX. We think this is a huge misconception. TJX sells quality, desirable brands at a much lower price than you can generally find them. There is a treasure hunt aspect, and a much greater value proposition for a different customer. Old Navy sells cheap branded apparel in malls. That $7 tee shirt is almost always $7. The customer is different, the businesses are not comparable. That is a risk when realized in the stock price.
ONE-YEAR TRAILING CHART
