A Pleasantly Surprising Retail Report

The Gap (GPS) reported a solid quarter, in line with guidance, and management raised forward-looking guidance and increased the dividend 60%.

The underlying trends were positive and better than what we expected. Given the very mixed reports from its peers we are pleasantly surprised. Shares are down in the aftermarket on lower merchandise margins (which declined 30 bps y/y) and CEO commentary that traffic trends were down from 1Q, not surprising given the recent trends we've been hearing from the group. Offsetting the traffic commentary, Internet sales rose 27% and ticket size was up.

Earnings were 64 cents a share vs. 49 cents y/y and at the high end of guidance. Revenues were in line at $3.9 billion, with strong result in the Gap and Old Navy and a 27% gain in online sales. Same-store sales rose 5%, reported total sales increased 8% and on a constant currency basis total sales rose 10% y/y. Gross margins expanded 60 bps to 40.5% vs. 39.9% y/y and operating margins increased 160 bps to 13.5%. Inventory per store increased 6% and below total constant currency sales. Merchandising margins were down 30 bps (the only surprise in the quarter), but rent and occupancy leveraged 90 bps and this will continue to be an area of leverage. Total operating expenses were $1 billion, up $44 million y/y. As a percentage of sales, total operating expenses leveraged by 100 bps. Year-to-date free cash flow stands at $542 million and total cash at the end of the quarter was $1.9 billion. Total capital expenditures were in line with expectations at $315 million and flattish to last year's $297 million. As expected, square footage growth was flat as the company continues to right-size its U.S. store base.

Unlike most of its peers, guidance was raised for the full year to $2.57-2.65 a share from $2.52-$2.60 and at the midpoint represents 12% y/y growth. Two callouts were the continued hit from currency (in the 2Q FX hit sales by $52 million and if currency stays where it is will impact sales by $250 million) and last year being a 53-week year vs. this year at 52 weeks (4Q has one less week this year vs. last year's 4Q). This will skew the earnings growth higher in the first half than second half (the week that drops off this year is one of the higher volume/holiday week). These two issues should not be a surprise and the company has discussed this multiple times. Operating margin goals of 13% and square footage growth of 1% were also in line. The company will open 160 stores and close 80 stores, weighting the growth in Gap international, Old Navy Japan, Athleta and global outlets offset by closures in Gap North America.

Overall, a solid quarter in a challenging environment. We like the restructuring story and the strong management execution. The company is taking market share and we like the growth opportunities in its smaller brands like Athleta, Intermix and Piperlime and its international expansion efforts especially for the Gap Brand and Old Navy.

Regards,

Jim Cramer, Stephanie Link, and TheStreet Research Team

DISCLOSURE: At the time of publication, Action Alerts PLUSwas long GPS.