The Gap, Inc. NEUTRAL ZACKS CONSENSUS ESTIMATES (GPS-NYSE)

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1 March 19, 2015 The Gap, Inc. Current Recommendation SUMMARY DATA NEUTRAL Prior Recommendation Outperform Date of Last Change 03/19/2013 Current Price (03/18/15) $42.33 Target Price $ Week High $ Week Low $35.74 One-Year Return (%) 3.81 Beta 1.28 Average Daily Volume (sh) 4,576,914 Shares Outstanding (mil) 421 Market Capitalization ($mil) $17,821 Short Interest Ratio (days) 2.95 Institutional Ownership (%) 51 Insider Ownership (%) 29 Annual Cash Dividend $0.88 Dividend Yield (%) Yr. Historical Growth Rates Sales (%) 3.3 Earnings Per Share (%) 13.3 Dividend (%) 21.7 using TTM EPS 15.3 using 2015 Estimate 15.0 using 2016 Estimate 13.2 Zacks Rank *: Short Term 1 3 months outlook 3 - Hold * Definition / Disclosure on last page (GPS-NYSE) SUMMARY Gap rebounded strongly in the fourth quarter, wherein both the top and bottom lines increased year over year and also came ahead of the Zacks Consensus Estimate. Strong performance across Old Navy stores, improving omni-channel capabilities, effective inventory management and global expansion acted as catalysts. Despite reporting better-than-expected results, Gap provided a subdued outlook for fiscal 2015 on account of currency headwinds and labor disruption at the West Coast ports that are likely to hurt earnings per share. Further, Gap s soft comps performance over the last 3 months due to dismal results at its namesake and Banana Republic Global brands may also impact results. These factors have led to a downward revision in the Zacks Consensus Estimate. Risk Level * Below Avg., Type of Stock Large-Growth Industry Retail-App/Shoe Zacks Industry Rank * 158 out of 267 ZACKS CONSENSUS ESTIMATES Revenue Estimates (In millions of $) Q1 Q2 Q3 Q4 Year (Apr) (Jul) (Oct) (Jan) (Jan) ,729 A 3,868 A 3,976 A 4,575 A 16,148 A ,774 A 3,981 A 3,972 A 4,708 A 16,435 A ,797 E 4,077 E 4,118 E 4,835 E 16,827 E ,556 E Earnings Per Share Estimates (EPS is operating earnings before non-recurring items, but including employee stock options expenses) Q1 Q2 Q3 Q4 Year (Apr) (Jul) (Oct) (Jan) (Jan) 2013 $0.71 A $0.64 A $0.72 A $0.68 A $2.74 A 2014 $0.58 A $0.70 A $0.74 A $0.75 A $2.76 A 2015 $0.55 E $0.71 E $0.81 E $0.75 E $2.82 E 2016 $3.20 E Projected EPS Growth - Next 5 Years % 11 (Quarterly figures may not add up to annuals due to rounding off) 2015 Zacks Investment Research, All Rights reserved S. Riverside Plaza, Chicago IL 60606

2 OVERVIEW With over 3,500 stores across the world, The Gap Inc. is a premier international specialty retailer offering a diverse range of clothing, accessories, and personal care products for men, women, children as well as infants. Its flagship brands include Gap, Banana Republic, Old Navy, Piperlime and Athleta and Intermix. Over three-fourths of Gap s revenues are generated from its U.S. operations. The company reports its operating results under 4 segments: Gap Global, Old Navy Global, Banana Republic Global and Others. Gap Global: This segment reports the operating results of all stores, including company-owned, franchise and online stores for the Gap brand both domestic and international. Old Navy Global: This segment reports the operating results of all stores, including companyowned, franchise and online stores for the Old Navy brand both domestic and international. Banana Republic Global: This segment reports the operating results of all stores, including company-owned, franchise and online stores for the Banana Republic brand both domestic and international. Others: The relatively newer brands namely Piperlime, Athleta and Intermix fall in this segment. These brands are managed by the president of the Growth, Innovation, and Digital (GID) division, who oversees the store and online operations of these brands. REASONS TO BUY Highly Recognized Retailer: Gap is a leading player in the highly fragmented specialty retail sector, offering a diverse range of clothing, accessories and personal care products for men, women, children and infants. Its flagship brands include Gap, Banana Republic, Old Navy, Piperlime and Athleta. The company s globally recognized brands complement one another, enabling it to leverage its position in the sector. Expanding Global Footprint Bodes Well for Growth: In an effort to penetrate deeper into the $1.4 trillion global apparel retail market, the premier specialty retailer is focusing more on increasing its international presence. Over the past few years, the company has aggressively expanded its global footprint across emerging markets including China, Russia, South Africa and certain Latin American countries. Meanwhile, it has adopted a policy of strategically reducing its exposure in North America, which is witnessing sluggish growth and high competition. Keeping up with this policy, the company plans to open 115 stores, net of closures and relocations, in fiscal 2015, focusing mainly on China, Athleta and global outlet stores. Expanding Franchise-operated International Stores: Apart from operating company-owned stores, Gap is doing a commendable job with its franchise business with operations spread across 50 countries. With its first franchise store launched in 2006, the company has now widened the international reach of its brands with almost 400 franchise-operated stores around the world. In fiscal 2015, the company expects its franchise partners to open nearly 35 new stores, net of closures. Enhancing ecommerce and Omni-channel Capabilities to Boost Top Line: With the brick-andmortar retailing concept losing its luster over the past few years in the United States, consumers have gradually drifted toward online shopping. Therefore, in a move to streamline its North American business, Gap is enhancing its ecommerce and Omni-channel capabilities by adopting a number of Equity Research GPS Page 2

3 initiatives. As part of its Omni-channel endeavors, Gap is extending its find-in-store and Reservein-Store facilities to all of its stores, while it recently introduced a new Order in Store service in about 1,000 U.S. Gap, Old Navy, Banana Republic and Athleta stores. We believe these initiatives will boost its top line in the long run. Additionally, Gap has recently collaborated with leading European fashion ecommerce site, Zalando, as a part of its global expansion endeavors, where it will introduce its online shop. Through this store Gap will offer a wide array of items including accessories and clothing from Gap Women, Gap Men, GapKids and babygap, beginning in summer Enhancing Shareholder Wealth: Gap has a track record of maintaining disciplined capital management along with a strong balance sheet. The company also generates strong free cash flow, which help boost earnings per share through large stock repurchases and further enhance shareholder value by consistently raising its dividend. In fiscal 2014, the company generated free cash flow of $1,415 million and operating cash flow of $2,129 million, while it incurred $714 million as capital expenditure. During the fourth quarter, the company bought back $148 million worth of shares. Further, consistent with its strategy of boosting shareholder returns, Gap approved an incremental $1 billion share repurchase program and raised its annual dividend rate to $0.92 for fiscal Gap estimates capital expenditure of $800 million for fiscal 2015, highlighting its focus on investing in development strategies. REASONS TO SELL Disappointing Guidance and Declining Comps Trend Pull Estimates Down: Despite reporting better-than-expected fourth-quarter fiscal 2014 results, Gap came up with a soft outlook for fiscal The weak guidance was based on currency headwinds and delay in merchandise receipts at West Coast ports on account of labor dispute that are likely to hurt earnings per share. Further, the company has been reporting weak comps for the last three months on account of dismal performances at its core Gap and Banana Republic Global brands, which may impact its bottom line. These factors have instilled a downward trend in the Zacks Consensus Estimate for the first quarter, fiscal 2015 and Macroeconomic Headwinds May Dampen Operating Performance: Consumers confidence and spending behavior may dampen due to macroeconomic factors including increase in fuel and energy costs, credit availability, high unemployment levels, and high household debt levels, which may negatively affect the consumer s disposable income. This in turn, could affect the company s growth and profitability. Currently, Gap s operating performance faces a major threat from the prevailing weak macroeconomic conditions in the emerging markets as well as in Canada, which contributes significantly to its revenues. Competitive Pressure: The company operates in a highly fragmented market and competes with a number of well-established players such as Estee Lauder, Coach, V.F. Corp., Phillips-Van Heusen, Jones Apparel, Liz Claiborne and Kenneth Cole Productions. The company primarily competes on the basis of fashion, quality and service. A failure to offer high-quality distinguished products at a competitive price may hamper Gap s market share, consequently resulting in reduced top and bottom lines. Seasonal Risk: Gap s business is seasonal in nature and generates a high proportion of sales during the fourth quarter, which is characterized by the crucial holiday season. Furthermore, the company boosts its merchandise levels in anticipation of the season, thereby exposing itself to significant risks in case the season fails to deliver the expected operating performance. Equity Research GPS Page 3

4 RECENT NEWS Gap's February Sales Remain Soft, Comps Down 4% Mar 5, 2015 The Gap Inc. continues with its disappointing comparable store sales (comps) performance. After witnessing a decline of 3% in January, comps further tumbled 4% in February. In the same period last year, comps fell 7%. We also observe that the company s soft performance at most of its segments led net sales to decrease 1.2% year over year to $918 million. February comps at Banana Republic Global and Gap Global fell 5% and 7%, respectively, compared with respective declines of 7% and 10% recorded last year. However, Old Navy Global comps remained flat as against a 6% decline posted in Feb Management stated that the company s February sales results remained soft owing to the month being a short one. Looking ahead, Gap is all set to embrace Spring and remains focused on driving its sales for the fiscal year. The company is slated to release its sales data for Mar 2015 on Apr 9. Gap Beats on Q4 Earnings, Issues Subdued Outlook Feb 26, 2015 The Gap Inc. posted fourth-quarter fiscal 2014 earnings of $0.75 a share that came a penny ahead of the Zacks Consensus Estimate, and jumped 10.3% year over year on the back of strong performance across its Old Navy stores. Management highlighted that excluding the impact of foreign currency fluctuations, the company s earnings per share surged approximately 20% during the quarter under review. We observed that despite a positive earnings surprise of 1.4%, the company provided a subdued guidance for fiscal The soft guidance was issued due to currency headwinds and delay in merchandise receipts at West Coast ports on account of labor dispute, which are expected to hurt earnings per share by $0.16 and $0.13, respectively. Net sales increased 2.9% year over year to $4,708 million, marginally above the Zacks Consensus Estimate of $4,707 million. On a constant currency basis, net sales grew 5%. Also, with continued focus on developing its omni-channel network, Gap s quarterly online sales came in at $792 million, up 13.5% from the prior-year quarter. Comparable-store sales (comps) advanced 2%, against a 1% improvement in the year-ago period, as the company continued to gain from strong performance at Old Navy, which reported double-digit comps. Brand-wise, comps at Old Navy Global rose 11% versus flat comps last year. Banana Republic Global s comps increased 1% in contrast to a 3% decline reported in the prior-year quarter. However, comps at Gap Global were down 6% as against a 1% increase recorded in the year-ago quarter. Gross profit for the quarter increased 4.1% to $1,658 million, driven by higher sales, whereas gross margin expanded 40 basis points (bps) to 35.2%. On the other hand, operating income declined marginally by 0.6% to $519 million because of a rise in operating expenses, whereas operating margin contracted 40 bps to 11%. Financials Gap ended the quarter with cash and cash equivalents of $1,515 million, long-term debt of $1,332 million and total shareholders equity of $2,983 million. During fiscal 2014, the company generated cash flow Equity Research GPS Page 4

5 from operations of $2,129 million and incurred capital expenditures of $714 million, resulting in free cash flow of $1,415 million. Management now projects capital expenditures of approximately $800 million during fiscal 2015, with primary focus on enhancing omni-channel and supply chain capabilities. Concurrent with the quarterly results, the company separately announced that its Board of Directors has authorized a new buyback plan of $1 billion and a hike in annual dividend. Last year in October, the Board had approved a $500 million share repurchase authorization. During the reported quarter, the company bought back 3.7 million shares for $148 million. Since the commencement of 2010, the company has bought back 297 million shares at a price of $24.42 per share, aggregating more than $7.25 billion. The company s new annual dividend of $0.92 per share reflects an increase of about 4.5%, and represents the sixth straight year of annual dividend increment. The company stated that the new quarterly dividend of $0.23 a share will be paid on or after Apr 29, 2015 to shareholders of record as of Apr 8. Store Update Gap ended the fourth quarter with 3,709 outlets in 50 countries, of which 3,280 were company-operated and 429 were franchise. In fiscal 2015, management plans to open approximately 115 company-operated stores, with primary focus on greater China, Athleta and global outlet stores. The company s franchise partners are expected to open about 35 more stores in fiscal 2015, net of closures. Gap projects square footage growth of about 2.5% in fiscal During fiscal 2014, the company introduced 39 outlets in greater China, comprising 7 Old Navy stores and 32 Gap stores. The company expects to open about 40 stores in greater China during fiscal The company, at the end of the fourth quarter, operated 101 Athleta branded stores in the U.S., and now plans to expand this performance and lifestyle brand further by opening 20 more stores in fiscal Outlook Gap disappointed with its fiscal 2015 earnings forecast of $2.75 $2.80 per share. Further, management anticipates operating margin for fiscal 2015 to come around 11.7% versus 12.7% reported in fiscal VALUATION Gap s current trailing 12-month earnings multiple is 15.3x compared with the industry average of 23.7x and 18.1x for S&P 500. Moreover, the stock is trading at a significant discount to the industry based on forward earnings estimates. Over the last five years, Gap s shares have traded in the range of 8.9x to 20.1x trailing 12-month earnings. Our target price of $44.00, 15.6x 2015 EPS, reflects this view. Equity Research GPS Page 5

6 Key Indicators F1 F2 Est. 5-Yr EPS Gr% P/CF 5-Yr High 5-Yr Low The Gap Inc. (GPS) Industry Average N/A 17.3 S&P H & M Hennes & Mauritz AB (publ) (HNNMY) N/A Nordstrom Inc. (JWN) L Brands Inc. (LB) TTM is trailing 12 months; F1 is 2015 and F2 is 2016, CF is operating cash flow P/B Last Qtr. P/B P/B ROE D/E Div Yield 5-Yr High 5-Yr Low Last Qtr. Last Qtr. The Gap Inc. (GPS) EV/EBITDA Industry Average S&P N/A 2.0 N/A Equity Research GPS Page 6

7 Earnings Surprise and Estimate Revision History Equity Research GPS Page 7

8 DISCLOSURES & DEFINITIONS The analysts contributing to this report do not hold any shares of GPS. The EPS and revenue forecasts are the Zacks Consensus estimates. Additionally, the analysts contributing to this report certify that the views expressed herein accurately reflect the analysts personal views as to the subject securities and issuers. Zacks certifies that no part of the analysts compensation was, is, or will be, directly or indirectly, related to the specific recommendation or views expressed by the analyst in the report. Additional information on the securities mentioned in this report is available upon request. This report is based on data obtained from sources we believe to be reliable, but is not guaranteed as to accuracy and does not purport to be complete. Because of individual objectives, the report should not be construed as advice designed to meet the particular investment needs of any investor. Any opinions expressed herein are subject to change. This report is not to be construed as an offer or the solicitation of an offer to buy or sell the securities herein mentioned. Zacks or its officers, employees or customers may have a position long or short in the securities mentioned and buy or sell the securities from time to time. Zacks uses the following rating system for the securities it covers. Outperform- Zacks expects that the subject company will outperform the broader U.S. equity market over the next six to twelve months. Neutral- Zacks expects that the company will perform in line with the broader U.S. equity market over the next six to twelve months. Underperform- Zacks expects the company will under perform the broader U.S. Equity market over the next six to twelve months. The current distribution of Zacks Ratings is as follows on the 1130 companies covered: Outperform %, Neutral %, Underperform 8.9%. Data is as of midnight on the business day immediately prior to this publication. Our recommendation for each stock is closely linked to the Zacks Rank, which results from a proprietary quantitative model using trends in earnings estimate revisions. This model is proven most effective for judging the timeliness of a stock over the next 1 to 3 months. The model assigns each stock a rank from 1 through 5. Zacks Rank 1 = Strong Buy. Zacks Rank 2 = Buy. Zacks Rank 3 = Hold. Zacks Rank 4 = Sell. Zacks Rank 5 = Strong Sell. We also provide a Zacks Industry Rank for each company which provides an idea of the near-term attractiveness of a company s industry group. We have 264 industry groups in total. Thus, the Zacks Industry Rank is a number between 1 and 264. In terms of investment attractiveness, the higher the rank the better. Historically, the top half of the industries has outperformed the general market. In determining Risk Level, we rely on a proprietary quantitative model that divides the entire universe of stocks into five groups, based on each stock s historical price volatility. The first group has stocks with the lowest values and are deemed Low Risk, while the 5 th group has the highest values and are designated High Risk. Designations of Below-Average Risk, Average Risk, and Above-Average Risk correspond to the second, third, and fourth groups of stocks, respectively. Equity Research GPS Page 8