Pretty much every stock in retail has been in rally mode since early November. Why? It looks like 2017 is shaping up to be the best retail holiday shopping season in recent memory.
But the rally in Gap Inc (NYSE:GPS) started much earlier than November. Back in August, the company announced blowout second quarter numbers. GPS stock hasn’t looked back since and is up nearly 50% since then.
Such a big rally may give investors pause, and with good reason. Gap stock is not only at 52-week highs, but also at its highest level since summer 2015. Valuation on GPS stock is near three-year highs, while the dividend yield hovers at a two-year low.
So what now? Although I am largely bullish on a ton of retail names during this big holiday rebound, I think Gap stock has already had its day in the sun. At $34, GPS stock feels more than fully valued, and I don’t see this stock heading much higher over the next 12 months.
Gap Has Been a Retail Winner
It should be stated that the reason GPS stock has likely already peaked is because Gap proved itself to be a retail winner well before this recent holiday bounce.
After being mired in negative comparable sales growth for several quarters, Gap has now posted four consecutive quarters of positive comparable sales growth. The best part about this streak is that the two-year stack comp gets better each quarter. Last quarter, the two-year stack comp turned positive.
That’s big news. It means that Gap Inc is actually growing on a two-year basis and not just regaining what was lost last year.
Another positive aspect of the Gap revenue growth narrative is that sales improvements are coming from all parts of the business. Old Navy continues to post strong numbers, and those numbers are only getting stronger. Gap has gone from negative comparable sales growth to positive comparable sales growth. Even the struggling Banana Republic is rebounding to flattish comps.
All in all, comparable sales growth trends are quite bullish for Gap Inc, and I think these trends will persist. Lapping positive comps next year will be difficult, but I think GPS can report flat to low single-digit growth in comparable sales over the next several years. Such comparable sales growth will lead to flattish sales growth because the company is closing stores.
The margin expansion narrative is equally as impressive. GPS has posted five consecutive quarters of gross margin expansion. Gross margins are clearly in rebound mode, and I think margins still have some room left to expand back to near their 40% highs.
The operating expense rate is up due to higher spend to support robust growth in the digital business, but management plans to take a bunch of costs out of the system over the next several years. That plus positive comps should lead to healthy expense leveraging.
How Much Is Gap Stock Worth?
All in all, this is a flat sales growth story with strong margin growth potential. The Street thinks that will translate into 7% earnings growth in the long term, and I think that number is about right.
But how much is GPS stock worth given 7% earnings growth? A $34 price tag seems like a stretch.
The five-year average price-to-earnings multiple for GPS stock is around 14, but earnings were falling in many of those years, so that should be taken with a grain of salt. Back in 2013-14, though, when earnings were growing, GPS maxed out around 16x earnings (see here).
GPS stock is currently trading at just over 16x this year’s earnings estimate.
Consequently, I think GPS stock is maxed out.
Bottom Line on GPS Stock
Retail is bouncing, and GPS is a retail winner.
But GPS stock has likely peaked. I think it’s best to look for opportunities elsewhere in the rebounding retail sector.
As of this writing, Luke Lango did not hold a positive in any of the aforementioned securities.