$20 looks like a good fit for The Gap after XL earnings beat

Key Points

• Last week, The Gap reported Q3 earnings per share of 59 cents, nearly three times what Wall Street forecasted.
• Following the report, shares surged 32% to $18.43, its highest level since February 2022.
• Analysts anticipate Q4 EPS of 22 cents, which would be a sharp improvement from the 75-cent loss recorded last holiday quarter.

Don't be surprised if you see many shoppers at The Gap Inc. NYSE: GPS this holiday season. 

Why? 

The retailer is crushing it. 

Well, sort of.

On Friday, the company behind Old Navy, Banana Republic, Athleta and Gap stores reported third-quarter earnings per share (EPS) of 59 cents, nearly three times what Wall Street forecasted. Although this was 17% lower than the prior year period, it reinforced a mounting case that the company is solidly on the comeback trail. After losing money in 2022, The Gap is on pace to return to profitability in encouraging "fashion" this year.

While sales continue to lag last year's levels, management has shored up expenses by flushing out inventory and launching successful promotions to lure back customers. These measures and reduced commodity costs drove a 3.9% gross margin expansion in Q3, helping The Gap beat consensus earnings estimates for the third straight quarter. 

The Gap was among the names poised for outperformance when we previewed last week's earnings plays. Discounting activity was easing, freight costs were becoming a tailwind, and the retailer had just entered the home goods space via BR Home. The Street's 20-cent EPS prediction seemed low — indeed, it was. 

One catalyst we didn't see coming was Old Navy. The Gap's largest segment returned to comparable sales growth during the quarter, led by improving demand for women's, kids and baby clothes. With the company's three other brands posting negative comp sales, signs of life at Old Navy is a bullish development. 

The Gap's surprise quarter stands out in an uneven recovery for apparel retailers tied to discretionary spending cutbacks due to inflation and higher credit card rates. Some companies, like Abercrombie & Fitch and Guess, have outperformed. 

Others, like Victoria's Secret and Shoe Carnival, are underperforming. Third-quarter results aren't necessarily moving apparel retail stocks as expected. American Eagle Outfitters released strong Q3 numbers on Monday, but the stock got clobbered by a weak Q4 outlook.

The Gap exceeds expectations and sees good things ahead. Shareholders are getting rewarded. Last week, its shares surged 32% to $18.43, their highest level since February 2022. 

Yet, with The Gap still trading more than 50% off its post-pandemic peak, investors may still have plenty of opportunity to shop for a bargain. 

Will Gap beat Q4 earnings estimates?

For The Gap to keep its turnaround story alive, it will likely have to perform well during the holiday shopping season. Disappointing results during this key reporting period could cause shareholders to take gains, erasing much of the stock's recent climb from single-digit prices. A fourth consecutive earnings beat, on the other hand, could propel the stock well into the $20s. 

At this stage, the latter scenario seems more likely.

For starters, The Gap will benefit from having an extra week in the fourth quarter compared to last year, which should boost fourth-quarter sales by $150 million. It won't benefit from Gap China, which it sold to Baozun earlier this year. Factoring these both in, management is projecting flattish revenue for Q4 of $4.2 billion. Analysts anticipate this will translate to EPS of 22 cents, a sharp improvement from the 75-cent loss recorded last holiday quarter.

We won't know fourth-quarter results until February 2024, but there may be clues. Over the next few months, U.S. retail sales data and e-commerce activity will point to how much consumers spent during the holidays. Results from The Gap's closest peers may also be signals.

With seemingly every retailer offering early Black Friday deals these days, The Gap will have plenty of competition. Will shoppers bite on Old Navy's in-store and online-only promos? 

Hard to say. 

Will The Gap do better than 22 cents per share in profits? Based on what they delivered last quarter and the momentum in the business — probably. 

What is the consensus price target on The Gap?

Analyst reactions to The Gap's Q3 report have been all over the map regarding stock ratings. The common thread: no firms have changed their position. Since Friday's release, there have been five buys, three holds and one sell — all reiterations. 

Among the nine, price targets range from $13 to $22. This has pushed the consensus target to approximately $16, below where the stock currently trades. 

Yes, Wall Street continues to be fashionably late to the Gap comeback party. Good news for investors — this means there's still time to try on the clothing retailer.