S&P Global Ratings raised its debt ratings on Gap Inc. reflecting improving operating performance, strengthening credit metrics, and supported by a favorable macroeconomic backdrop.

S&P Global raised its issuer credit rating on Gap Inc. to ‘BB’ from ‘BB-‘, and the rating on the company’s senior secured notes to ‘BB+’ from ‘BB’.

The rating agency said strong operating results at Old Navy and Athleta led to solid topline growth during the most recent quarter, with comparable sales increasing 12 percent above 2019 levels.

S&P said, “We believe continuing momentum at these brands will enable the company to reach its recently revised sales target of approximately $18 billion this year, roughly 10 percent above 2019 levels. Further, efforts to reposition the company’s mature brands, Banana Republic and Gap Global, for profitable growth are progressing, in our view. The company continues to close unprofitable stores and is on track this year to close 75 percent of the 350 Gap Global and Banana Republic North American stores slated to close by the end of 2023. We also believe the company’s performance benefited from stronger consumer demand as improved mobility contributed to increased consumer spending on apparel. Rebounding profitability, good free cash flow generation and conservative cash management have strengthened the company’s credit protection metrics. Based on these improvements and our updated forecast, we revised our financial risk profile assessment to intermediate from significant.

“Gap Inc.’s merchandising and marketing initiatives are resonating with customers that have been eager to spend on apparel. Successful product assortments, ramped-up marketing and reduced discounting are fueling Gap Inc.’s solid operating performance. Old Navy, Gap Inc.’s largest brand, generated comparable sales of 18 percent during the most recent quarter compared to 2019, driven by strength in its value-focused, diverse apparel offering. We believe the recent launch of the brand’s BODEQUALITY initiative, which expands its women’s apparel line to a wider range of sizes, can serve as a key growth channel and position it to achieve its 2023 sales target of $10 billion.

“Athleta, the company’s fastest-growing brand, is well situated in the growing activewear apparel segment. In our view, heightened brand awareness from recent high-profile partnerships, footprint expansion, including its entry into Canada this year, and ongoing digital investments will support sales approaching $1.5 billion this year, on track to meet its $2 billion target by 2023.

“Comparable sales at Gap Global grew 3 percent during the quarter vs. 2019 levels, driven by better inventory and enhancements to the customer experience both in stores and online. We believe the changes being implemented within its European business, including shifting to a partnership model and shuttering its stores in Ireland and the U.K., will benefit margins and enhance profitability over time.

“Performance at the Banana Republic improved sequentially, but comparable sales trends remain negative relative to 2019. The brand’s focus on occasion wear has contributed to its slower recovery. We believe efforts to restore relevance will take time and pricing strategies may encounter resistance from a customer base accustomed to discounts and promotions.

“Topline trends and expense reduction initiatives are driving operating margins higher but operating risks remain and we expect competitive dynamics will intensify. We believe Gap Inc. is making progress towards achieving its goal of expanding its operating margin to 10 percent by 2023. Operating income rebounded significantly this quarter, benefiting from sales recovery, higher merchandise margin, and reduced store expenses. Digital sales growth, store closures, and lower rents enabled the company to better leverage its fixed costs. Additionally, a less promotional environment and tighter inventory resulted in less discounting across all of Gap Inc.’s brands, leading to more than 100 basis points (bps) of merchandise margin expansion compared to 2019. We expect Gap to continue to invest heavily in its omnichannel capabilities as digital sales growth remains elevated. The company’s ability to reduce fixed costs, expand product margins, and drive sales volume on a sustained basis will be critical to offsetting the structural cost pressures that accompany the sales channel shift to online.

“While the company’s sales and margin targets are achievable in our view, fashion misses (which have hampered performance in the past) and heightened competition from both established and new entrants could pose challenges. Operating conditions also remain in flux as the spread of the Delta variant has led to a surge in COVID-19 cases and rising hospitalizations. Supply chain headwinds, inflation, and rising wage pressure are additional challenges that Gap Inc. will need to navigate. We still believe Gap Inc. is susceptible to downside risk in light of its highly discretionary merchandise offering, still-elevated exposure to mall traffic, and ongoing turnaround initiatives at its mature brands. As a result, we continue to apply a negative comparable rating analysis modifier.

“The positive outlook reflects the potential for a higher rating if Gap Inc. can sustainably expand the sales of its higher-growth, more-profitable brands and strengthen relevance at its mature brands while maintaining its existing conservative financial policy.”

Photo courtesy Athleta/Robin Vieira