Widening the Gap

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\"RRHaving followed Gap and Gap Inc. for 25 some years, I’m intrigued with the many growth opportunities the $16+ billion company still provides. As an analyst, I’ve long applied a portfolio approach to Gap Inc.; when one brand is humming another is flubbing— and basically that’s been the case. Gap Inc. is accessible: luxury (albeit boring) at Banana; value at Old Navy; and just-plainclothes- with-a-hint-of-attitude (mostly from good marketing, not so much design) at Gap. Recent acquisitions, along with new global opportunities and a changing industry, begged another look at this behemoth. And I like what I see!

A Short Recap

Birthed in the counter-culture of Haight-Ashbury, San Francisco, The Gap Store arrived in 1969. Amidst the music and psychedelics of the period, Jimi Hendrix, the Grateful Dead and Jefferson Airplane, The Gap Store sold Levis to hippies. By 2014, 45 years later, Gap Inc. is an empire spanning six retail brands with a combined store fleet of 3,565 stores in 48 countries and sales in excess of $16 billion. That’s a lot more than jeans! Along the way, Gap evolved from a third-party retailer to a specialty retail brand dressing babies to Baby Boomers. Corporate siblings include Banana Republic, purchased in 1983 soon after Mickey Drexler, the merchant king, arrived and transformed Gap into an iconic brand beloved around the world. It was under Drexler’s purview that Gap became cool again. Through the 1990s he and his team had a string of successes, including a 10-year revenue CAGR of 22%; and the 1994 launch of value retail brand Old Navy, which grew to $1 billion in sales by 1998—and $3.9 billion by 2000. During the 90s, the Gap brand was synonymous with cool. The marketing promise was best-of-class as Gap used famous celebrities in artistic black-and-white photo shoots to promote the brand. Aspirational by nature, the US mass middleclass market could be cool too, just by wearing Gap.

So cool in fact, that by the end of the decade the classic products Gap made cool—khakis, white shirts, jeans—no longer required the Gap logo. But Dockers, Old Navy—frankly it no longer mattered what brand you chose to wear. The uniform was enough and Gap entered middle age by making cool ubiquitous.

Middle Aged and Boring

By age 30, Gap Inc. hit the wall in time for the new Millennium. A total of 3018 stores generated sales of $11.6 billion in the fiscal year ended January 29, 2000. Same-store sales rose 7% that year and the EBIT margin peaked at 15.6% of sales, the latter not replicated, though the former 7% comp gain was achieved again in FY Jan 2004. Gap Inc. began the Millennium opening new stores, which cannibalized the existing store base; 658 net stores opened in FY2001 (a 31% increase in square footage) and sales per square foot dropped 12% to $482 and comps declined 5%. The following year FY Jan 2002 the drop was a more precipitous 18% to $394 on a 13% comp decrease and an additional 495 net stores. After 19 years with Gap, Mickey Drexler stepped down as CEO, replaced by Disney executive Paul Pressler.

\"shutterstock_164791130\"Stagnant Sales Growth

Under Pressler’s watch, sales peaked in the FY ended Jan 29 2005 at $16.3 billion. Same-store sales for the first decade of the Millennium declined in eight out of ten years, then were flat, then rose 7% in FY Jan 2004 (attributable to merchandise orders placed under Drexler’s reign). Pressler also launched Piperlime, a pure e-commerce play in 2006 selling a curated footwear assortment. Gap Inc.’s current CEO, Glenn Murphy, replaced Pressler in July 2007. While sales still haven’t topped the $16.3 billion achieved in FY Jan 2005, the consensus is for $16.7 billion this year (up from $16.1 billion).

Murphy has brought in designer names, including Patrick Robinson and more recently Rebekka Bay, to spruce up Gap’s fashion quotient while remaining true to its distinctive American roots. He acquired women’s sports apparel brand Athleta in 2008. At the time, it was a catalog and online retailer, but now it operates 71 retail stores. Murphy recently cited Athleta as “on its way to becoming our fourth iconic brand.” Intermix is an upscale contemporary specialty concept (37 stores selling on-trend emerging and established designers such as Stella McCartney, Proenza Schouler, Missoni, Phillip Lim, Rag & Bone, Helmut Lang, and Jimmy Choo). Gap Inc. online sales have grown to 14% of total or $2.3 billion, and Murphy’s made a big push internationally, most specifically into China, where he sees the projected 200 million middle class Chinese (expected by 2020) to be the perfect target market for Gap, Gap outlet and Old Navy. He’s projecting $1 billion in sales in 2017, up from $300 million last year. Since Murphy’s arrival, store fleet optimization (mostly Gap domestic) ensued, with 6 million square feet of selling space eliminated.

The Next 15 Years

At its annual investor day, Murphy rearticulated Gap’s four corporate-wide goals:

  1. Global growth which starts with China.
  2. Omnichannel with a focus on ordering in-store that will improve conversion.
  3. Responsive supply chain.
  4. Seamless inventory.

These four integrated goals support the mission to become the #1 global retail apparel company. Gone are the days of establishing a mega-apparel brand the likes of Ralph Lauren, Giorgio Armani, or… Gap. Today’s shoppers want unique personalized products that reflect their individual fashion viewpoint. With insight captured from selling trends at Intermix and Piperlime (which now sells apparel and accessories as well as footwear), Gap Inc. has the opportunity bring these learnings to Banana and Gap brands, improving assortments and differentiating basic products. Consistent product execution remains an issue, but its responsive supply chain initiatives with strategic vendors will allow for design decisions being made closer to season. This year, Gap Inc. expects to have 50% of its long-lived product on vendor-managed inventory, supporting rapid replenishment and a pull model in fabric based on customer demand. The benefits are manifold: quicker replenishment will reduce lost sales and better match consumer demand on size and color, reduce fashion risk, and improve merchandising execution. Cross-channel logistics and seamless inventory support demand fulfillment at the highest possible margins, increasing full price selling and building brand equity.

On the value front, outlets (the brick-and-mortar channel with its superior returns) are a priority, opening over 200 global outlets in the past five years internationally and more to go. This spring, Gap Inc. brought Old Navy to China with a store and e-commerce in Shanghai. Early indications are positive. Old Navy will benefit from Gap’s learnings over the past four years since it entered the Chinese market and now operates over 80 stores (15 are outlets) in 22 cities and enjoys about 80% unaided brand awareness. Given the Chinese propensity for value, Old Navy prospects are promising. By the end of 2014, there will be 100 stores in China and Gap Inc. intends to grow Old Navy very, very quickly to meet that burgeoning Chinese middle class.

Back to the Future

Meanwhile the domestic Gap brand is enjoying a bit of resurgence with Millennials, though recent sales trends have been weaker than we would like (-5% comp for the first 8 months of FY 14). As Grace Ehlers recently wrote in The Robin Report, “While Gap has been in flux for a decade trying to figure out who it is and who it could be, the Millennial Gap consumer has had a very strong understanding of the brand’s identity and how the brand should continue. And over and over again, in focus groups and style forums around the world, the answer has rung out—bring back the Gap of the 90s and become the classic brand that you were.”

Finally, the next jewel in the Gap Inc. portfolio, Athleta, is right in the sweet spot of the apparel industry with its performance-wear combined with a strong lifestyle element, both attributes that support full price selling. Gap Inc. is opening Athleta stores rapidly to address the growing market for dual-purpose performance apparel, and will end 2014 with 100 stores. And that’s without international expansion. Less expensive (but not by much) and less cheeky than lululemon, Athleta has the potential to be America’s middle market performance brand for women.

Murphy’s decision to depart Gap Inc. (announced October 8) and hand over the reins to Art Peck, longtime Gap veteran and currently President of Growth, Innovation & Digital was a surprise announcement, made in tandem with weaker than expected September comps (flat on a consolidated basis, -3% at Gap Global, +2% at Banana and +1% at Old Navy). Peck seems like the right guy given his 10 years with Gap and his expertise. While not a merchant, his understanding of customers evolving shopping behavior in the midst of the rapid changes of the retail landscape will be a plus. Murphy will stay on through February 1, 2015 working alongside Art and mentoring him in preparations for his next assignment.

In summary, global expansion, focusing on higher margin channels (outlet, online and franchise locations) and omnichannel and supply chain initiatives, will work together to expand EBIT margin, rising from the 12.6% in FY 14 and adding another 150 to 200 basis points over the next few years. Murphy’s departure, lowered EPS estimates reflecting margin erosion and weak sales trends at Gap and a stock market correction provide an attractive entry point for new investors (GPS shares are down 13.0% since the announcement and the S&P 500, down 4.6%). During the 90s, a different Gap Inc. averaged 13.6% for its EBIT margin. Its global competitors, H&M and Inditex (Zara) sport 17.3% and 17.8% EBIT margins and trade at 76.7% and 96.1% respective premiums to Gap Inc. shares, based on forward EPS estimates and October 14, 2014 closing prices.

I see modest margin improvement driven by fabric platforming, shorter lead times, Athleta, and global growth in FY15. Gap Inc. is resilient and serves so many of my own style needs. I would buy the 1969 edition Gap jeans, stop by Intermix for some wicked shoes, and then go buy some Gap Inc. shares (Ticker GPS).

Marie Driscoll is a highly experienced equity analyst focusing on apparel brands, apparel retailers, and luxury goods stocks. She has served in key analytical and business development roles in leading financial research firms. Access to industry leaders, financial acumen, and analytic insight support her actionable investment advice. Marie was recognized three times in The Wall Street Journal’s “Best on the Street” analyst survey, capturing the first place ranking for stock selection in the Clothing & Accessories industry in 2009. Marie started Driscoll Advisors late in 2011, providing consulting services to academia, industry, and non-profits. Previously (2003-2011) she was with Standard & Poor’s equity research department as Director of Consumer Discretionary Retail.



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