Gap is Quietly Evolving


Most retailers had a difficult time in 2015. Between foreign currency headwinds, the West Coast port closure, and unusually warm winter weather it was a difficult environment to operate in. This has left investors wondering who will make adjustments and come back stronger in 2016. The Gap Inc. (NYSE:GPS) is the owner of several brands including Gap, Banana Republic, Old Navy, Athleta, and INTERMIX. It is led by Art Peck who transitioned to CEO February 1st of last year. Art joined Gap in 2005 and prior to being CEO, he was President of the company’s growth, innovation, and digital division. This might explain why so many of the company’s strategies and investments today are around their omni-channel platform and digital shopping experience.

The company is investing in areas of the business that could move the needle in 2016 and beyond. On Art Peck’s first conference call in February, he discussed the company’s initiative of getting its women’s product back on track. There were several issues that were causing women to leave Gap. However, management is adamant that they have identified the issues and they will be resolved. The company made strides in 2015 on adjusting the aesthetic direction of its women’s products. Art and his team have made it clear that they value the opinions of their customers. Fashion trends are changing faster than ever and it’s crucial that they identify them early. Art Peck mentioned that he reads hundreds of customer reviews that help him understand what customers want. Consequently, the company is making product changes especially in the Gap and Banana Republic brands. They are adding more color and will be more disciplined in the fit and quality of products which will drive customer loyalty.

Gap has been investing in its supply chain since 2013 and it is beginning to pay dividends. Gap is now using seamless inventory. This allows the company to use the same inventory for stores and online sales. CEO Art Peck explained that it will result in a higher average unit retail (AUR) because this system allows the company to get the product to the “highest bidder” whether they are online or in a specific store. The company is making itself more flexible and responding faster to customer needs. This inventory management system gives the company the ability to order less inventory initially, test it out with customers, and then respond with what is selling. Not only will this make customers happy but it will also boost sales. In addition, the company is using this model to leverage its omni-channel platform by reducing shipping costs and offering two day shipping to compete with Amazon (NASDAQ:AMZN). Prior to using seamless inventory, there was a ten month lead time before merchandise could actually get on the shelf’s. In 2016, this lead time will be reduced to six to seven months and they will also have flexibility in adjusting merchandise to current trends.

The company has been weighed down over the last year or so by the West Coast port closure as well as foreign currency headwinds. Together these two issues impacted margins by an average of 100 basis points per quarter from Q3 2013 to Q2 2014. This is worth noting because many analysts believe that margins have been in a downtrend and they think it might continue. However, the West Coast port closure is now behind the company and foreign currency headwinds will be eased due to the lag in currency hedging. In my opinion, margins will begin to increase in 2016 and will have plenty of room to expand due to the multi year initiative of investing in the supply chain. Today, gross margins are around 37.5% and I expect them to be closer to 40% five years from now. Operating margins could also move from 10.6% today to around 13% which would be well above the industry average of 11.76%.

Prior to the company’s investor day in June, they announced they would be closing 175 specialty stores in North America and a few stores in Europe. This is an effort to “right size” its store fleet and have an appropriate mix between specialty stores and the more profitable outlet stores. By 2018, the company will have reduced its specialty store count from 685 to 500 and will have opened about 20 more outlet stores in North America. This will bring the outlet store count to 300 in North America. The company believes this is the optimal mix of specialty stores and outlet stores. The net cost of the plan is approximately $150 million and will have annualized savings of $25 million. Closing these stores was a difficult decision for the company but it will create value for investors in the long run.

Although Gap, Banana Republic, and Old Navy get most of the spotlight, I would like to take a second to mention Athleta. This brand is known for its women’s active apparel and it has shown strong growth since being acquired by Gap in 2008. Art Peck was responsible for Athleta when he was President of growth, innovation, and digital. It is important to note that Athleta already uses the seamless inventory system that is being interwoven into the other brands. The brand is also much further along in the digital shopping experience. Athleta grows quickly in both of its sales channels. The digital channel is the optimal channel for growth because Gap doesn’t have to build a store to get the growth. Currently, Athleta only has about 120 stores in North America but I would expect many more in the future. This is an exciting brand that could grow into something special.

Gap Inc’s stock is down about 48% from its 52 week high set back in March 2015. The valuation is very reasonable. Analysts expect the company to make $2.45 a share next year which I deem to be conservative especially given the company’s history of buybacks. The company is on pace to buyback about $1 billion worth of stock in 2015 which equates to them buying back about 10% of the company. I expect them to approve another large buyback program for 2016 since the company generates over $1 billion of free cash flow each year. The stock also pays a nice 4% dividend. Sabrina Simmons CFO has made it clear that they would like to maintain about $1 billion worth of cash. The company made a very savvy move last October by borrowing $400 million in short term debt. I say it was savvy because the interest rate terms are LIBOR plus .75%, which means they are only paying about .50% of interest since LIBOR is currently negative. Having this extra cash gives the company the ability to continue to invest in its self, buyback stock, and keep its large dividend.

On an intrinsic valuation basis, my cash flow model suggests the stock could be worth $30 representing almost 30% upside. My model assumes that after tax operating income will decrease in 2016 and then turn positive in 2017. The stock also appears to be cheap compared to the rest of the apparel industry. Please see the chart below.Gap

Gap trades at a discount on all three metrics. It is particularly cheap using the EV/EBITDA metric at only 4.18 versus the industry average of 9.02. This is incredibly cheap for a company that continues to be very profitable even while its restructuring.

Bottom Line

Art Peck and his team are incredibly bullish on the future of the company. Investors should be excited about the investments and changes that have been made. As we get into 2016, both Banana Republic and Gap have much easier comps. In addition, expectations for the company are incredibility low. With the amount of stock the company has been buying back, sales could remain flat in 2016 and earnings would increase 8-10%. The benefits from the investments in the supply chain are beginning to show up which allows the company to be flexible and respond quickly to new fashion trends. I think investors are overlooking the benefits of having a responsive supply chain. 2016 may be the year that Art Peck’s optimism begins to show up in the company’s financial performance.

As always, thanks for reading!


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