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I Feel Bullish on The Gap

August 15, 2014 | About:
ovenerio

ovenerio

4 followers

Apparel brands are increasing their focus on new product lines, e-commerce, investments in company-owned retail, as well as international expansion. In this article, let's take a look at one apparel retailer in a better consumer spending environment in most major markets.

A well-known brand

The Gap, Inc. (GPS) is one of the most popular brands in the U.S. apparel sub-industry.This specialty apparel retailer operates Gap, Banana Republic and Old Navy stores, offering casual clothing for the moderate, upscale and value-oriented markets.

Gap has a solid history in the industry because it is one of the longest-retail stores and offers its products to a wide range of people of any age. Having a multitude of customers, Gap grew a lot in the past and became the largest specialty apparel retailer in the U.S.

The firm has a fierce competition and that has affected its revenue growth. An example is the international firm Inditex, which is one of the largest fashion retail groups in the world with eight brands and over 6,300 stores in 87 markets.

International expansion and others

The company plans to benefit from its international expansion strategy, reducing its dependency on North America and opening stores abroad. New markets in Asia offer a new audience and could help leverage operating expenses, which are also in plans to be reduced. Additionally, it plans a reduction in weak-performing stores in the U.S.

Another key driver for the company comes from the growth in the direct-to-consumer business. Marketing and merchandising strategies that began a few years ago were effective to keep it on track.

Further to the international expansion, supply chain improvements and e-commerce sales make the firm take a better position to compete with other fast-fashion retailers like H&M.

Shareholder´s wealth

The company will generate $6 billion in free cash flow over the next five years, and this will probably be returned to shareholders via dividends and share buybacks. The current dividend yield is 2%, and it has paid dividends since 1976.

Revenues, margins and profitability

Looking at profitability, the company's revenue seems to have hurt the bottom line, decreasing earnings per share. The retailer reported earnings per share of $0.58 for the first quarter from $0.71 for the same quarter the previous year. During the past fiscal year, it increased its bottom line by earning $2.75 versus $2.32 in the prior year. This year, Wall Street expects an improvement in earnings ($2.93 versus $2.75).

Finally, let´s compare the best measure of performance for a firm's management: the return on equity. The ROE is useful for comparing the profitability of a company to that of other firms in the same industry.

Ticker

Company

ROE (%)

GPS

The Gap

41.8

AEO

American Eagle Outfitters, Inc.

7.12

TJX

The TJX Companies, Inc.

50.53

 

Industry Median

9.02

The company has a current ratio of 41.8% which is higher than the one exhibit by American Eagle Outfitters (AEO). In general, analysts consider ROE ratios in the 15-20% range as representing attractive levels for investment, so the ROE of The Gap, Inc. (GPS) looks very attractive. For investors looking for a higher ratio, The TJX Companies Inc. (TJX) could be the option. It is very important to understand this metric before investing and it is important to look at the trend in ROE over time.

http://www.gurufocus.com/chart/GPS#&serie=,,id:undefined,s:undefined,,id:ROE,s:GPS&log=0&per=0"> src="http://chart.gurufocus.com/1408068671256.png" />

Relative Valuation

In terms of valuation, the stock sells at a trailing P/E of 16.2x, trading at a discount compared to an average of 23.5x for the industry. To use another metric, its price-to-book ratio of 6.1x indicates a premium versus the industry average of 2.12x while the price-to-sales ratio of 1.2x is above the industry average of 0.8x.Two metrics indicate that the stock is relatively undervalued and seems to be an attractive investment relative to its peers.

As we can see in the next chart, the stock price has an upward trend in the five-year period. If you had invested $10.000 five years ago, today you could have $27.011, which represents a 22% compound annual growth rate (CAGR).

1408067482344.png

Final comment

As outlined in the article, aspects such as the opportunities in new markets, the growth in the direct-to-consumer business and marketing and merchandising good strategies make me feel more confident on my bullish sentiment.

Moreover, the relative valuation and the return on equity that significantly exceeds the industry median look very attractive for investors.

Hedge fund gurus James Barrow (Trades, Portfolio), Ray Dalio (Trades, Portfolio) and Chuck Royce (Trades, Portfolio) added this stock to his portfolio company in the second quarter of 2014, and I would advise fundamental investors to consider adding this stock to theirs as well.

Disclosure: Omar Venerio holds no position in any stocks mentioned.

About the author:

ovenerio
We provide independent fundamental research and hedge fund and insider trading focused investigation.

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