The Gap (GPS, Financial) is now by far one of the largest and most recognized apparel retail companies in the world. The company sells clothing, accessories and style products for men, women and children under five brands: The Gap, Banana Republic, Old Navy, Athleta and Intermix. The company currently has over 3,500 company-operated and franchise store locations in the United States, Canada, the United Kingdom, France, Ireland, Japan, Italy, China, Hong Kong, Taiwan, Asia, Australia, Europe, Latin America, the Middle East and Africa. The company has been compiled over the years from an assortment of internally developed retail stores and well recognized external acquisitions including Banana Republic and Athleta. The company’s diversified brand portfolio and broad international reach without question helps to stabilize its earnings stream in the highly volatile and “faddish” global retail marketplace. In addition to its retail outlets, the Gap also sells its products to customers online. Most of its products are designed in the U.S. and manufactured by independent sources in China. Some products are designed and manufactured by third-party companies, especially for its Intermix brands. Sales of Gap products now account for 38% of total company sales; Old Navy products account for 40% of sales; and Banana Republic products account for 18% of sales. The company’s online presence continues to grow and has become more strategically integrated into its future sales strategy. Customer surveys have indicated that shopping through Gap online has become very easy. Customers can easily see what products are in stock, add them to their shopping baskets, request delivery at various speeds and, importantly, pay the online price.
Financial highlights
The Gap continues to benefit from a combination of the global economic recovery and a series of acquisitions and international expansion initiatives to hold a slightly positive growth trajectory in a business that has struggled to find new sources of growth and that most investors have given up on. Net sales for 2014 increased 2% but decreased 3% year-over-year in the first quarter 2015 due to unfavorable currency impacts and a decrease in net sales at Gap and Banana Republic, partially offset by an increase in net sales at Old Navy. The unfavorable currency impact was primarily due to the weakening of the Japanese yen and Canadian dollar against the U.S. dollar. Comparable Q1 2015 online sales favorably impacted total company comparable sales by 1% and 3% in the first quarter of fiscal 2015 and 2014, respectively. Excluding the impact of foreign exchange, net sales decreased 1% and comparable store sales decreased 4% for the first quarter of fiscal 2015 compared with the first quarter of fiscal 2014. GPS closed approximately 1% of store locations in Q1 2015.
Operational improvements in procurement and supply chain efficiencies, combined with improved merchandising and purchasing discounts helped the firm generate gross profits of $1.4 billion in Q1 2015, down slightly from $1.5 billion in Q1 2015. Operating margins fell slightly to 10.6% from 11.7% over the same period. Net income for the first quarter of fiscal 2015 was $239 million compared with $260 million for the first quarter of fiscal 2014. Net margins have averaged 7.6% over the last 12 months after reaching a high of 7.9% in 2014, and hold steady way above recessionary levels of 4.9%. The market expects earnings per share of $2.76 for the full year 2016 and $3.05 for the full year 2017. Margins are expected to hold steady as retail price competition and discounting remain substantial. The company continues to invest in itself, distributing $329 million to shareholders through share repurchases and dividends.
Purchase considerations and reasons for caution
Perhaps it is understandable that most investors perceive the Gap and the company’s brand lines to be yesterday’s news, as new more popular and more fashionable brands have come to market. This is largely true –Â new players have captured an increasing share of the market –Â but the company is not dead yet and has tremendous success historically at developing new brands for style-conscious and experience-conscious shoppers. The company continues to upgrade profitable stores and close unprofitable stores. It is always attempting to make its merchandise assortments more exciting, and costs remain well under control. Marketing efforts are being well targeted and are more appealing and focused than in the past and are aimed at reinvigorating appeal among younger and older generations. The Gap is not just a casual and mid-upper line apparel store anymore. The company has managed to enter the sporting apparel market with Athleta, and it is hoped that traction will continue to build in this area. The international economy, however, remains a point of risk, and any decline in employment or increase in mortgage defaults, increase in taxes, or change in any other factor that squeezes consumer disposable income could hurt sales. The stock’s Beta of 1.31 captures the economic sensitivity of this position. The company also relies heavily on promotional discounts and special sales to support revenues, which among many customers has become the only time they buy from GPS; other than Old Navy consumers, we estimate that at least a quarter of consumers only buy during sales periods and don’t ever pay full retail price. Additionally, free shipping promotions on Gap.com and a no-questions return policy could hurt operating margins moving forward if a greater proportion of store buyers switch to making online purchases. It is also not possible to deny that the Gap product line has lost some appeal among the younger generation and high price points at Banana Republic has pushed some customers to cheaper alternatives. Management must continue to focus on reversing these trends and work to achieve absolute marketing excellence.
Fair-value estimation
A company’s fair value estimate can be calculated as the present value of expected future free cash-flows to equity. Free cash-flows to equity represent the amount of cash-flows available to common stockholders after all operating expenses, interest and principal payments to lenders have been paid and necessary investments in capital equipment and working capital have been made to maintain and grow operations.
Here we estimate fair value in five steps:
- we forecast the firm’s free-cash flows to equity for the next 10 years using econometric processes;
- we discount those cash-flows to the present;
- calculate a terminal value for the firm 10 years out based on a long-term expected growth rate and terminal discount rate and discount it to the present;
- add the discounted terminal value to the discounted value of free-cash flows to equity over the next 10 years; and
- divide the present value of all cash-flows by the diluted number of shares outstanding.
Figure 1 presents our free-cash flow estimates. Figure 2 presents valuation results and Monte Carlo Simulation results.
Figure 1: Free cash-flow estimation
Figure 2: Valuation estimate and Monte Carlo simulation results
Conclusion
GPS’s per share earnings in 2015 were $2.87. Historical earnings per share grew at an annual rate of approximately 9% per year since 2005. GPS’ sales per share in 2015 were $37.35. We project that sales will grow at a blended rate of about 2.5% per year between 2016 and 2025. We expect slight operating and net margin compression. Interest expenses will remain minor. Capital expenditures will remain at recent historical levels in the amount of approximately 4% of sales. Our fair value estimate of GPS equals $45.19. At a current price of $35.86, this suggest that GPS is underpriced by about 26.0%. Also, based on a pure Monte Carlo simulation, there is a 71% probability that the company's true underlying fair value exceeds the current market price. While not a strong buy opportunity, and while we do anticipate needing to be patient on this one, consistent with morningstar’s 4-star undervaluation rating, we do think that GPS provides a sufficient margin-of-safety to qualify for investment.
