As one of the first national specialty apparel retailers, Gap (GPS) benefited early on from a number of advantages, including size, brand recognition, and long-standing relationships with landlords and vendors. However, given the lack of barriers to entry in the space, and an easily replicable merchandising strategy, this lucrative business attracted competition from all fronts. As Gap's brands fell out of favor, store productivity and merchandise margins plummeted. Therefore, Gap's lease-adjusted returns on invested capital have fallen to the low-teens range in recent years, down from the high teens in the late 1990s. While we believe the retailer's current efforts to reposition brands should yield positive results over the next few years, we are not convinced that Gap can consistently sustain excess returns in the long run, given the lack of product differentiation. Additionally, we anticipate that the competitive landscape will continue to heat up, thanks to the rising popularity of fast-fashion retailers like H&M, Forever 21, and Inditex. As a result, Gap's structural advantages no longer appear sufficient to support a narrow economic moat. In our view, specialty apparel retailers have to possess both a structural advantage and product differentiation in order to consistently generate returns in excess of their cost of capital over the long run.
Gap Does Not Possess Product Differentiation
Breaking away from the traditional department store format, Gap emerged as one of the first national specialty retail chains in the United States in the 1990s. By offering differentiated stylish-yet-affordable basic apparel that appeals to the masses, the firm built itself into an impressive 3,000-store empire, with annual revenue increasing more than sixfold to $14 billion in fiscal 2000, up from just $2 billion in 1990. During that period, many believed that Gap had established a portfolio of seemingly infallible brand names including its namesake label, Old Navy, and Banana Republic, which captured a broad spectrum of consumers at different income levels and ages ranging from infants to adults. So why did Gap fail to maintain its brands?
The answer is simple. The business model was easy to replicate, and the bigger Gap grew the harder it was to have a clear identity. Without superior technology or structural advantages tied to its merchandise, competitors could easily mimic Gap's designs and marketing strategies. Additionally, given the lack of barriers to entry and minimal switching costs in the apparel retail industry, it was not difficult for other specialty retailers like J. Crew (JCG) teen retail chains like Abercrombie & Fitch (ANF), and mass merchants like Target (TGT) to steal a piece of this lucrative market from Gap. To make matters worse, Gap lost its brand identity along the way as it veered away from signature basics into younger and trendier fashion clothing, which left its core customers neglected. As a result, Gap suffered five consecutive years of revenue declines from fiscal 2005 to 2009.
In our view, it is exceptionally difficult to build an economic moat based solely on perceived brand differentiation in the specialty apparel space. This was also our primary reason for removing Abercrombie & Fitch's narrow economic moat in mid-2009. Therefore, despite believing that popular chains such as J. Crew, Urban Outfitters (URBN), and Lululemon (LULU) will post phenomenal returns on invested capital in the near term, we remain hesitant to say that they have built economic moats, given the highly cyclical nature of the specialty apparel industry. Currently, Inditex is the only specialty apparel retailer in our coverage universe with a narrow economic moat, where its competitive advantages are based primarily on its vertically integrated business model. Unlike Gap, we believe Inditex possesses product differentiation that is sustainable, built upon the firm's ability to design, manufacture, and stock the stores with the latest fashion trends in a short amount of time (two weeks compared with the six-month industry average) and at much lower price points compared to its peers.
Gap Faces Intense Competition in Domestic and International Markets
Despite our belief that Gap's near-term results will benefit from current efforts to build a clearer identity across all three chains, we don't think the firm can sustain meaningful revenue growth over the long term. In our view, increasing popularity of fast-fashion chains, which offer the latest trends at lower prices, threaten to steal a piece of Gap's already shrinking market share in the specialty apparel space. As shown in the graph below, sales at fast-fashion retailers like Inditex and H&M have surpassed Gap in recent years and will likely continue to do so in the future. With only about 200 H&M stores and 50 Zara stores in the U.S. currently, we project that these retailers have plenty of room for growth in the domestic market and could place significant pressure on Gap's top line and merchandise margins over the long term. Additionally, we think one of Gap's biggest challenges is that it has overexpanded its store base. While Gap's size has allowed the firm to benefit from economies of scale, we believe it has started to work against the retailer. In our view, Gap's large store base limits its ability to tweak product lines swiftly when compared to smaller, nimbler firms like Urban and J. Crew. In our view, this puts Gap at a disadvantage as demand in the specialty apparel market is largely driven by a retailer's ability to keep up with fast-changing trends. And with consumers increasingly looking for individuality in their wardrobe, the ubiquitous nature of Gap's merchandise may be less appealing to today's consumers, as we agree with Urban Outfitters' founder Richard Hayne's idea that "big is the enemy of cool" in the specialty apparel market. (Click to enlarge)
Given Gap's struggles in the U.S., it is hard for us to believe the firm will succeed as it expands into more fashion-forward markets like Europe and Asia, where competition is intense. Although Gap has gained some initial popularity in select markets in Asia by marketing its Western appeal to consumers, we believe the firm will have to work hard to retain these customers by differentiating itself from existing casual apparel brands in the region such as Giordano's and Uniqlo, which have 1,800 and 800 stores, respectively. In our view, Gap will have to offer something unique and constantly keep up with the latest trends in different regions in order to attract customers into the stores. Furthermore, Gap will be bumping up against the largest specialty retailer, Inditex, which boasts of short inventory lead time in bringing the latest fashion trends to its stores. And with less than 500 stores outside of North America, Gap pales in comparison to Inditex's retail distribution network of 3,400 stores excluding U.S. and Canada. As a result, we project that it'll be difficult for Gap to consistently generate returns in excess of its cost of capital over the long term.
Gap's Structural Advantages Are Insufficient to Support a Narrow Economic Moat
Given Gap's massive purchasing volume, large store base, and favorable relationships with real-estate managers and suppliers, the firm continues to benefit from cheaper rent and lower product costs. Over the past five years, Gap's rent per square foot has averaged $27, compared with other retailers that have rent per square foot in the $35-$40 range. However, it is important to note that, while part of Gap's lower rent can be attributed to scale, we think it is also because a good proportion of its stores (mainly Old Navy) are located in strip malls and other less expensive locations. In our view, cheap rent is only beneficial to the firm if these stores can drive sufficient sales volume, which hasn't been the case in recent years. Additionally, the weakening of Gap's brands, as discussed previously, has further pressured store productivity and margin levels, keeping them below historical averages. In 2009, Gap's average sales per square foot was only $340, down significantly from $430 in 2004. Given a weaker top line, the firm has not been able to translate these cost advantages into superior returns, with a median return on invested capital of 12.6% over the past five years, compared with 18.6% for the other specialty apparel retailers in our coverage universe. Therefore, we believe changes in the competitive landscape have hampered Gap's ability to realize meaningful benefits from its lower cost structure, and it is no longer sufficient to support a narrow economic moat.
We Believe Gap Is Fairly Valued
Our fair value estimate of $20 per share implies forward 2010 fiscal-year price/earnings of 12 times, enterprise value/EBITDA of 4.8 times, and free cash flow yield of 8.6%. At a current market price of $22 per share, we believe the stock is fairly valued. In our view, the firm should deliver meaningful improvements in its top-line growth and profitability in the near term, as it benefits from better merchandising and improving spending trends. However, we think there is limited upside over the long term, as the firm will likely have a tough time fending off rivals in the specialty apparel space, since nothing has fundamentally changed in Gap's business model. Additionally, we believe Gap has saturated the domestic market, and the firm's future growth is contingent upon the success of its expansion abroad. However, faced with formidable rivals like Inditex and H&M, it will probably be an uphill battle.
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