Despite rising by more than 50% over the last six months, Gap (GPS) is still looking fundamentally strong. In this article, I will run you through a DCF model on Gap and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to American Eagle Outfitters (AEO) and Aeropostale (ARO). I find that Gap is meaningfully trading below intrinsic value, despite the assumption of bearish projections.
First, let's begin with an assumption about the top-line. Gap finished FY2011 with $14.5B in revenue, which represented an 0.8% decline from the preceding year. I model revenue conservatively growing 2% over the next half decade or so.
Moving on to the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model operating expenses as 89% of revenue versus 3.4% for capex. Taxes are estimated at 39.5% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model).
We then need to subtract out net increases in working capital. I expect this metric to hover around -1% of revenue over the projected time period. Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 10% yields a fair value figure of $34.87, implying 31.8% upside.
All of this falls within the context of an attractive transitioning to emerging markets and online platforms. As management notes:
"In spite of 2011 earnings being below last year, we actually did make quite a bit of progress against our strategic plan. So we have 2 key initiatives…
The first key initiative is to reduce our dependency on our North American specialty bricks and mortar business. So we did accomplish quite a bit on that front in 2011. First off, we grew our online business of penetration to our total sales by 2 percentage points...
The second area which we made quite a bit of progress is our move to expand our brands internationally. At the beginning of the year, we operate in 31 countries, combination of franchised and company-owned stores, and we ended 2011 by operating in 39 countries. In China, we opened 10 stores. We finished the year with 14 stores and feel very good about the progress we're making in China, particularly in Hong Kong. And in 2012, we have a plan right now to open 30 stores".
From a multiples perspective, Gap is equally as attractive. It trades at a respective 16.9x and 12.9x past and forward earnings versus 22.3x and 13.9x for American Eagle and 25.4x and 15.2x for Aeropostale. Assuming a multiple of 16.5x and a conservative 2013 EPS of $2.04, the rough intrinsic value of Gap's stock is $33.66 - virtually in-line with my DCF result.
Consensus estimates for American Eagle's EPS forecast that it will grow by 24.4% to $1.07 in 2013, and then by 15.9% and 18.5% more in the following two years. Assuming a multiple of 16.5x and a conservative 2013 EPS of $1.21, the rough intrinsic value of the stock is $19.97, implying just 16.2% upside. This is not enough upside, in my view, to merit calling the investment a "value play". While the 2.6% dividend yield and upwards revisions to EPS helps eliminate some of the downside, the risk/reward looks weak compared to Gap.
Consensus estimates for Aeropostale's EPS forecast that it will grow by 33.3% to $1.20 in 2013, and then by 18.3% and 21.8% in the following two years. Assuming a multiple of 16.5x and a conservative 2013 EPS of $1.39, the rough intrinsic value of the stock is $22.94, implying very little upside. With the stock offering no dividend yield and greater volatility than American Eagle, I expect more investors to abandon the company in the near-term - the 14% greater volatility than the broader market makes this strong brand a risky investment in the light of its higher multiples.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.