Gap's Identity Crisis vs. J. Crew's Smooth Sailing

Includes: GPS, JCG
by: Bill Allen

With the financial media focused on The Gap (NYSE:GPS) this past week and the resignation of CEO Paul Pressler, it may be a good time to discuss the long-term bull case for J. Crew (JCG), whose current chief was Pressler's predecessor.

The Gap's difficulties deserve their own article, but I will quickly recap the company's history to provide some perspective. Don and Doris Fisher founded the company in San Francisco in 1969 as a retailer of Levi's jeans, gradually adding over a dozen other brands to its inventory. Seeking merchandising talent, the Fisher's hired Millard "Mickey" Drexler from Ann Taylor in 1983, and Drexler quickly changed the firm's retailing strategy by consolidating its retail brands into the private-label Gap line, expanding store locations, and providing basic yet classic clothing for customers.

Although sales exploded in the 1980s and early 1990s, Gap executives had the business acumen to open the lower-priced Old Navy chain in 1994, as revenue growth slowed in their core Gap brand. Old Navy became a huge success, but in 2002, facing new competition, unsuccessful merchandise changes, and tension between Drexler and the Fisher family, the Gap pushed Drexler out the door and hired Pressler. This article from NY Magazine also notes Drexler's lack of attention to the fundamental operations and financial management of the firm, and states that Drexler remained (remains?) angry regarding his treatment by Fisher and the Gap's board.

Pressler's financial savvy, however, couldn't overcome the company's merchandising missteps, negative perception of its clothing and increased competition from specialized retailers. The firm also suffered from an exodus of talented executives, including Maureen Chiquet noted in this recent Business Week story.

Unable to stem declining sales, Pressler resigned, with Robert Fisher (son of the founders) assuming an interim leadership role. Although the Gap hired Goldman Sachs (NYSE:GS) as an advisor last fall, Fisher recently downplayed the possibility of taking the firm private. With minimal debt, $2B in cash, a 30+% ownership stake and family pride, the Fishers may try to resurrect the business. While anything's possible, I'd probably throw Gap stock into the Charlie Munger "too hard" pile.

Drexler to the Rescue
In early 2003, Texas Pacific Group (TPG), a large J Crew shareholder since 1997, hired Mickey Drexler to replace then-CEO Ken Pilot and Chairwoman/Founder Emily Woods. One of retailing's great brands, J Crew had poorly managed its merchandise selection and inventory, lacked focus on customer service, and failed to stand out among other retailers. Hoping to salvage its investment, TPG hired Drexler to revitalize the company.

Drexler quickly began rebuilding the J Crew brand, simplifying merchandise lines, uncluttering stores, selling limited quantity, higher priced items, and improving customer service. He also hired several former Gap colleagues who provided management/operating depth and complemented his leadership skills - including former Old Navy Executive VP Jeff Pfeifle and Gap Senior VP Tracy Gardner. Although the company required a few years to implement its new product lines and operating strategy, Drexler eventually restored the firm's credibility with the American consumer and the investment community. Burdened by over $500 million of debt at double-digit rates, he overcame a delayed IPO in 2005 to issue public shares in the summer of 2006, raising $400 million to extensively repay its borrowings and refinance the remaining $250 million at 7%, dramatically reducing J Crew's interest expense. This past month, the firm retired another $50 million.

Make no mistake, J Crew is an expensive stock, trading at over 30 times earnings in a competitive marketplace amidst a potential spending slowdown.

However, I believe that the firm has begun a significant, multi-year growth period in which the company could double its store base while gaining significant operating leverage and economies of scale through improved product sourcing and inventory management. J Crew recently invested a seven-digit sum for information technology upgrades to centralize inventory management and analyze product demand. It can spread this cost over multiple sales channels - full price retail store, outlets, catalog and Internet sales - while reaching consumers in their preferred shopping environment. Also, although in its infancy, the company has initiated the development of several complementary brand concepts -Crewcuts for kids (currently located within J Crew stores with 2 standalone sites), and Madewell, initially selling casual women's clothing - that will benefit from management's previous experience at the Gap.

Zooming Past Competitors

The superior execution of Drexler's management team has already resulted in double-digit sales and profit increases during the last year, and a currently expensive stock could become much cheaper. While Abercrombie (NYSE:ANF) and American Eagle (AEOS) face increased inventory and higher working capital requirements, J Crew has decreased its inventory needs relative to sales, increasing turnover and freeing cash for debt repayment and store expansion. Differentiating itself further from its competition and establishing increased brand equity, the company has introduced specialized clothing lines for women and formal merchandise for men. It possesses an understated multi-year lead in establishing a store base and brand for adults seeking high quality, classic apparel.

In comparison, American Eagle's current rollout of the Martin+Osa brand (targeting adults in their 30's/40's) will require substantial capital and heavy promotion. Lastly, with a little over 200 J Crew and outlet stores combined, the company can pursue methodical expansion of 25-30 stores per year through the decade.

J Crew's customer service has also greatly improved, strengthening consumer loyalty. Moreover, while the firm traditionally focused on women's clothing (comprising 66% of sales last quarter), its recent emphasis on comprehensive clothing lines allow for real expansion in men's wear sales growth. Operating margins, currently 12% of sales, could easily expand to 15-18%, matching Abercrombie's. The firm has a history of exceeding its earnings guidance, currently $1.20/share for 2007. Assuming 18% sales growth, 20% EPS growth, greater operating leverage through better sourcing, and debt reductions, JCG earnings could approach $1.80-$2/share in the coming years, reducing the forward earnings multiple to under 20.

Drexler is also highly motivated to maximize shareholder returns. He chose to receive much of his compensation in company equity in order to build a large ownership position in J Crew. Upon the company's IPO and conversion of convertible stock, Drexler now holds nearly six million shares, or 10% of the company. He did not participate (sell) in the firm's recent secondary offering, choosing to maintain his current holdings. Fidelity recently initiated a 12% stake in the company.

Possible Investment Issues
What could derail my thesis? A deeper housing and economic slowdown combined with increased energy prices and inflation for basic goods - over which the Fed has recently expressed some concern - could dent the earnings of all retailers. Those with higher multiples such as J Crew would bear the brunt of any difficulties. Merchandising mistakes could occur, leaving the firm with rising inventory levels and increased markdowns, but with the existing management in place, I believe this to be unlikely. Also, the company caught the market offguard twice in the last few months, first announcing the resignation of Emily Woods from the board and recently noting that TPG would sell one-third of its 21+ million share stake. However, TPG retains 12.1M shares in the firm (18% fully diluted), which I expect will remain a long-term investment.

Unlike the Gap and other mature retailers, J Crew will not suffer from an identity problem; it will remain focused on the evolution of its traditional offerings that have differentiated the firm for over 20 years. It can clearly communicate its brand to the consumer through its merchandising strategy and customer service. J Crew's business execution will propel the company to superior profitability and an enhanced reputation through the decade. Any decline to below $35/share should be considered a long-term investment opportunity.

“I love to work...I have a passion for what I do.” - Mickey Drexler

Thanks for your time, and I welcome all feedback.

Disclosure: Author is long JCG

Sources: Gap Gets Out of Groove Facing New Generation, James Hall; also for a basic overview, please see Can the Gap Be Saved?, USA Today and concerning its business and leadership troubles, Gap Is in Need of a Niche-NYTimes, Gap Seeks Rescue CEO-SJ Mercury, and Gap Needs a CEO-WSJ.  NYMag article regarding J Crew - Mickey Drexler's Redemption

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