Gap: Leveraging Cash Cows And Future Stars To Stay Ahead

Summary

• Gap Inc. has been able to survive the retail onslaught in recent years through investing in its best sellers and cutting out the under performers.
• While retailers across the country close hundreds of stores each year, Gap has increased its store presence while maintaining growth.
• Old Navy and Athleta balance each other to create both consistent and aggressive growth.

For traditional retailers, there have been a number of issues that have resulted in decreased foot traffic, sluggish sales, and store closings. At high end retail stores including Nordstrom (JWN) and Neiman Marcus, consumers have lost the desire to pay price premiums for luxury goods that can be found elsewhere for much cheaper. It's evident in the regression in financials for Nordstrom that consumers just aren't buying into the luxury department model anymore. EBITDA growth for Nordstrom has sputtered as the department store struggles to find new ways to draw in customers to its selection of luxury products.

Gap, Inc. (NYSE:GPS) has never seemed like a very sexy business. Most consumers know of Gap for its Old Navy Brand, a clothing and accessories company that sells relatively inexpensive goods and has been the main driver of revenue for Gap. However, it also owns notable subsidiaries including Banana Republic and the fast growing Athleta. Many retailers have faced poor performance from racking up excessive debt, opening stores in areas with low foot traffic, and a lack of competitive marketing. However, Gap has stuck to a simple strategy of monitoring and cutting out under performers, placing stores in areas with high foot traffic, and sticking to its core business of offering value and quality products to its customers. There are several areas of Gap that make it a long term play for the next 12 months going forward.

Investing in the Winners, Cutting out the Losers

Gap's best selling brand continues to be the Old Navy line, and Gap plans to open 60 more Old Navy locations in North America and will reinvest in its current locations through store renovations throughout the year. At the same time Gap will also be closing up to 200 of its struggling Banana Republic locations over the next two years.

What's different in Gap's strategy is that they are not just cutting costs like traditional retailers who attempt to stay afloat by selling their assets. Instead, Gap is selling off poor performers like Banana Republic, gaining capital from the asset sales, and then using the capital to reinvest in its growing and successful business divisions. This results in an increase in the asset base versus just using cash from asset sales to pay off creditors from heavy debt financing that other retailers have gotten themselves into.

Declining sales from Banana Republic have been apparent for several years amid stiff competition from "fast fashion" retailers H&M and Forever 21 that have seen explosive growth recently. Old Navy comparable sales store growth trailing twelve months is about 5.4% with annual sales per store at approximately $5.4M. Banana Republic comparable sales store growth trailing twelve months is about -3.7% with annual sales per store at approximately $2.4M. Target square footage for Old Navy is 15,000 square feet compared to 8,000 square feet for Banana Republic. That means Gap is generating $360 per square foot at Old Navy versus $300 per square foot at Banana Republic. The store productivity and comparable sales growth makes it a clear decision to invest in Old Navy to drive revenues higher.

eMarketer Inc, 2018.

However, despite the growth from Old Navy, Gap has recognized the need to diversify and has invested heavily in its fitness lifestyle brand Athleta. It's part of a larger effort by Gap to start investing into more niche markets that may provide higher growth than its traditional business divisions. Gap acquired Athleta in 2009 and has taken it from its online-only model to include brick-and-mortar stores in an effort to challenge Lululemon. CEO Art Peck did not disclose Athleta's exact sales growth but said it was in the "mid teens to mid twenties" throughout 2017. After estimated store openings this year, Athleta locations will represent approximately 5% of Gap Inc's total stores, leaving Athleta much room to grow in the future.

After slugging 2016 and 2017 performances, Gap's financials are back on an uptrend. Earnings per share rose from $1.69 in 2016 to $2.16 in 2017. Quarterly EPS looks strong as well with recent EPS reportings of $0.53 in Q1 2018 and consensus estimates of $2.45 for FY 2018, an increase of 11.8%.

Though much of Gap's revenues are concentrated in the low margin, value branded Old Navy line, margins appear to be coming off a 2 year trough. Gap gross margins were 36% for 2016 and 2017 but rose to 38% in Q1 2018. With the investment and increase in revenue concentration in the expensive and high margin Athleta line, Gap could see continued margin improvements going forward in 2018.

Refocusing the Retail Presence to Outlets and Online

The traditional indoor mall format appears to be disappearing. Though Gap plans to add 60 Old Navy stores in the next year, the majority of these will be focused on open-air plaza locations such as shopping outlets with similar stores. Many retail stores are clustered in traditional malls that have seen a fall in foot traffic.

The traditional indoor shopping mall has been slowly shrinking. It's expected that 50% of indoor shopping malls operating today will be gone by 2023. Inversely related to the decline of indoor shopping malls is the rapid rise of open-air plaza shopping centers. These new shopping centers combine specialty grocery stores, outlet stores, and restaurants. For example, in Miami, the struggling Sears property at Aventura Mall will be replaced with a massive, open-air plaza that spans 12 acres. Zach Winkler, the developer, said, "Plans like Esplanade Aventura are sign's of retail's evolution into a more experience-driven industry."

Gap's strategy to place its new Old Navy and Athleta stores in these open-air plazas allows Gap to capitalize on shifting trends and not only capture growth from their customer base but also the consumer preference to shop at these venues. It's not just growing the individual brands that will help a retailer succeed, it's also placing those successful brands in vehicles that will even further accelerate them. Vehicles such as open-air plazas seem to be the answer.

Along with the shift into open-air plazas, Gap is also leveraging the online selling power of Athleta. Active wear and "athleisure" clothing has transformed into one of the major apparel segments. It now represents 17% of the entire apparel market, and its total size is growing at about 16% CAGR.

The Athleta brand has competed effectively with Lululemon (LULU) and is the leading player in the online active wear market space.

Slice Intelligence, 2018.

Athleta now has a little over 30% market share in the women's athletic wear brands market, largely driven by its online presence.

Defensive Against Cyclicality

While retail is spread across a wide range of prices, Gap occupies a space where its major brands are both value oriented while also being of high quality. Its flagship brand, Old Navy, carries the brand's value products where consumers can find most quality clothes under $30. While the margins on such goods are not going to be as high as the many luxury brands and boutiques that have seen strong growth, it places Gap in a position to be better hedged against a possible economic downturn.

Athleta certainly is not an inexpensive brand as it occupies similar, if not higher price ranges than Lululemon, but it provides aggressive growth where Old Navy is more slow and stable.

Old Navy's revenues will remain stable during current economic conditions and may even improve during a downturn. Its growth is relatively slow but provides consistent returns. Athleta will expand fast during times of prosperity but will likely suffer during the next economic slowdown when consumers cannot pay $100 for a pair of yoga pants. However, the two brands help each other out. Old Navy is the cash cow that keeps Gap in its place as a multi-billion dollar retailer. Athleta is the fun, niche, and aggressive brand that allows Gap to expand and grow into new markets. While other brands have struggled to adapt in the "retail bloodbath", Gap has found ways to innovate and stay ahead of the competition.

The Takeaway

Gap is a long term play for 12 months and extended. While the share price has recently fallen off about 16% since January, this presents an attractive entry point for Gap. The retail sector may not seem like the hottest area of investment right now, but Gap is an interesting opportunity in where it has both defensive qualities and catalysts for aggressive growth. The Old Navy brand is strong and continues to see comparable store sales growth and should fare well regardless of economic conditions. Athleta is going head to head with Lululemon and is beating them in online sales while Lululemon's valuation is trading at a much more expensive level than the overall Gap company currently is. Look for Gap to start trending higher in the next six months as it continues to invest in its stronger brands.

Some risks to continue to consider are the stiff online retail competition. Lululemon, though second to Athleta in online sales, is still an apparel powerhouse, and could catch up. The revenue drivers for Gap in general are also tied to consumer confidence and consumer spending, so economic slowdowns may hinder Athleta sales despite heavy investment in its brand development. Retail is a crowded space, and consumer preferences can shift easily. It will be necessary for Gap to keep its product lines diversified enough to be defended against changing trends in the retail space.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.