- The Gap will release Q1 earnings before the end of the month.
- Low margins are being squeezed due to the global supply chain crunch and because Old Navy, the flagship brand, isn't growing.
- The company’s recent refinancing is positive, but it doesn’t mean capital will be utilized efficiently.
- The stock trades near its enterprise value and is not worth buying; price target of $15 with an 18-month view.
This report provides a slightly bearish case against The Gap (NYSE:GPS), citing weak forecasts by leadership, continued margin squeeze, and low brand strength. The model forecasts a $14 share price target, and I rate this stock as “Hold”.
The Gap, Inc. is an apparel retail company based in San Francisco, CA. The company offers clothing, personal care items, and additional accessories for men, women, and kids. They have four key brands, including: Old Navy, The Gap, Banana Republic, and Athleta. GPS is an omni-channel retailer, operating both online and in person with over 950 stores in North America. GPS designs, produces, advertises, and sells a range of apparel, footwear, and accessories with company-operated stores in the United States, Canada, Japan, Italy, China, Taiwan, and Mexico. GPS has also partnered with unaffiliated franchisees to operate stores globally, including in Europe, Latin America, Asia, and Africa.
GPS recently announced a plan to revitalize their retail offerings by cutting 300 stores from its weaker brands, and focusing on growth via online sales. The company is looking to improve their margins and profit, which are the weakest amongst their peers. The key issue in this plan though is speed – their competitors are quickly transitioning toward online sales, and some of their peers have strategies to do so. Additionally, GPS’s more notable brands are not growing. Old Navy, which accounts for 54% of sales, decreased in comparable sales vs both 2020 and 2019 while The Gap, which accounts for 24% of sales, only grew by 2% vs. its 2019 comparable sales. With a supply chain crunch within the retail space expected to persist, GPS’s continued struggles are not comforting. While there is growth among their Athleta brand, it accounts for a small percentage of revenue and may fall out of favor as time goes on, which is a key risk every apparel corporation deals with.
Industry And Competition
GPS is part of the fast fashion segment in apparel, with key competitors including American Outfitters (AEO), Abercrombie & Fitch (ANF), and Urban Outfitters (URBN). While the global fast-fashion market is expected to grow annually by 7% over the medium term, GPS executives have forecasted “low single digits” growth. GPS lags their peers due to a couple key issues. The first is ever-changing management; Sonia Syngal is the company’s fourth CEO in 18 years and prior to being CEO, she led Old Navy – which has not been growing over the past two years. I believe she is a competent executive, but I wonder if her being a long standing GPS executive is enough of a mindset change for GPS to bolden their strategy. The other disadvantage is their high amount of debt and tight margins. While the company refinanced their debt at a blended rate of 3.75% due several years away, given their increasingly weak margins, this development is merely a small positive. Simply put, GPS is not as nimble as their competitors and are forecasting weak revenue growth.
At a high level, there are several key risks associated with being in this industry. The risk concerning GPS’s inability to get ahead of and respond to fluid consumer preferences is ever-lasting. Additionally, the risk of potentially margin-destroying downward pricing pressure due to high inflation & supply chain issues is necessary to note. Another significant risk is the potential impact from COVID-induced lockdowns. GPS is still quite reliant on in-store sales, though this metric is dropping. The company's digital sales continue to grow, however, prolonged lockdowns in any of the countries GPS has stores in would provide a substantially negative impact. Additionally, GPS has multiple brands that need attention for CAPEX – a distracted focus for execution can be concerning when attempting to streamline operations.
Where I Could be Wrong
While this report reviews the bear case for Old Navy, there are some positives for GPS. The first is their online sales growth; fiscal year 2021 online sales grew 57% versus 2019 and don’t seem to be slowing down. This growth is as strong, or stronger than competitors, and its powered by Athleta. Given their expansive offerings from children to adults, by ensuring the consumer online experience is positive, GPS may exceed forecasts with a quick shift to online supremacy and strong inventory management. The company also has strong penetration in the U.S., which comprises 85% of their geographic sales. Their historical strategy of country penetration over wide-spread global growth has allowed them to weather some tough times with brand strength across value to premium segments, and may prove more resilient than I anticipate. GPS also has a strong partner in Kanye West, a well-known musical artist. While his line has not been impactful 18 months into the partnership, potential remains for success. Lastly, GPS’s financial structure is moving in the right direction, given their recent refinancing of the 8.5% blended rate debt to longer-term, lower rate debt.
Model Shows Limited Upside
Should GPS hit their management guidance, I don’t see a scenario where the stock roars back to its previous highs anytime soon. Single digit forecasted growth is below the industry CAGR and retail headwinds are not in the company’s favor. Even anticipating that their cost of debt doesn’t rise much above its current blended rate, the high WACC is concerning given the stocks high beta. Even with a lower market premium than my forecast for their competitor AEO, the stock’s high WACC and low growth and return on invested capital blunt the stock.
I forecast the terminal value of over $5.5B, given a blended 2.5% revenue growth for five years as per guidance from management. I see SG&A expenses falling from 9% to 7.5% as a percentage of revenue within a 5-year period as synergies from online penetration increase. I hold all other key ratios equal as a percentage of revenue from 2021 figures, as there are not many material differences in 2018 and 2019 figures.
Even as operating profit slightly improves over the 5-year term, only a $15 share price can be supported with fundamentals. The company has a decent dividend, but it may be cut soon. I assume continued weak sentiment from Wall St. and don’t see this stock rebounding much over the next 18 months.
GPS is floundering at a time when retail market headwinds are beginning to take shape. Supply chain struggles and an increasingly fierce battle for online sales continue in the U.S. apparel industry. The company's key brands are not growing well and they have had several management reshuffles over the past two decades. Low revenue forecast growth and small margins are not comforting. GPS is worth about $15/share and I don't see positive themes on the horizon to warrant buying the stock today.
This article was written by
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