Novice Investing - Identifying Your Fashion Gap

Date: Thursday 02nd 2010f September 2010 12:09:56 PM

Identifying Your Fashion Gap - 11/20/2009

By: Hari Wibowo

Gap Inc.
Two Folsom Street
San Francisco, CA 94105
United States

Gap Inc. (GPS) is one of the largest specialty retailers with more than 3100 stores, 134,000 employees and revenue of $ 14.5 Billion. It competes with Abercrombie & Fitch, American Eagle Outfitters and J Crew among others. Gap's main brand include its namesake Gap brand, Banana Republic and Old Navy. Lesser known brand include Piperlime and Athleta.

As with most retailers, Gap sales is concentrated during fall period especially the eight weeks between November and December. This accounts for 21% of Gap's net sales. As a result, inventory management and identifying sales trend are highly crucial to Gap's success. Further, being in the clothing industry, Gap needs to keep abreast of the current fashion development. If these three factors were out of place, you can imagine how much of the excess inventory needs to be sold at a much reduced price.

Gap's 2008 annual report identified its success is highly dependent on: 1) attracting customer traffic, 2) sourcing merchandise effectively, 3) competitively pricing its products and achieving customer perception of value, 4) anticipating and quickly responding to changing consumer demands, 5) maintain favorable brand recognition, 6) develop innovative, high quality products in sizes, colors and styles that appeal to consumers, 7) provide strong and effective marketing support.

That, in essence, is giving what customers want. It's easier said than done. Gap has the scale, compared to other clothing retailers. It has a sales of $ 14.5 Billion of which $ 1 Billion of it came from its online arm. That compares with J Crew and Abercrombie & Fitch with sales of $ 1.4 Billion and $ 3.5 Billion respectively.

2008	Gap	Abercrombie	J Crew	American Eagle	Pacific Sun
Gross Margin	37.5%	66.7%	38.9%	39.2%	25.5%

Speaking of scales, that normally correspond to the increase in gross margin. Why? Bigger customers such as Gap can demand a lower price to their suppliers, which is smaller in size than Gap. As a result, Gap can manage to reduce purchasing price while maintaining sales price, resulting in higher gross margin. The table above lists the gross margin of several clothing retailers. Taking a look at the table, Gap doesn't seem able to capitalize on its sheer size. Pacific Sun's low margin was due in part to its much smaller size and its product appeal (evident in the negative 24% of same store sales ). Meanwhile, J Crew and American Eagle manage to match Gap's gross margin while being smaller in sizes. Of particular interest is Abercrombie & Fitch which manages to maintain a high gross margin due to its refusal to involve in a price mark-down. We'll discuss Abercrombie in a later stage since its no mark-down policy has created another problem, which is negative 22% of same store sales while Gap and the rest managed to cap same store sales decline to a single digit. (Gap = - 8%, J Crew = - 5%, American Eagle = - 10%)

Despite this relatively meager gross margin, Gap has in fact increase its gross margin during 2008, which is smeared with the biggest financial crisis since World War II. Thus, while Gap's gross margin is far from being ideal, management has in fact done a good job in leveraging its power and brand during fiscal year 2008.

Looking at Gap's 2008 revenue segment, sales are concentrated mainly in the US (75% of total). Asia and Europe each contributed to less than 7% overall revenue. There can be two sides of the coin. On one hand, we expect US economic growth fueled by consumer spending will taper down. On the other hand, Gap has many untapped potential in Asia and Europe, just by looking at the revenue numbers. While Asia consumers in particular have lower purchasing power compared to US and Europe consumers, it steadily climb off the ladder. As the Asian economies grow, lead by China, many citizens will be lifted out of poverty and can afford a basic luxury of owning a Gap's clothing line. Having said that, investor must expect that gross margin in the Asian market will be lower than in the US. This is because many of the other local and international outsourcing is located in this area.

Going through the financial crisis, Gap is well equipped to ride out the storm. It has no debt and positive net cash of $ 1.8 Billion ($ 2.58 per share). Meanwhile, management is not engaging in an aggressive accounting system. One simple way is to look at the time to fully depreciate its property, plant and equipment (PPE) assets. As of 2008, the full depreciate rate is 5.2 years, which is decent considering most of its PPE is for leasehold improvement and furniture. With current share price of $ 22 per share and estimated earning per share of $ 1.50 by January 2010, Gap is trading at 14.6 times earnings. This is not terribly expensive but it is not terribly a good deal either. Considering the fickle nature of the fashion business, investors should wait to buy Gap at the lower end of its valuation.

END

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Disclaimer: The sole purpose of this article is educational. This article is merely the opinion of the writer and is not in any way a buy/sell recommendation regarding Gap Inc. (GPS) or any other securities.

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