The Gap Inc.(NYSE:GPS) could be one of the biggest transformation stories in the retail sector due to its potential for increased square footage growth and an ability to deliver positive comps. The company's leverage to athletic category, Old Navy, and e-commerce should provide opportunities for upside.
Gap is a leading global retailer offering clothing, accessories, and personal care products for men, women, children, and babies under the Gap, Banana Republic, Old Navy, Piperlime, Athleta, and Intermix brands. The company operates in more than 90 countries worldwide through about 3,100 stores, over 350 franchise stores, and e-commerce sites.
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The overriding bear thesis on GPS is a lack of conviction in its ability to comp positively given soft traffic trends and tough comparisons. It's tough to believe in better traffic right now.
However, while traffic may be the biggest opportunity for improvement (as traffic has been negative for more than a decade), there is an opportunity for continued gains in conversions, units from product improvements and e-commerce and supply chain initiatives.
UBS analyst Roxanne Meyer sees a long runway for comp improvement for GPS as it has only had 2 recent years of positive store-only comps. She expects 2-3 percent growth in total comps for the next 2 years
Meanwhile, e-commerce should provide cushion to comps. E-commerce has been a 2-point lift to total comps on average for the last 2 years. GPS is ahead of the curve in the US in terms of its e-commerce capabilities, initiatives and investments (i.e. recently piloted "reserve in store" should help drive traffic and conversion), which should drive overall comp gains.
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GPS' management believes that the e-commerce business can grow by $1 billion plus over the next 3 years, which would put it at over $3 billion.
Meyer noted that the Street is underestimating a sales lift from what will be accelerating square footage growth following the completion of a 5 year store closing program. More than low single digits comps could be achievable longer term from e-commerce growth, outsized exposure to athletic apparel and potential for an inflection point for core businesses under new leadership/merchant talent.
Growth of franchises and China (may turn profitable in fiscal 2014) is gravy. Separately, the successful execution of fabric platforming/rapid response and seamless inventory could generate $1 plus EPS in fiscal 2017, and is likely GPS's single biggest opportunity to grow margins as it improves inventory execution and full price selling.
All these opportunities lead GPS to one of the highest incremental margin stories in the industry. GPS's mix shift to higher margin businesses and supply chain initiatives are not well understood by investors.
GPS has outsized exposure to athletic apparel versus peers and accounts for at least 10 -15 percent of the sales growing in double digits. Gap has a higher exposure to the growing athletic apparel category than most specialty retailers with GapBody, GapFit, Active by Old Navy, and Athleta and, therefore, has a big opportunity to leverage growth in this segment. Athleta stores are likely 50 percent more productive than Gap stores.
In addition, Old Navy's leadership team is just hitting its stride under its President, Stefan Larsson, its Creative Advisor Jill Stanton, who joined the company in February 2012, and its new head of marketing, Ivan Wicksteed, who joined within the last year.
Rebekka Bay's first full impact on Gap product in February is a potential catalyst. Gap's new Creative Director Rebekka Bay started at the company in October '12 and will have her first full impact on product starting in February.
Moreover, GPS's strong cash position will continue to be an investment positive and provides a cushion to performance. Over the last 4 years, GPS has spent $1 billion - $2 billion on stock repurchase annually, generating as much as 14 percent of EPS growth in fiscal 2011. The company has also increased its dividend annually.
Meyer expects free cash flow to continue to exceed $1.2 billion over the next few years and that spending on stock buybacks and dividends more than offset free cash flow. She models 5 percent annual earnings growth over the next 3 years from stock repurchase activity. She further expects GPS to deliver more than 15 percent EPS growth over the next 3 years and potentially over $5 of EPS in fiscal 2017.
Shares of GPS are at an attractive entry point. GPS is currently trading at 11 times its forward earnings versus the group average of 12.5 times, and a PEG of 0.7 times (group average of 0.8). On an EV/EBITDA basis, GPS currently trades at 6.6 times. They traded between $31.19 and $ 46.56 during the past 52-weeks.
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