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How Gap Lost Its Economic Moat

Competition in specialty apparel has reduced Gap's ability to generate superior returns.

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As one of the first national specialty apparel retailers,  Gap (GPS) benefited early on from a number of advantages, including size, brand recognition, and long-standing relationships with landlords and vendors. However, given the lack of barriers to entry in the space, and an easily replicable merchandising strategy, this lucrative business attracted competition from all fronts. As Gap's brands fell out of favor, store productivity and merchandise margins plummeted. Therefore, Gap's lease-adjusted returns on invested capital have fallen to the low-teens range in recent years, down from the high teens in the late 1990s. While we believe the retailer's current efforts to reposition brands should yield positive results over the next few years, we are not convinced that Gap can consistently sustain excess returns in the long run, given the lack of product differentiation. Additionally, we anticipate that the competitive landscape will continue to heat up, thanks to the rising popularity of fast-fashion retailers like H&M, Forever 21, and Inditex. As a result, Gap's structural advantages no longer appear sufficient to support a narrow economic moat. In our view, specialty apparel retailers have to possess both a structural advantage and product differentiation in order to consistently generate returns in excess of their cost of capital over the long run.

Gap Does Not Possess Product Differentiation
Breaking away from the traditional department store format, Gap emerged as one of the first national specialty retail chains in the United States in the 1990s. By offering differentiated stylish-yet-affordable basic apparel that appeals to the masses, the firm built itself into an impressive 3,000-store empire, with annual revenue increasing more than sixfold to $14 billion in fiscal 2000, up from just $2 billion in 1990. During that period, many believed that Gap had established a portfolio of seemingly infallible brand names including its namesake label, Old Navy, and Banana Republic, which captured a broad spectrum of consumers at different income levels and ages ranging from infants to adults. So why did Gap fail to maintain its brands?

Zoe Tan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.