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Undervalued Retailer Closes Gap With Competitors

Gap's investments in supply-chain responsiveness and omnichannel capabilities could lead to rapid margin expansion.

With investor attention focused on what we perceive to be near-term, fixable product issues within the core

These initiatives reduce lead times and allow the company to read demand and react to the color, size, or silhouette that customers are purchasing. In total, these initiatives should reduce volatility in performance, increase full-price sell-through, and fulfill previously missed sales, putting Gap well on track to matching fast-fashion core competencies. The company expects to increase the percentage of assortment on the responsive model to 50% by the end of 2016. If it is successful, we see no reason Gap could not only reduce the operating margin gap between itself and other fast-fashion retailers, but also further distance itself from no-moat companies. The stock is currently trading at a discount to our fair value estimate as a result of product challenges and an underappreciation of the margin expansion opportunity, and we believe this is an attractive entry point for investment.

Gap Product Issues Are Addressable With negative comparable sales for the past three quarters, the Gap Global segment has been struggling under the weight of fashion missteps and a fall marketing campaign by Wieden+Kennedy that did not resonate with customers. We acknowledge that it will take time to turn this product around, as longer lead times, correcting designs, and clearing previous inventory are likely to continue to impede near-term sales. However, we think product issues are correctable and fashion misses are a problem encountered periodically by almost all retailers. In fact, the company recently turned Banana Republic sales around, with comparable sales recovering to flat over the past two quarters and an increase in November after four quarters of declines. In our opinion, the factor that separates a couple of quarters of pain from a more persistent steady decline is whether the brand intangible asset is intact, and we think there has been no degradation of Gap's brand. Traffic statistics for Gap.com support our thesis. Despite product missteps, traffic to the site has remained relatively flat (excluding seasonality), and unique visitors increased 1% in October 2014 according to Compete.com. We think this indicates that customers remain loyal to the brand but are not converting to purchases at ticket prices.

Although there is a risk that repeated visits ending in product disappointment could eventually result a more negative brand view, we think Gap will fix product issues before this happens. We think a couple of factors support a turnaround thesis.

First, incoming CEO Art Peck promoted two executives to senior positions. Jeff Kirwan, who previously served as president of Greater China for Gap, became global president for the Gap brand in December 2014. Andi Owen, who previously led the Gap Outlet division, is now global president for Banana Republic. Peck eliminated the creative director position at Gap, resulting in Rebekka Bay’s departure. We are encouraged that Peck has a sense of urgency about fixing poor Gap brand performance and note that he previously was involved with successfully adjusting aesthetic issues at the Gap brand in 2011. We think he will hit the ground running when he fully takes over the CEO position in February.

Second, Gap will face easier comps in 2015. We estimate that Gap Global comparable sales will decline 5% in fiscal 2014 after increasing 3% in fiscal 2013. Given these easing comps and current product tweaks, we think comparable sales will flatten in the first half of 2015 and trend into positive territory in the second half. Additionally, although the core Gap brand accounts for approximately 40% of sales, the company has a strong portfolio of other brands, including Old Navy, Banana Republic, and Athleta, which can somewhat offset weakness in any one brand. As our model forecast is based on only roughly 2% consolidated comp sales growth in 2015, we think strength in Old Navy and the recovery in Banana Republic can offset slight continued weakness in Gap and still allow the company to achieve this conservative growth rate.

Finally, we think improvements in supply-chain responsiveness, while not fully allowing for immediate product fixes, will provide the capability to adjust underperforming product inventory levels and somewhat compensate with strong categories. Progress can already be seen. In the third-quarter conference call, management highlighted that as a result of vendor-managed inventory, it was able to very quickly cut production of the underperforming five-pocket denim and switch that into pants. Management is also doing customer market research, in addition to using data from its own stores, at retailers including Macy's and Nordstrom to see what is selling strong at the market level. As a result of this, it has put more inventory into activewear, outerwear, and accessories and is seeking a better balance between fashion and core product. Finally, the company has added an extra flow in the first week of January for Gap, which we think will provide more newness in the business. Inventory per store declined 2% in the third quarter on flat net sales and was up only 2% in the second quarter on 3% sales growth. All in all, we think management has adequately recognized and is addressing the product problems at Gap.

Gap Has the Platform Necessary to Adopt a More Responsive Supply Chain Given the higher margin generated through the fast-fashion retail model, it is not surprising that many apparel companies are attempting to speed both inventory turns and responsiveness. However, we don't think this model is easily implemented, and ultimately we expect few companies to be able to approach the margins seen by H&M and Inditex. In our opinion, many factors contribute to a pull-based model, including scale, strong manufacturing relationships, technology investments, and strong internal feedback loops. We believe Gap has these and is one of the few apparel companies that can successfully transition to a responsive supply chain.

In apparel, fast fashion has reshaped the way designers and producers think about the manufacturing process. Having once based the process solely on a cost-reduction model, apparel manufacturers now need to consider speed to market, ability to leave capacity open to late orders, and efficacy in reaching a global fleet of stores, all while still paying attention to cost. Often, margin maximization is achieved not through the lowest labor cost, but by pursuing multiple strategies for different product lines and balancing speed and pricing power with production cost. BCG estimates that seven factors play into strategic line planning optimization: (1) de-averaging design, development, and the supply chain; (2) reducing time to market; (3) reducing end-to-end cost of goods sold; (4) improving end-to-end product visibility: (5) integrating online and brick-and-mortar channels; (6) balancing local, regional, and global responsibilities; and (7) aligning plans with trends in consumer purchasing and competitive offerings. We think these guidelines are an excellent example of how segmentation, strategic goals, and divergent methodologies play into modern manufacturing decision-making.

The old method of apparel manufacturing was very simple and linear. Apparel companies designed a fall/winter and a spring/summer collection, materials were sourced, products were manufactured, and garments were shipped to a distribution center, from where they were delivered to the appropriate retail venues. The entire process required apparel manufacturers to commit approximately six months in advance to the designs for 40%-60% of their seasonal lines. At the start of each season, nearly 80% of that season's inventory was committed, and deliveries to retailers were made about four times a year (Nelson Fraiman, Zara Case Study, 2010; Seth Stevenson, "Polka Dots Are In? Polka Dots It Is!," Slate.com, 2012).

The new manufacturing process is more circular, relying on feedback loops, customization, speed to market, and more frequent inventory turns to increase sell-through of full-priced merchandise. Perhaps one of the best examples of this is apparel retailer Zara, the flagship concept of Inditex. Zara commits six months in advance to only 15%-25% of a season's line and locks in only 50%-60% of the line by the start of the season. Turnaround is quick. The time from design to the garment hitting store shelves can be as short as a few weeks (Fraiman/Stevenson). A key theme we have noticed across our coverage universe is the integration of the design, production, and retailing processes to maximize sales and costs. Flexibility and differentiation in design, manufacturing locations, and distribution channels have become paramount to success.

We think scale, manufacturing relationships, technology investments, and internal feedback loops are essential to the flexibility that characterizes a winning supply chain strategy. With more than 3,000 stores, Gap is one of the larger apparel retailers, and we think this gives it more bargaining power with suppliers. Gap purchases private-label and non-private-label merchandise from more than 1,000 vendors in 40 countries. Its revenue is roughly 6 times greater than the peer average. The company has also reorganized into a global brand structure, which we believe supports better internal communication. We think this has contributed to the company's ability to achieve a 13% operating margin in 2013 versus the 5% average of the peer group.

Gap Has Made Necessary Investments to Begin to Recognize Margin Expansion Gap has invested heavily to develop numerous supply-chain advantages, and we think it is well ahead of its domestic competition in laying the foundation for a responsive supply chain. According to the company, fabric platforming is the key enabler of lead-time reduction. It allows Gap to leverage scale and drive average unit cost savings over time, respond quickly within a season, and drive simplicity. Vendor-managed inventory, in which key vendors keep a pool of inventory of finished goods that they can draw on for replenishment, is targeted at long-living product and enables better in-stock levels. Management credited this capability for Gap's ability to shift out of underperforming denim and into pants. Rapid response is targeted at seasonal product, so the company can read demand and react to the color, size, or silhouette that customers are buying. Finally, test and respond is targeted at fashion and allows the company to assess customer style preferences on buys so purchases are made into known demand.

In addition to these capabilities, we think investments in seamless inventory will eliminate friction among various geographies and distribution channels so that inventory imbalances can be eliminated and price points will be maximized. Gap has implemented global fit and global labels to allow for this transition. The Shanghai distribution center is now fully integrated between stores and online for all China geographies. Gap will co-locate store and online inventory at the U.K. distribution center. The Athleta business already operates on a seamless platform. We think Gap can achieve full integration by 2016.

As a percentage of sales, capital expenditure has increased from 3.0% to 4.1%. We model capital expenditure as a percentage of sales to average 4.3% annually going forward, as we think management intends to attempt to remain at the forefront of technological innovations.

Results can already be seen. Over the past year, Gap has outperformed domestic competition and has begun to narrow the disparity in operating margin between itself and fast-fashion competitors.

Gap's Valuation Is Attractive at Current Levels Because of investor concern regarding the Gap brand turnaround, Gap is trading at a 14% discount to our fair value estimate of $48. As we believe the weakness in the core Gap brand is both fixable and temporary, and as we see the company poised to recognize margin expansion, we think this discount is unjustified.

Our fair value estimate is based on forecast 3% average annual compound revenue growth and 7% average annual compound operating income growth over the next five years. We think both of these measures are achievable.

Our top-line forecast assumes 2% comparable-sales growth with the remainder due to new store openings. We think Gap is better positioned to achieve comparable sales growth than many of its competitors, given that it has already repositioned its store portfolio. The company has been rightsizing its store base while expanding its online presence, shedding about 14% of the North America specialty fleet since 2008 and increasing e-commerce to 14% of sales in 2013 (roughly doubling in five years). We think online penetration remains a significant opportunity, with penetration of only 16% in North America (versus penetration levels north of 20% in other apparel retailers) and only 4% in international markets. Rebalancing the portfolio toward online, outlet stores (550 by the end of 2014), and franchise stores (450 stores by end of 2014) has contributed about 12 points of contribution shift toward higher-returning channels since 2008 (now 31% of business). We think the company will continue to reduce square footage in North American stores while expanding Athleta, expanding Old Navy and Gap in Asia, and expanding global Gap and Banana Republic outlets. We see Gap Inc. China growing from $300 million in revenue in 2013 to more than $1 billion in three years.

We see operating margin expansion as the main driver of valuation, as Gap has invested heavily in technology and supply chain systems, which we believe can narrow the margin disparity between Gap and its global fast-fashion competitors. In our model, we think Gap can reach an operating margin of 15.4% in five years from 13.3% currently (still well below the high-teens margins of fast-fashion competitors). This reflects our belief that the company is successfully executing on its responsive supply chain, omnichannel, and seamless inventory initiatives, as evidenced by its work on fabric platforming, reserve in store, and order in store. Much of the growth will probably result from gross-margin potential, which we see growing roughly 4% annually, with the remainder coming through cost savings and leverage of selling, general, and administrative expense.

Ultimately, we think our projections calling for 3% average annual revenue growth and 7% average annual operating income growth are reasonable and achievable. We are encouraged that the company already appears to be seeing some early results from a more responsive supply chain and its omnichannel strategy. Although Gap's constant currency sales growth of only 1% in the third quarter demonstrates that the company has much work to do to fix its product issues, inventory dollars per store were down 2% and gross margin was up 20 basis points. With easing comps and improved product making its way into stores in 2015, we think this margin expansion story will become more apparent as the Gap overhang is removed. We believe the stock's current price offers an attractive entry point for investment with a sizable margin of safety.

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