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Athleta: Gap's Undervalued High-Growth Asset

We think it's perfectly positioned to capitalize on health and fitness trends.

Although investor attention has been rightly focused on

Although athletic apparel and footwear has recently benefited from the "athleisure" fad, with consumers wearing athletic clothes for fashion versus athletic activity, we think a fundamental and sustainable shift toward a health and fitness lifestyle in addition to an underserved and defensible athletic apparel market make the space poised for long-term growth. Even after the athleisure fashion trend fades, we expect athletic apparel growth to continue to outpace the general apparel market for use in exercise.

The U.S. Office of Disease Prevention and Health Promotion has set goals to increase levels of physical activity in America. Although progress has been made (only 18% of American adults met objectives for aerobic physical activity and muscle strengthening in 2008 versus almost 21% of adults in 2012), this is still a very low penetration level and there is much more room for growth. As of 2012, almost 30% of American adults reported no physical activity in their leisure time, only 50% participated in moderate levels, and 34% in high levels. As physical fitness activity levels grow, we think demand for athletic apparel will grow.

In addition to government initiatives, we think the introduction of self-monitoring devices in the form of websites, apps, and wearable technology will drive growth in the fitness market. Fitbit sold almost 11 million devices in 2014, more than double that of the year prior. Other athletic companies have demonstrated belief in the power of these new devices too, with Under Armour UA acquiring MyFitnessPal.

There is even much more room for growth in physical activity among millennials. Although they come in at the highest levels of meeting U.S. government physical activity guidelines among all age groups, less than 50% of millennials reached target levels.

If physical activity grows as a proportion of Americans' time, it makes sense that athletic apparel market growth would continue to outpace the general apparel market. Athleta, with its technically advanced performance products, is well positioned to benefit from this growth. We view the athletic apparel market as largely underserved, with little in the way of innovation until recently. Developments in performance fabrics, design, technology, and manufacturing are likely to drive outsize volume and pricing growth. We believe technically differentiated apparel will steal share from basic cotton T-shirts and shorts as innovation drives upgrades. So despite our belief that current levels of outperformance are unsustainable when the athleisure trend fades, we still believe athletic apparel sales will outpace the overall apparel market as fitness-related usage grows.

We estimate that U.S. athletic apparel sales will grow at a 6% compound annual growth rate over the next five years versus general apparel retail growth of 3%. This 6% growth rate is below the three-year historical average activewear apparel growth rate of 8%, as we model the discontinuation of the athleisure fashion trend in 2016.

Gap's Moat Advantages Could Give Athleta a Significant Competitive Edge Not all companies are created equal in competing for market share in athletic wear, in our opinion. With some barriers to entry, technical differentiation in product, and the importance of brand in identifying quality, we believe this apparel subsector has unique attributes that make an economic moat relevant and sustainable.

Consumers appear willing to pay a premium for technical performance products, as evidenced by the higher margins of activewear companies versus traditional specialty apparel retailers. As most companies do not break out merchandise margin and there is a high degree of variable of costs included in the gross margin as well as distribution channel mix differences, operating margin is probably the cleanest comparison of profitability. The average operating margin at activewear-based companies over the past three years was 16.6% versus 9.9% at general apparel retailers.

We think that the cost of conducting research in performance capabilities and the difficulty of developing sourcing and manufacturing for technical products makes well-capitalized companies with existing research and development centers and supply chains focused on athletic wear better positioned to penetrate the space. Although we've seen smaller fashion brands launch athletic wear collections, we think these lines are being designed more for leisure wear than athletic use and incorporate fabrics sourced from the firms' existing apparel supply chain. The products, while stylish, lack the technical features of the products of established athletic wear companies, including temperature control, sweat wicking, fit, and elasticity. In the long run, we see the athleisure fad fading and expect these lines to be the hardest hit by the shrinking market size, while athletic technical products maintain share for fitness use.

The acquisition of Athleta in 2008 gave Gap a pure-play athletic apparel presence and an edge in developing the technical performance products necessary to become an athletic apparel retailer versus a fashion retailer selling athletic wear for leisure. The brand tests all products to ensure that performance is as relevant as style. Running clothes utilize chafeless fabrics, have elasticity to move through workouts, wick away moisture, and feature reflective stitching on every item to ensure visibility. Silver salts give some fabrics antimicrobial protection. Bras come with three levels of support depending on the intensity of the workout. Although we think features such as these are a good start, we think Athleta's level of technical differentiation trails that of Lululemon LULU, Nike NKE, and others and believe that further investments in performance can build pricing power and brand strength.

Also, Athleta, like Lululemon, is differentiated with its brick-and-mortar presence. We think the boutique environment of its store base, the company's ability to control the quality of the salesforce, and the opportunity to host fitness classes and events in local stores to build a community are competitive advantages over activewear manufacturers such as Nike and Under Armour, where the significant majority of their sales are wholesale.

Gap management has said it sees the possibility for Athleta to become Gap's fourth big brand. Given the athletic wear market size, growth rate, and margin premium, we would agree. Gap has more than $1 billion in cash on its balance sheet and has generated approximately $1.1 billion in annual average free cash flow over the past five years. We expect the company to generate about 6% of revenue in free cash flow (about $1 billion) on average annually over the next five years. With cash available to invest in store growth and an established and skilled real estate team for scouting store locations, Athleta's store growth could be rapid if prioritized. However, despite the above-industry top-line growth and premium margin potential, it appears that the market is giving Gap almost no credit for this asset on a valuation basis.

Gap's Valuation Is Attractive at Current Levels Because of investor concern regarding the Gap brand turnaround, Gap is trading at a 40% discount to our fair value estimate of $45 per share. As we believe that Athleta is being undervalued by the market, the weakness in the core Gap brand is fixable and temporary, and the company is poised to recognize margin expansion, we think this discount is unjustified. Our fair value estimate is based on forecast 2% average annual compound revenue growth and 6% average annual compound operating income growth over the next five years.

Our top-line forecast assumes 1% comparable sales growth. We think Gap is better positioned to achieve comparable sales growth than many of its competitors, given that it is repositioning 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 the company will continue to shed underperforming North American stores, while growing Athleta, expanding Old Navy and Gap in Asia, and increasing global Gap and Banana Republic outlets. We see current Gap North America fleet-optimization efforts further shrinking Gap specialty stores by 185 from the end of 2014 to a total of 500. We see Gap China growing from about $500 million in revenue currently to over $1 billion in two years and expect the Gap business to be profitable this year.

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% in five years from 12.4% in 2014. This is still well below the high teens margins of fast-fashion competitors. This reflects our belief that the company is successfully executing 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 is likely to result from gross margin potential, which we see growing roughly 3% annually, with the remainder coming through cost savings and leverage of selling, general, and administrative expense. Additionally, we think mix shifts toward more profitable revenue drivers will aid in margin expansion. Using an 8.7% cost of capital, our discounted cash flow analysis results in a $45 fair value estimate.

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