Gap's Moat Is Gone

We no longer think brand strength can deliver pricing power for

Although we believe pursuing a responsive supply chain was the right strategy to enhance its competitive advantage, Gap has failed in the execution. Evidence on multiple fronts points to this. Management originally targeted 50% of product to be on the responsive supply chain by the end of 2016 and positive comparable sales in the first quarter. Instead, by the first quarter, Old Navy president Stefan Larsson had left the company, Old Navy performance (highlighted as the goal of what a responsive supply chain could achieve) was faltering, and CEO Art Peck was referring to supply chain efforts as “a journey, not a destination.” Conversations with the company have led us to believe that a more reasonable expectation for lead times is nine months (versus the prior goal of around a three-month manufacturing process), which further stands to impede its recovery.

In addition, the performance data points we do have show a decline in relevant metrics versus improvement. At first glance, inventory growth is getting closer to aligning with revenue growth. However, a look at gross margin leads us to believe that this doesn’t stem from better inventory management matching supply with demand, but rather it is the result of heavy discounting to clear excess inventory. Since 2013, gross margin at Gap has fallen from 39.0% to 36.2% (as of 2015), versus roughly flat constant-currency gross margin at fast-fashion competitors.

As a result, we no longer think it is appropriate to model upside from this initiative, leading to our lowered fair value estimate.

Right Strategy, Wrong Execution Gap is an iconic American brand, selling basics at affordable prices. The company scored a second hit with Old Navy, which has a slightly more family- and value-oriented bent. Together the two brands make up almost 80% of company revenue. However, consumer preference has shifted to value over brand in general apparel retail, and competition has flooded the space, namely through fast-fashion retailers H&M, Zara, and Uniqlo. Gap's adjusted return on invested capital declined from 17% in 2013 to 13% in 2015 and is expected to be under 10% in 2016. The challenge the company now faces is to minimize fashion misses and inventory mismatches through a responsive supply chain, become more technologically sophisticated for younger consumers, and maintain a differentiated and relevant brand identity in the face of growing fast-fashion competition.

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 16% of sales in 2015 (roughly doubling in five years). We see current Gap North America fleet-optimization efforts further shrinking Gap specialty stores by 185 from 2014, to a total of 500. This will increase exposure to more-productive and higher-growth vehicles, including international, factory, and e-commerce.

However, cost reductions will not reinvigorate top-line growth, and we are concerned that company investments in a responsive supply chain, omnichannel capabilities, geographic expansion, and better design have had no effect in staving off same-store sales declines. Although some recent weakness can be attributed to cyclical weakness in apparel, with clothing and accessory store sales growth of only 2.2% on average annually over the past three years (versus 3.4% total average retail sales growth), fast-fashion competitors appear to be taking market share, posting positive comparable sales versus a 1% average annual decline at Gap. We still believe Gap’s plan to pursue a pull-based supply chain would address the weakness, but we have seen few signs that management has been able to successfully execute on this strategy.

Waning Pricing Power Fills In Moat We no longer think brand strength can deliver pricing power for Gap. We believe the company will prove unsuccessful in obtaining its targeted cost advantages, and we've lowered our narrow moat rating to none.

We expect adjusted returns on invested capital to average 10% over the next five years, only slightly above our 8% cost of capital assumption. A 10% average adjusted ROIC is well below those of narrow-moat competitors Inditex ITX (23%) and H&M HM B (15%).

Brands appear to have limited pricing power relative to the past, and customers appear to be favoring price and performance over brand labels. Even though Gap is still in the top 50 most powerful brands of 2015 according to Tenet Partners’ CoreBrand Index, pricing power has fallen, as evidenced by significant gross margin declines. Gross margins have declined from a peak of 39.4% in 2012 to 36.2% in 2015. Conversely, companies with cost advantages that enable them to offer more attractively priced apparel have increased sales and maintained margins. Revenue at off-price retailers TJX TJX and Ross ROST has grown in the midsingle digits on average annually over the past three years, while growth at fast-fashion retailers Inditex and H&M has averaged in the low double digits. We think the cost advantage competitive moat source is more relevant to modern consumer preferences for value than the brand intangible asset.

Consumers also appear willing to pay a premium for a product that performs better. This fits with our belief that consumers now value experience over material goods, as performance-based apparel is used in activities. Gap’s Athleta brand fits in this camp, but at less than 5% of revenue in 2015, we think it is unlikely to have a noticeable impact on the overall company margin over the next five years. Gap’s operating margin has averaged 12% over the past three years, well below Lululemon’s LULU 21%, L Brands’ LB 17%, and VF’s VFC 18%.

Established Brand Portfolio Offsets Multitude of Risks We assign Gap a high fair value uncertainty rating. We believe that exposure to economic risks, including unemployment, wage growth, consumer confidence, and debt, is compounded by fashion risk, a competitive and overcrowded apparel retail space with no barriers to entry, international expansion, and difficulty in implementing change in a large organization. From fiscal 2011 to 2015, comparable sales growth ranged from 5% to negative 4%. Over the past five years, operating margins have ranged from 13.3% in fiscal 2013 to 9.6% in fiscal 2015.

We believe the company could be facing some margin headwinds. After a year of trimming expenses on poor product, the company is now ramping back up its investment in people, stores, and advertising. If investments in a responsive supply chain fail to yield increases in merchandise margins, this may further pressure operating margins. Additionally, as seen with the West Coast Port delays, disruption to the supply chain can have a significant impact on both top-line and margin performance.

Management is also a risk. There has been significant management turnover, and the loss of Stefan Larsson could negatively affect responsive supply chain efforts. Continuity in strategy could be a problem.

Channel trends may be an issue. If consumers continue to show a preference for online shopping, and if Gap is unable to convert store customers into online customers, market share may decline.

Much of new store growth will focus on international markets where real estate availability and cultural, economic, and operational differences may affect performance. We also believe that the company could be overstored.

Offsetting these risks is Gap’s established brand portfolio. We think the portfolio strategy at various price points hedges some of the risk of fashion misses or unique customer weakness at any one brand. Additionally, strong brands may inspire more customer loyalty and be slightly more sticky than brands with less history.

We think Gap is in strong financial health. It finished 2015 with $1.4 billion in cash and equivalents on its balance sheet, well in excess of the $1.2 billion target cash balance reserve that not only provides for working capital needs but also is a reserve for unexpected business downturns. As we expect Gap to generate average free cash flow of more than $800 million annually during the next five years, we see no significant risk to liquidity levels. About half of the cash and equivalents are held in the U.S. and are generally accessible without any limitations. Gap also has access to a $500 million revolving credit facility, which provides additional flexibility in supplementing short-term liquidity needs. It has debt of $1.7 billion, with a $400 million term loan maturing in 2016 that we think the company has sufficient cash to pay down. The debt/EBITDA ratio sits at less than 1. We think the company has sufficient funds to cover working capital needs, reinvest in the business, continue to pay dividends, and return money to investors through share repurchases.