March 12, 1998

A Closer Look: The Gap
by Yi-Hsin Chang (TMF Puck)

When the Fool Portfolio unloaded its shares of Gap Inc. (NYSE: GPS) in August 1996, Tom Gardner justified the sale by saying, "We love The Gap." During the 16 months the Fool Port held Gap shares, the casual apparel retailer "expanded margins, increased sales substantially, generated robust cashflows, did not defer costs or compromise growth with heavy borrowing, did a bang-up job of marketing the Gap experience, and handsomely rewarded shareholders."

The Fool Port simply opted to cash out and invest instead in what it believed would be a better place for its money: computer networking giant 3Com (Nasdaq: COMS). Today Gap is trading at around $47, more than double its value in August 1996 after factoring in a 3-for-2 stock split last December. 3Com, on the other hand, is now trading at around $35, about three-quarters of its value 16 months ago.

Well, some things have changed at Gap since the Fool Port ditched its 310 shares in the company. For one, the San Francisco-based retailer had grown to 2,130 stores totaling 15.3 million square feet at the end of January from 1,680 stores totaling 11.1 million square feet in February 1996. Sales have increased 48% in two years to $6.508 billion, while earnings have risen 51% to $534 million, or $1.30 a share. But some things remain the same at old reliable Gap. Its core business is still the basics: T-shirts, jeans, and khakis. Mickey Drexler, who has been the brains and driving force behind the Gap since he joined the company in 1983, still serves as president and CEO. And despite its size and seemingly ubiquitous presence, the retailing behemoth marches on, opening more and more stores domestically and abroad while maintaining double-digit growth in annual sales and profits.

In the past year, Gap has focused on developing and growing its brands. It revved up spending on advertising and marketing, shelling out more than $160 million, roughly 2.5% of sales, for gigantic billboards, prominent newspaper and magazine ads, and TV and radio commercials featuring such artists as legendary jazz singer Lena Horne and rock guitarist Dave Navarro of the Red Hot Chili Peppers. The company kicked off its Gap@Work advertising campaign in September by dressing more than 3,500 men and women who work on the trading floor of the New York Stock Exchange in casual clothes. The company also launched an online store, where customers can buy Gap basics and find the locations of stores near them.

In 1998, the company plans to spend even more on advertising -- more than $200 million, or roughly 3% of sales. The idea is to firmly establish the Gap brands, especially in the small- to medium-sized markets that once were thought to be too small to sustain a regular-sized Gap. In these new markets, the company has started opening "combination stores" measuring 6,500 to 9,000 square feet with clothes from The Gap, GapKids, and babyGap. Gap CFO Warren Hashagen figures that the company can open at least another 200 to 300 stores around the country in these smaller markets. This year the company plans to add 300 to 350 more stores worldwide: 85 to 95 Gap stores, 45 to 50 GapKids stores, 35 to 40 Banana Republic stores, 100 to 120 Old Navy stores, and 45 to 50 stores outside the U.S. In addition, the company plans on expanding 80 existing stores and significantly remodeling 100 more -- in all adding more than 3 million square feet, or 20% in square footage.

Old Navy Clothing Co. is the company's newest division and the fastest growing one in terms of sales and number of stores. In November, Old Navy surpassed the $1 billion sales mark in less than four years of operation. So far it doesn't seem like Old Navy is taking customers away from the flagship Gap stores. Indeed, Old Navy merchandise is markedly lower in quality and pricing, targeting a distinctly different audience. The shirts, though cotton, feel a little rougher, but you can buy a pair of blue jeans for around $20 plus affordable clothes for tots and kids. Drop by an Old Navy near you, and you'll see shoppers you would never see in a Gap, much less a Banana Republic. And regular Gap shoppers used to Gap quality won't be interested in the offerings at Old Navy, where you'll see shopping carts and supermarket-style checkout lines. As Gap's Hashagen points out, the company wouldn't be growing Old Navy as aggressively as it is if it was concerned that the new stores would cannibalize Gap stores.

Although Gap plans to continue its overseas expansion, the international operations have proved to be far more difficult than its U.S. businesses. The company has yet to make money in France and Germany, where it has had to invest in its own infrastructure. But overall, including the company's more successful ventures in Canada, Britain, and Japan, the international division has managed to grow earnings. (Gap declines to disclose percentage sales breakdowns for its various divisions.) The company is taking a cautious approach internationally -- it won't enter any new countries in 1998. The company plans to take it slow and learn from its mistakes in these five initial markets so that it will be better prepared to tackle other markets down the road as the international division begins to make significant contributions to the company's sales and earnings.

In time, upscale Banana Republic may prove to be the laggard concept in the company. Banana Republic's sales growth already lags behind The Gap and Old Navy. In January, when sales jumped 28% at Old Navy and 12% at The Gap, Banana Republic saw a mere 5% growth in sales. By year's end, Banana Republic may well be the division with the least number of stores, even behind international. Last fall, the company tried lowering some of the prices at Banana Republic, and it has added a home and gift collection in some stores. It also plans to launch a Banana Republic credit card this spring and relaunch the Banana Republic catalog in late summer. The catalog may be a way to attract new customers who prefer shopping by mail, but in an electronic age when most catalog companies, including J. Crew and L.L. Bean, have gone online in full force, Banana Republic appears to be swimming against the tide.

One potentially worrying change in Gap's recently released financial results is its long-term debt of $496 million compared with zero long-term debt in the past few years. Last September, the company sold $500 million in 10-year bonds for the purpose of expanding its stores, investing in its brands, developing additional distribution channels, and repurchasing Gap shares. Selling the bonds raised the company's total debt-to-equity ratio to 36.7% from 2.4% a year ago. But Standard & Poor's gave the senior debt securities a single-'A' rating and assigned the company a corporate credit and bank loan rating of single-'A,' citing Gap's "strong business position in casual apparel" and its expectation that the retailer will continue producing "above-average measures of performance." Looking at debt service coverage (earnings before interest and taxes divided by interest expense) shows the company can stand a little leverage. The infusion of funds does allow Gap to keep growing, and as long as the company maintains its strong sales and earnings growth, the money will have been well invested.

For now at least, the company says it isn't looking to acquire any new brands as it did in 1983 with Banana Republic when it was just a catalog and two-store chain selling safari clothing. Nor is the company cooking up any new in-house brands. CFO Hashagen says the company still has plenty of opportunities for growth. He expects to see a fair amount of domestic growth in the next three to five years and international sales to become "more meaningful" in five year's time.

Right now, sales abroad constitute less than 10% of company sales. Unlike many companies that are being hit by the economic turmoil in Asia, Gap expects to benefit from a stronger dollar and pay less for its imported goods. The company gets 70% of its merchandise from overseas, including 10% from Hong Kong, and it pays for almost all of it in U.S. dollars. The company anticipates cost savings in the third and fourth quarters, which it plans to reinvest in the business.

Gap continues to increase sales and profits, and is focused more than ever on marketing its brands and rewarding shareholders, in part through a massive program to buy back 45 million of the 395 million outstanding shares in an effort to boost earnings per share. The company expects EPS to increase more than 20% in the first half of this year and less than 20% in the second half of the year. Judging by Gap's history and its plans for the near future, perhaps it's time to give the Old Reliable a second look.

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