Gap and Fast Rumored to Talk Merger

In the acquisition food chain, the big fish usually eat the small fish, but the big fish are occasionally eaten by even bigger fish. So it's no surprise that there was speculation last week that Gap (NYSE: GPS  ) -- a company that bought out Intermix last year -- could now be the target of a buyout itself. The alleged suitor is Japan's Fast Retailing (NASDAQOTH: FRCOY  ) , owner of the Uniqlo brand and one of the bigger apparel retailers in the world. Fast has a market cap well over $20 billion, while Gap is floating along near $16 billion.

Fast has published its merger or acquisition criteria, and it has two main boxes that brands need to check before they'll be considered: growth and profitability. According to the company, "The key condition for growth is whether the brand has the potential to develop globally. If the brand has a solid underlying concept, we can actively share our infrastructure." Let's see if Gap meets the standard and look at what would be in it for both companies.

What's in it for Fast
Gap's growth has been strong over the past year, with the stock and margins rising. Since the beginning of 2012, its stock is up 77% due to the work that has been done to turn the company and the brand around. That's reflected in the 41% gross margin and 13.5% operational margin, both of which climbed four percentage points in the last quarter. Those increases were supported by Gap's refinement of its brands, most notably its Old Navy brand. Comparable sales at Old Navy were up 8% this January, after falling 6% in Jan. 2012. One of the big focuses at Gap has been the differentiation of Old Navy from its core Gap brand. Work at both brands has made Banana Republic stand out from Gap and has supported comparable store growth there as well.

The success at its main brands has also given the company a chance to support growth at its other brands. Notably, Gap's Piperlime and Athleta segment increased revenue by 31% last quarter. It also added eight new Athleta stores in the third quarter, and was on track to open another 15 to 20 by the end of 2013, bringing the total store count close to 50. Finally, Gap added the high-end Intermix brand to its portfolio at the beginning of January, purchasing the company and its 32 locations for $130 million in cash.

What's in it for Gap
With all that growth, it's easy to think that a buyout would be one-sided. But Gap has a lot of international growth potential that it hasn't been able to tap, yet. Looking again to fourth-quarter sales, international comparable sales fell 2%. That's a step in the right direction from the 8% fall a year ago, but it's still not the kind of performance that's going to unlock the value of Gap overseas.

Fast is already a successful international brand. In its last fiscal year, the Uniqlo brand recorded $1.9 billion in sales outside Japan. Gap only hit $934 million in international sales in its last fiscal year. Due to the strong overlap in product type between the two, a merger would allow Gap ample opportunity to take advantage of Fast's existing manufacturing and logistics capabilities. That would help international stores get product onto the shelves more quickly and help Gap keep up with quickly changing international trends.

In addition to those obvious physical benefits, Gap would also have access to the cultural understanding that Fast's management team possesses. One of the biggest hurdles that American brands face going into Asia is cultural. Where does the target market shop? How are trends spread? Which brands signify a "good" shopping center? All of these questions require deep insider knowledge that Gap has seemingly been lacking in its international operation. Fast would bring answers to the company.

Who should be worried
This isn't the first time that rumors about Fast and Gap have come out, but it is the first time since Gap's turnaround began last year. That means that the combined companies would now be a different kind of force to be reckoned with, and competitors should be on the lookout for the new beast. Companies such as lululemon athletica (NASDAQ: LULU  ) and Guess? (NYSE: GES  ) are both working toward international growth, and new blood at Gap would be bad news.

Lululemon is planning to expand its Asian and European showroom presence over the next two years, building new distribution centers in Hong Kong and Rotterdam. One of the company's largest strengths in North America has been its speed to market. Lululemon was the first high-end yogawear place in town. But Gap's Athleta brand has been growing, and while the American war may be won, the international yoga battle rages on. If Gap can get into Asia and Europe with Athleta faster than lululemon, it can take a big step toward international market dominance.

For Guess?, the merger is less of an issue in Europe, where the denim retailer already earns about 40% of its revenue -- but Asia is up for grabs. In its last fiscal year, Guess? only earned 10% of its total revenue in Asia, and management has worried about Asian growth due to larger concerns about the economy. If Gap could swing in with its extensive denim lineup, Guess? would be in a bad place.

The bottom line
As I said, this isn't the first time the Fast-Gap rumor has come up, but it highlights where both companies have potential to grow. Uniqlo has proven its worth around the world, but with just five stores in the U.S., it has a lot of room to grow. Gap is working out the other way and can really push up revenue with a renewed focus on international growth, which management put off to one side last year. That growth could mean a whole new kick for Gap's stock, and I'm looking for signs of that by the middle of this year.

lululemon athletica has the potential to grow its sales by 10 times if it can penetrate its other markets like it has in Canada, but without question, the competitive landscape is starting to increase. Can lululemon fight off larger retailers like Gap and Nordstrom and ultimately deliver huge profits for savvy investors like yourself? The Motley Fool answers these questions and more in our most in-depth lululemon research available for smart investors like you. Thousands have already claimed their own premium ticker coverage, and you can gain instant access to your own by clicking here now.


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