Gap Caps Off a Phenomenal Year

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If there's been one stock I've most enjoyed over the past year, it's been Gap (NYSE: GPS  ) . The retailer was down on its luck and ailing from bad decisions through the end of 2011. Quality was down, it couldn't get product made quickly enough to catch trends, and its eponymous brand was muddled and competing with its own Old Navy brand. Then things took a turn for the better, and after a year of hard work, Gap is back in front.

The company released fourth-quarter earnings yesterday and gave investors one more thing to celebrate. Revenue was up 10.5% off of the back of strong comparable store sales growth, which rose 5% last quarter. That all trickled down to a 66% increase in earnings per share for the quarter. The full-year results looked great as well, with comparable sales up 5% and earnings per share up 49%. In short -- it was a good year to be a Gap investor. But 2013 isn't going to be easy, either. Here's what Gap did right last year, and what challenges it faces this coming year.

Renewed brand strength
If you can pin down one thing that made last year successful, it would have to be the company's focus on its core brand. The new vision of Gap separated the brand from Old Navy, and helped bring customers back into the fold. As a result, comparable sales in North America rose 6% at both brands for the full year. Internationally, Gap had excellent results in Asia, where revenue grew 11% over the full year.

The company used that strength to fuel three big decisions. First, it decided to make a push on its lululemon athletica (NASDAQ: LULU  ) rival brand, Athleta. Over the course of 2012, it increased its store count from 10 to 35. As a result, revenue from the Athleta-Piperlime division rose 31% over the year. The second move Gap made was to add a high-end boutique brand, Intermix, to its portfolio. Intermix competes at the Michael Kors (NYSE: KORS  ) level, unlike Banana Republic which competes with J. Crew. Gap is excited about Intermix because it has seen what high-price sales can look like with Athleta. CEO Glen Murphy said last year, "[It] helps having Athleta in the business because we realize how high is high, because their [regular] price selling is very attractive."

Finally, Gap restructured its business in line with its brands instead of based on geography. That allowed the company to focus on the worldwide customer, instead of on localities. This move got a lot of talk on the conference call and it's going to underpin the business's entire 2013 strategy.

The potholes ahead
This year, Gap is going to focus on growth -- something that the brand's previous weakness hadn't allowed it to do for years. The company is planning on growing square footage, for the first time since 2007, by about 1% over 2013. The biggest challenge will be on the international front, where Gap is going to be pushing hard using the newly restructured businesses. Murphy said that Old Navy is going to expand in Japan, opening 15 or 20 stores this year. China is going to see an additional 35 stores, and Athleta is going to open 30 stores in different locations.

That's going to take a lot of energy and capital to make happen, and the company expects to increase capital expenditure slightly to $675 million. But that's far from risk-free spending, as much of the expansion will be based on limited knowledge of the area. For instance, the Japanese expansion is resting on the company's one existing Tokyo store.

The biggest risk that Gap faces is going too big, too quickly. If it wants Athleta to compete with Lululemon, then it needs to beat Lululemon to the punch, but not sink tons of cash into weak areas. For its part, Lululemon is expanding slowly on the international scene, and could risk a big step backwards if it gets beat to the punch by Gap. Similarly, Intermix risks playing catch-up for the rest of its life if Kors keeps growing like kudzu. Kors increased comparable store sales by 41% last quarter, which is well beyond the reach of Intermix. The company is going to have to innovate quickly if it wants to take any market share from Kors.

Adding it all up, I'm optimistic that Gap will achieve its goals this year. I think that it's going to be a more subdued year, as the company will be comparing sales and income to those of a strong 2012 instead of a weak 2011. Having said that, the stock is still nicely priced, and it should give investors a solid -- though likely not spectacular -- return.

Lululemon 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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