RULE MAKER PORTFOLIO

<THE RULE MAKER PORTFOLIO>

Will it be Hip to Zip?

By Matt Richey (TMF Verve)

ALEXANDRIA, VA (August 13, 1999) -- The Gap (NYSE: GPS) is in the business of being popular. Baggy khakis, sandblasted jeans, white V-neck T-shirts, and other "basics" have been the thing. For the past several years, the San Francisco retailer has proven that classic styles plus cool marketing plus cool stores equals hot sales growth. Toss in some savvy financial management, and you get even hotter earnings growth. That was the story once again yesterday as Gap topped Wall Street estimates by a penny with second quarter earnings of $0.22 per share, up 47% from a year ago. But not everything is as hopping as it once was for our Rule Making retailer.

Today, I'm going to give Gap its quarterly checkup by walking through the first five of the 10 Rule Maker Criteria, saving the second five for Monday.

1) Dominant Brand -- Being cool is a constant challenge (remember high school?). If you let down your guard for even a moment, you may find yourself runner up to the new cool kid. Or, in the case of Gap, competitive threats may be coming from a number of players who have bulked up on their cool quotient. Check out the following second quarter same-store sales for Gap and three of its main competitors:

Abercrombie +17%
American Eagle +16%
The Limited +9%
The Gap +8%

The problem is that when it comes to clothes, most people like variety. Gap, with its strong portfolio of stores (The Gap, Banana Republic, Old Navy, GapKids, and Gap Body), does a better job than any other retailer at being the default for casual clothing. But even so, being the top dog in this industry doesn't come easy.

As an experiment, I enlisted the help of my 20-year-old sister, Anna, a college student at The University of Tennessee, a very fashion-conscious shopper, and a former employee of both The Gap and Abercrombie & Fitch. I asked her, "Considering fashion, wearability, price, coolness, and basically anything that matters to you, rank your favorite stores." Here are the results:

1. J. Crew (a company Fools wish was public)
2. Banana Republic
3. Abercrombie & Fitch
4. Express
5. Ann Taylor
6. Limited
7. Gap
8. Old Navy

She added, "J. Crew does the best job of covering all the bases -- from casual to classy and cotton to leather, plus accessories, shoes, etc. The rankings are basically irrelevant other than that they represent the order of where I'd shop -- but I would go to ALL of them... My friends' opinions are surely different, although everybody likes most of those stores...."

So, while Gap continues to be the dominant brand in its industry (and the #29 global brand), the retail apparel business is swarming with other hungry competitors. As Tom mentioned following Gap's first quarter results, Abercrombie & Fitch (NYSE: ANF) is the competitor that deserves special attention in this category.

2) Repeat-purchase Business -- Gap's market-segmentation strategy -- Old Navy (affordable and trendy), The Gap (reasonably priced and classic), and Banana Republic (upscale and elegant) -- allows the company to hit a wide range of consumer styles and price points. A majority of consumers are shopping at at least one of these stores on a monthly basis.

3) Convenience -- During the past year, Gap has added 339 stores giving it 2,611 in total, which places it well ahead of Abercrombie's 208 and American Eagle's 426. The only competitor that comes close is The Limited with its 3,373 stores, but Limited's highly diverse portfolio of brands (Express, Lerner New York, Structure, Galyan's, and Henri Bendel) means that each brand is spread more thinly. So, by retail reach alone, Gap is the convenience winner.

4) Expanding Possibilities -- Domestic expansion is still underway with the expectation for another 250-300 store openings by year end. Gap Body stores, which will offer lotions and undergarments, are slowly rolling out with 15 locations expected to open this year. Right now, management considers the Gap Body concept still to be in development stage, but once it determines the optimal store size and merchandise assortment, the company will aggressively expand the store count.

Elsewhere, while still small right now, Gap's e-commerce initiatives are one clear area where the company has room to grow. Later this year, the company plans to revamp the gap.com website and roll out a Banana Republic site. One very practical use for the websites will be to offer a wider variety of sizes that aren't normally stocked in the stores.

Another growth avenue is international expansion. The company is advertising aggressively in Japan and the United Kingdom; management considers these two locations to have the most potential in the near-term. Gap's operations in France were break-even last year and are expected to be profitable this year. One dampening factor to profitability in overseas locales is that occupancy costs are much higher.

5) Your Familiarity and Interest -- I shop regularly at The Gap, Old Navy, and Banana Republic and find the company's segmentation strategy to be fascinating.

On Monday, I'll finish up with Gap's financial performance, in particular focusing on our five financial criteria. For a preview of what's to come, check out da numbers at this link, which shows how Gap stacks up as a Rule Maker versus its three primary public competitors: Abercrombie & Fitch, Limited, and American Eagle Outfitters. Here's a preview of what the numbers reveal -- Gap isn't exactly winning the popularity contest anymore.

Finally, be sure to check out tomorrow's Fool Radio Show, which will feature an interview with Coca-Cola's Director of Investor Relations, Larry Mark. In addition, yours truly will be chatting with Tom Gardner about Rule Maker investing, so be sure to tune in.

Have a great weekend, and Fool On!

08/13/99 Close
Stock Change    Bid
AXP   +4 15/16  134.69
CHV   +  11/16   96.75
CSCO  +1 7/8     63.56
DPH   +  3/16    18.44
EK    +  9/16    71.44
GM    +3 5/8     64.19
GPS   +2 5/8     40.50
INTC  +3 13/16   79.75
KO    -  5/16    59.81
MSFT  +2 15/16   84.69
PFE   +  1/2     34.50
SGP   +  7/8     50.19
TROW  +  1/16    33.31
XON   -  1/4     81.56
YHOO  +4 7/16   132.81


                  Day     Month  Year    History
        R-MAKER  +2.98%   0.31%  12.20%  41.29%
        S&P:     +2.27%  -0.08%   8.59%  34.33%
        NASDAQ:  +3.46%  -0.03%  20.30%  59.59%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
   6/23/98   68 Cisco Syst    29.21     63.56   117.64%
    2/3/98   54 Microsoft     45.13     84.69    87.63%
    5/1/98   82 Gap Inc.      23.05     40.50    75.68%
   2/13/98   52 Intel         46.93     79.75    69.94%
   5/26/98   18 AmExpress    104.07    134.69    29.42%
    2/3/98   66 Pfizer        27.43     34.50    25.76%
    6/3/99   11 *Delphi Au    17.19     18.44     7.26%
   8/21/98   44 Schering-P    47.99     50.19     4.57%
    2/6/98   56 T. Rowe Pr    33.67     33.31    -1.07%
   2/27/98   27 Coca-Cola     69.11     59.81   -13.45%
   2/17/99   16 Yahoo Inc.   126.31    132.81     5.15%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon         64.34     81.56    26.78%
   3/12/98   15 Chevron       83.34     96.75    16.09%
   3/12/98   20 Eastman Ko    63.15     71.44    13.13%
   3/12/98   17 *General M    61.28     64.19     4.74%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
   6/23/98   68 Cisco Syst  1985.95   4322.25  $2336.30
    2/3/98   54 Microsoft   2437.28   4573.13  $2135.85
   2/13/98   52 Intel       2440.28   4147.00  $1706.72
    5/1/98   82 Gap Inc.    1890.33   3321.00  $1430.67
   5/26/98   18 AmExpress   1873.20   2424.38   $551.18
    2/3/98   66 Pfizer      1810.58   2277.00   $466.42
   8/21/98   44 Schering-P   2111.7   2208.25    $96.55
    6/3/99   11 *Delphi Au   189.09    202.81    $13.72
   2/27/98   27 Coca-Cola   1865.89   1614.94  -$250.95
    2/6/98   56 T. Rowe Pr  1885.70   1865.50   -$20.20
   2/17/99   16 Yahoo Inc.  2020.95   2125.00   $104.05

Foolish Four Stocks
    Rec'd    #  Security     In At     Value    Change
   3/12/98   15 Chevron     1250.14   1451.25   $201.11
   3/12/98   20 Eastman Ko  1262.95   1428.75   $165.80
   3/12/98   20 Exxon       1286.70   1631.25   $344.55
   3/12/98   17 *General M  1041.80   1091.19    $49.39

                              CASH    $100.83
                             TOTAL  $34784.52


Notes: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.

*Although DPH is not a Foolish Four stock, it was spun-off from GM on June 3, 1999

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