Fool Buys Gap
April 20, 1995

The Gap Inc. (NYSE:GPS)
Type: Large-Cap Growth
Phone: (415) 952-4400
Closing Prices, April 19th, 1995: Bid $31 3/8 Ask: $31 5/8

Trailing 12-month revenues: $3.3 billion
Trailing 12-month EPS: $2.20
Last quarter reported: December 1994 (FY: Dec)
Next quarter reported date: 1Q, May 11, 1995
Consensus EPS estimates for quarter: $048e vs. $0.44
FOOL ratio: .79

Year-ahead PEG: .71

Trade: Buying 155 shares, April 20th

OVERVIEW

The Gap Inc. (NYSE:GPS), based out of San Francisco, CA, is a multi-billion dollar specialty retailer of casual apparel for men, women, teens, and wee ones. Tha company operates over 1500 stores nationally and internationally, with presence in the fifty largest metropolitan areas in the US, dozens of stores in Great Britain and Canada, a rebuilt homestead in Paris, and a growing interest in the Asian markets. Under the Gap Inc. umbrella sit The Gap, GapKids, BabyGap, Old Navy Stores, and Banana Republic. If you aren't familiar with these outlets, you probably haven't heard of McDonald's, Microsoft, or Coca-Cola. Banana Republic and Gap stores seem to sit on every corner, cannibalizing one another in Big City, America.

The Gap is going to be the only one of its kind in The Fool Portfolio, a large-capitalization growth stock that isn't a Dow heavy. Were it, GPS wouldn't even qualify as a Beating the Dow stock---not a high enough dividend yield at a mere 1.5%. What GPS is, though, is a monopoly-sized, specialty retailer with above-average sales and earnings growth, growing dividends, cash strength, and negligible long-term debt. Of equal importance here, the specialty retailing sector has gotten mauled over the past six months, leading into and following on the heels of a weak Christmas season. The Gap has fallen from a six-month high of $48 7/8 to its present perch at $31 5/8.That's a 35% drop in less than a year. Ouch.

Year-end earnings per share figures came in on March 2nd at $2.20, three cents above estimates. With $2.60 estimated for fiscal 1995, and a 17.3% projected five-year growth rate, The Gap looks cheap to a Fool. We're not playing an O'Higgins-style turnaround here, with their traditionally swollen yields and torched brand names. We're playing a growth and sector turnaround: a company with a respected brand name, some market-beating estimates, repeated estimate-beating quarters, and one in an industry that has been kicked around by the short-sighted Street. The meltdown looks to have provided an excellent opportunity for long-term, buy-hold-and-outperform investors like us to gather up some shares and sit on 'em.

BUSINESS

The Gap Inc. consists of four major retailing units, The Gap, GapKids, Old Navy Stores, and Banana Republic.

THE GAP STORES: These outlets have changed noticeably over the past eighteen months, with increased concentration on gender-specific displays and apparel. You don't see guys walking out of dressing rooms, circling in front of mirrors in women's jeans, espadrilles, and sunflower hats before realizing they went to the wrong corner of the store. Gap stores make up over half of the Company's offerings, and a Fool might expect to see more of these pop up internationally in the coming years.

GAPKIDS: This group continued to race forward in fiscal 1994, now totaling more than 300 stores nationwide. Modeled after the parent stores, GapKids provides a roomy showroom of colorful, contemporary clothes for little guys and gals. The majority of GapKids stores now have BabyGaps stashed in the back. Some stuffed animals here, some jumpsuits and overalls there, a nice mix. GapKids is a rapid grower for the Company.

OLD NAVY CLOTHING: Old Navy Stores, "Ye Olde Gap Warehouses," are larger outlets that shop cheaper apparel en masse to price-conscious shoppers. The fostering of Old Navy stores, with their mid-quality clothing and rock-bottom pricing, is enough to give GPS competitors the willies.

BANANA REPUBLIC: The upper-middle class blazes through the aisles of Banana Republic stores looking for higher-quality cloth at higher prices. More than any, Banana Republic has restructured their interior to clearly distinguish between men's and women's clothing. Finally, Banana Republic presents an interesting example of brand name construction away from the mother company. You can expect many of their non-shareholding customers to be unaware of the relationship between these guys and The Gap Inc.

FINANCES

The stock's miserable performance over the past six months is made all the more attractive to Fools who peruse the company's balance sheet, and income and cash flow statements. Let's eyeball its fourth-quarter and year-end earnings report first.

              4Q 1994        4Q 1993
Revenues  $1,210,000,000  $1,060,000,000
Earnings    $118,800,000    $109,300,000
EPS                $0.82           $0.75

                 1994           1993
Revenues  $3,723,000,000  $3,296,000,000
Earnings    $320,200,000    $258,400,000 
EPS                $2.20           $1.78

That leaves us with year-end sales growth of 13%, earnings growth of 24%, and per-share appreciation of 24%. Net profit margins swelled from 7.8% to a retail-hearty 8.6%. 4th quarter margins did, however, decline from 10.3% in 1993 to 9.8% in 1994.

A Foolish glance at the balance sheet occasions the phrase: INDUSTRY DOMINATION. A current ratio (current assets/current liabilities) above 2, working capital over $400 million, more than $350 million in cash, inventories under control, no trace of leveraging, and a cash dividend that, though small, has increased year after year. In 1994, the Company upped its dividend from $0.38 to $0.48 per share.

All signs point to pure, spotless, genuine, real, sheer growth going forward, which is going to translate into a larger international presence, a greater variety of offerings in the US (BabyGap, Old Navy et al), and hopefully, an even more gleeful bunch of Fools.

PERFORMANCE

Tat-tat-ratta-tat-ratta-tat-tat-tat, The Gap (NYSE:GPS) has gotten machine-gunned since its early autumn run to over $48 a share, down since then (as mentioned earlier) more than 35%. In fact, when looked at in the context of GPS's 1991 52-week high of $59, ARF ARF ARF, Da Gap has been a howler. That's right, over a matter of YEARS, this issue has rewarded high-end buyers with a whopping 46% loss. That smarts.

But Fools with an affection for the PEG, the year-forward PEG, cash ratios, and industry rotation know not to buy the stock after a roaring Christmas season, with stores overflowing, earnings peaking, the stock bursting through "resistance levels" (the ultimate will-o'-the-wisp), hitting new highs with momentum players trying to get their palms on as many shares as possible. It has been rightfully noted in our Gap folder that investors who had purchased the stock after significant declines over the past five years would have made a tiny fortune. After a 35% drop in a half-year, we think it's time to buy and hold on tight.

So, a Fool believes that price targets based off fundamental valuations are mighty important when it comes to picking your entry points into the retail sector. Do you remember The Fool's retail shorts listed just over a year ago in Ye Olde Printed Foole? Let's revisit them:

Bed Bath & Beyond at $34, now $18 1/4

Bombay Company at $30, now $8 5/8

Men's Wearhouse at $32, now $23 3/8

The Market. . . it moves randomly, right? After all, that's what your business school professor taught you (or your friend who made the mistake of attending business school!). That's what your business colleagues may have emphasized. Pshaw. Sectors come into favor and sectors go out of favor. With retail apparel getting kicked in the belly, and The Gap off significantly---though financially as strong as ever while beating expectations---we're looking beyond that relative strength below 40.

PROSPECTS

Certain situations pop up each year where a Fool is inspired, in a modified Buffett-style, to buy up shares of a public company and to hold on tight. The Buffett modification? If The Gap meets our short-term price target, we expect to unload these shares back onto the open market. Conversely, if the stock bumbles and stumbles in the coming months, we'll just hold on tight, knowing that we're supporting a company that is financially strong, has excellent, industry-beating national and international growth prospects, and is home to a world-class brand name.

Looking at the estimates going forward, GPS has $2.20 of earnings per share in the bank; it is slated to pull in $2.60 a year from now; and it's tabbed with a 17.3% five-year growth rate. The traditional-PEG generates an 18.2% growth rate for the year ahead (2.60 / 2.20), and a fair price of $40 (18.2 X 2.2). For those in the dark, the PEG holds that, at every given point in time, the P/E should equal a growth stock's growth rate for all financially-healthy companies. That means that our fair price today for The Gap is $40 a share.

In the case of billion-dollar behemoths, though, particularly those with plenty of cash and insignificant long-term debt obligations, a Fool sometimes pushes the earnings forward a year, and applies distant growth rates. Why? Because Wall Street may look further forward in the case of its stable giants. Applying the "Year-Forward PEG," we use a multiple of 17.3 (the five-year projected growth rate) off earnings of $2.60, yielding a fair price of $45 a share.

Additionally, The Gap's current dividend yield is 1.5%. Over the past several years, the HIGHEST this company's yield has ever reached is 1.49%, further confirming our belief that these shares are undervalued.

With the stock at $31 5/8, we believe that, in the short-term, GPS reasonably has a price target of about $40. That would represent a gain of greater than 25% from the current price. If not, if GPS stalls through the summer and autumn, into a middling Christmas season, well, The Fool holds on tight. Going forward from here, with an eye on industry rotations, we see market outperformance in the shirts, shorts, and shoes of The Gap.