At the heart of every investment is a comparison of options. A money market account versus the mattress. A bond index fund versus a certificate of deposit. An individual stock versus the S&P 500 index fund. Often, I find myself comparing one stock versus another, especially when the two companies share something in common. Take, for instance, Yahoo! (Nasdaq: YHOO) and former Rule Maker holding Gap Inc. (NYSE: GPS), which as of Friday were priced almost identically by the market at a valuation of right around $21 billion.
In addition to having virtually equivalent market caps, there are several broad similarities worth noting.
For one, both companies have a globally recognized consumer brand name. In the 2000 brand rankings by Interbrand, Gap ranked #29, while Yahoo! ranked #38. (It's also worth noting that since 1999, Gap's ranking held steady while Yahoo! moved up from #53.)
Second, both companies similarly dominate their industry, which is to say each holds a leadership position amidst a slew of competitors. In the Internet advertising industry, Yahoo! bumps heads with America Online (NYSE: AOL) and Microsoft (Nasdaq: MSFT). In retail apparel, Gap faces the likes of J. Crew (privately owned), Abercrombie & Fitch (NYSE: ANF), and Limited (NYSE: LTD).
Finally, both companies serve sustainable, enduring customer needs (as Rob discussed last Thursday). Ask yourself these questions: For Yahoo!, will there ever not be a need for businesses to connect with customers through advertising? For Gap, will there ever not be a day when most reasonably affluent human beings want to dress in casual, comfortable clothing? Advertising and apparel will be around as long as civilized society.
But enough about the similarities. It's the differences that will offer us some real insight into which of these two companies represents the better investment at the current price. One immediately apparent difference is that Gap has about 12 times more sales and 4 times more net income than Yahoo! over the past year. I think, however, that any current sales and income differences pale in comparison to the contrast we find in the business economics of these two companies. Three economic differences, in particular, stand out: inventory management, fixed asset requirements, and global reach.
Inventory is just the stuff a company sells. Inventory management is the entire process of getting a product to the customer. This process must be managed carefully in order to minimize inventory depreciation, spoilage, and carrying costs.
Let's consider Gap first. The logistics of selling clothing are incredibly difficult. Gap must vigilantly monitor the quantity and mix of clothing styles, colors, and sizes. Too much of some particular item, and it goes on the sales rack. That marked-down merchandise waters down profit margins. On the flip side, out-of-stock merchandise in a certain size/style/color causes Gap to miss a potential sale from an otherwise willing buyer.
Since Gap wants to be known for convenience, it leans towards overabundant inventory. The result? At the end of October, Gap had $2.6 billion in inventory -- a 41% increase over the past year, during which time quarterly sales increased only 12.1%. The costs of carrying all that inventory are enormous. Also, because of markdowns on excess inventory, Gap's gross margin in the third quarter was six percentage points below that of last year -- 36.8% versus 42.8%. Ouch.
One-hundred eighty degrees on the other side of the business coin sits Yahoo!, which has exactly zero physical inventory. Yahoo!'s inventory is its digital advertising space. No possibility here of spoilage. No carrying costs if a Web banner goes unsold. Yahoo!'s virtual product (really a service) protects the company from all the financial risk commonly associated with your typical manufacturing company.
Fixed asset requirements
Every company has a certain amount of "hard" equipment -- whether buildings or computers or retail outlets or delivery vans -- which is a necessary investment for running the business. The most profitable businesses require relatively low levels of such fixed assets.
Gap's 3,542 stores and other property and equipment carry a balance sheet value of $3.6 billion. That hefty sum is increasing dramatically as the company increases its retail footprint at a pace of 30% per year. In the past year alone, Gap spent $1.7 billion on capital expenditures -- mostly for new stores and lease agreements. These costs are an enormous drag on Gap's ability to generate free cash flow for shareholders. Never mind the $1 billion reported in accounting net income over the past 12 months; the cash reality is that Gap has lost $734 million in free cash flow.
In contrast, even as a young company, Yahoo! is already generating substantial sums of free cash flow because of its low fixed asset requirements. Yahoo! has only $98 million in net property and equipment, most in the form of office computer and networking equipment. From this $98 million investment, Yahoo! has earned nearly $1 billion in sales over the past year. In contrast, Gap's $3.6 billion fixed asset investment resulted in $13 billion in trailing sales. Divide the second number by the first and you can see that Yahoo! has superior fixed asset productivity. Yahoo!'s lean fixed asset requirements have been instrumental in its ability to generate $447 million in free cash flow over the past year.
Great Rule Makers are global Rule Makers. Companies like Pfizer (NYSE: PFE), Cisco (Nasdaq: CSCO), Coca-Cola (NYSE: KO), Microsoft (Nasdaq: MSFT), and American Express (NYSE: AXP) all serve customers the world over. Not every business, however, provides a product or service with global appeal.
One of the main reasons we sold Gap back in September was because of its difficulty expanding internationally. As Zeke Ashton wrote, "On the continent, by which I mean Germany, Switzerland, and Italy, the 'American' look of Gap is just not big, and never will be." Gap, which has been in business since 1969, generated just 11.3% of its total sales overseas as of the end of last year. It's going to take a lot of capital, time, and marketing savvy for Gap to become a powerhouse outside the U.S.
In contrast, as only a five-year-old company, Yahoo! already generates 16% of revenues from outside the U.S. As Forbes reported last week in its excellent cover story -- "Yahoo!: Killer Ad Machine" -- Yahoo!'s international penetration at this stage of its corporate lifetime compares favorably to Proctor & Gamble (NYSE: PG), which took 141 years to reach international revenue contribution of 20%. In fact, Yahoo!'s foreign users make up 40% of the total audience, so it's to be expected that Yahoo!'s international revenue will eventually catch up with the foreign audience and become its majority source of revenue.
So, clearly Yahoo! has superior business economics to Gap. But the final burning question is this: At the $21 billion price tag, is Yahoo! a better value than Gap when Gap currently generates $12 billion in annual revenues to Yahoo!'s $1 billion? I think so. I'd much rather own a company like Yahoo!, one that's able to scale rapidly and efficiently on a global basis. And, again, consider that Yahoo! already generates more free cash flow than does Gap, despite the large disparity in annual sales.
Based on Yahoo!'s superior inventory management, fixed asset productivity, and global reach, you won't be surprised that my vote for this month's $500 addition to the Rule Maker portfolio is for purchase of additional shares of Yahoo! The other Rule Maker managers will chime in with their votes during the remainder of this week, and we'll announce on Friday what we'll be buying.