Rule Maker To Buy
April 28, 1998
**When Rule Maker announces an intention to trade, that trade will be made within the next five business days, as opposed to the very next day. For more detail on how buys are determined and how this portfolio originated, please read the "11 Steps to Rule Maker Investing" section of the Rule Maker Portfolio.**
Rule Maker Portfolio Buy Report
Announcement: Purchasing $1,875 in The Gap, Inc. stock.
An Overview of Our Decision
I'm going to launch this Buy Report a little differently than our first five reports. Why? Well, when we decided to add Gap Inc. (NYSE: GPS) to the Rule Maker Portfolio, I was reminded that Tom was the guy behind the Fool Portfolio's decision to sell Gap stock in the summer of 1996 (see The Fool Portfolio Is Selling The Gap).
Why did they sell? I asked myself. There must have been a reason.
So, in the course of doing my research on Gap, I kept an eye out for any of the events that I mentioned in my Rule Maker report of March 11 on selling Rule Makers (see When to Sell a Rule Maker Stock). Had management at some point been dishonest with shareholders? No. Had this public company done a poor job of communicating to all of its owners? Nope. Had the company seen a dramatic downturn in the popularity of its loose-fitting jeans? No, not that. Had the balance sheet shown signs of business wear and tear? Certainly not.
So, what did I find? Well, I actually found something that Tom often preaches against today. The Fool Portfolio sold Gap back then based on its short-term valuation in the public markets. In other words, I found nothing -- not a thing -- to warrant the sale of Gap stock under our guidelines here in the Rule Maker. Our concerns in this area are far more with the viability and sustainability of pure earnings growth through a business for years to come than they are with the present P/E ratio assigned to that company's stock by investors.
And, it sure was nice to see my analysis and our hunches confirmed. I quoted the stock this morning; here's what I found. Since the Fool Portfolio cashed out of its position in the Gap, its shares have more than doubled -- marking market outperformance over that time. Though, at the time of sale, the Gap's stock may have appeared undervalued relative to another like 3Com (which the Fool Port purchased), there was nothing at the business level to indicate that valuation should have been Tom's primary concern (or secondary, or tertiary).
It looks like Tom learned something there, eh?
In fact, we need look no further than a popular message folder in Fooldom (see My Dumbest Investment folder) to be reminded that the lion's share of confessed errors there fall into two categories: 1) Investments in penny stocks pitched by telephoning brokers; 2) The too-early sale of investments in great companies. Tom should take a moment and fill out a post for that folder on the sale of Gap stock in the Fool Portfolio!
Ok, enough! Enough, I say. We've battered our leader plenty here. Let's move on to the discussion of why we're adding this filly to our portfolio.
An Overview of the Company
The Gap is an international specialty retailer that operates stores that sell casual apparel, shoes, and other accessories for men, women, and children. Its products are sold under such brand names as Gap, GapKids, babyGap, Banana Republic, and Old Navy Clothing Co.
Nearly all of the products carried by our company have private labels. Private label merchandise is one of the principal contributors to the strong consumer mindshare of Gap, which operates different stores for different market segments. For example, The Gap stores have clothing for men and women; GapKids clothing is for boys and girls ages 2-12; the babyGap line is for boys and girls under age 2; Banana Republic offers classic, casual, higher-end fashions for men and women; and Old Navy Clothing offers casual-basic and fashion clothing at lower prices for men, women, and children.
As of February 28, 1998, Gap operated a total of 2,143 stores under all of its brands in the U.S., Canada, the United Kingdom, France, Germany, and Japan. The company was incorporated in July 1969 and came public in May 1976.
The Basic Financials
Over the last ten years, Gap has continued to demonstrate consistent sales and earnings growth while maintaining gross and net profit margins that are among the best in the retail industry. During this time, Gap has also posted increasing positive cash flow.
Further, the company has increased its annual dividend per share every year since 1986 -- a great indicator of positive momentum for the business, but something we'll be questioning the company on in the years ahead (we're not huge fans of taxable dividends).
More laudable in our minds is Gap's methodical plan to buy back its own shares in the open market. Between 1988 and today, the company's total shares outstanding has decreased. Our company-to-be has made the decision that there are few easier ways to create value for shareholders than to buy back its ownership position in itself. No labor costs, no organizational challenges, no searching for uncontrollable short-term growth rates. Nope, Gap has found ease and reward by methodically repurchasing its own shares alongside the disciplined operation of its business.
This all adds up to what we consider a very Foolishly run business that has consistently provided great returns to its shareholders.
Let's take a look at some of the income statement numbers (of course, the complete 10-K is available for your perusal at www.freeedgar.com or at the SEC Edgar site -- Gap's 10-K Report). What we like to study is the company's present perch and 10-year historical growth rates... and here, they are:
Gap's 10-Year Growth Rates
Annual 1997 1988 Growth Rate Revenues $6.5 bil. $1.3 bil. 20% Gross Profit Margin 42% 35% 3% Net Profit $534 mil. $74.2 mil. 16% Net Profit Margin 8.2% 5.9% 6% EPS (cont. operations) $1.35 $0.18 19% Dividend $0.20 $0.05 15% Shares Outstanding 393.1 421.6 -2%
Check it out -- Gap has driven sales and earnings up dramatically, at 20% and 16% per year, respectively. Gross margins have been rising, as have net margins. And these margin improvements have come while the company has continued to enter new markets and has been diversifying its product line.
And how sweet it is to see earnings per share up 19% per year, in part because Gap's financial managers have bought back that 6.8% of the company (or 28.5 million shares) over the past ten years.
Basically, for us, all of the numbers on the income statement are heading in the right direction -- which is critical to our investment approach. Because as nifty as it is to run screens to locate great businesses in the here and now, we think it equally important (if not doubly so) to know where the company has come from and where it is headed. As identified in Step Six of our 11 Steps to Rule Maker Investing, direction is as important to us as present location. Directionally, the Gap is very much on target.
Let's look at a few more numbers about Gap...
The Basic Financials
Price (as of 4/27/98)...................$46.25/share
Calendar 1998 Est.Earnings........$1.6
Calendar 1999 Est. Earnings.......$1.90
P/E on Trailing Earnings...............34.3
P/E on 1998 Est. Earnings...........28.7
P/E on 1999 Est. Earnings...........24.3
Basic Rule Maker Criteria (*)
Market Capitalization....................$18 bil.
Gross Profit Margin......................42.0%
Avg. Net Profit Margin.................. 8.2%
Cash (and short-term securities)....$913 mil.
Long-Term Debt............................$496 mil.
Cash as % of Debt........................1.84x
Leveraged Flow Ratio (< 1.25)........0.93
Unleveraged Flow Ratio (< 1.5)......1.01
(*) All balance sheet data as of 1/31/98
Additional Data (*)
Consensus 5-Year Growth Rate.....17.29
Debt as % of equity......................36.7
Debt as % of revenues...................8.9
Return on Equity...........................33.0
Return on Invested Capital..............56.2
(*) All balance sheet data as of 1/31/98
Concentrated Look at the Business
As we mentioned before, Gap is a specialty retailer that operates 2,143 stores in the U.S., Canada, the United Kingdom, France, Germany and Japan. The company's products are sold under a variety of brand names including The Gap, GapKids, babyGap, Banana Republic and Old Navy. But, nearly half of the company's stores are the plain-ole, you-seen-em-everywhere Gap storefronts.
Gap stores sell wide assortments of classically styled, high quality, casual threads at moderate prices. The products sold in Gap stores across the land sit in many bureaus, closets, and bathrooms. Gap offers everything from denim, khakis, and T-shirts, to accessories and personal care products for men and women.
In 1986, Gap entered the children's clothing market with the introduction of GapKids. And in 1989, it launched babyGap. These stores offer casual clothes, outerwear, shoes, and other accessories of the same style as those sold in Gap stores. As of February 1998 there were a total of 573 GapKids and babyGap stores, including 105 in international locations.
Banana Republic was acquired by Gap in 1983 when it had -- get this -- only two stores. It now offers sophisticated, fashionable collections of dress-casual and tailored clothing and accessories for men and women. In plain English, this means that the clothes sold in Banana Republic are generally more expensive than those sold under the Gap brand. As of February 28, 1998, our company operated 259 Banana Republic stores, including 9 in Canada.
And then we have Old Navy stores, which have proved a brilliant stroke by Gap management. Rather than let themselves be cannibalized on pricing by competitors, Gap created its own discount stores when it launched Old Navy in 1994. The clearest difference between Old Navy and its low-priced competitors is the level of service Old Navy provides -- eschewing the blue-light specials and the stacks of clothes strewn across superstore tables and focusing on a well-lit, clean environment for the sale of lower-priced apparel. There are now over 285 Old Navy stores worldwide, and the future looks bright for the chain that almost was named "Forklift" (phew!).
Gap believes that its various brands are among its most valuable assets -- even though the true value of a name doesn't show up on any financial statement. As a matter of fact, one of the biggest changes that the company has made over the last few years is to start looking at itself as a brand rather than a simple retailer.
Ok, what about management?
In the leadership ranks, Gap's Chairman, Donald G. Fisher, is now 69 years old. In 1997, Fisher was named the National Retail Federation's Gold Medal Award Winner. This award was given for his tremendous contribution to the industry in reinventing the business, anticipating new trends, understanding consumers, and empowering others at Gap with the knowledge they will need to take the company to the next generation.
The last line there is critical. The rest of the executive management team at Gap ranges in age from 38- to 53-years-old, with Millard Drexler as acting CEO of the company. As Mr. Fisher looks to move himself increasingly into a casual retirement -- in casual clothes, casually eyeing the waters of the Caribbean -- his strategy of succession and his ability to train new leaders are crucial components to the future of Da Gap.
Historical Stock Performance
Gap came public in May 19, 1976, at $18 per share. After adjusting for splits, this translates to a price of $0.375 per share. And that means that Gap stock has appreciated at an annualized rate of just slightly less than 24.5% since that initial public offering (IPO). $5,000 invested in Gap in 1976 is worth over $620,000 today -- without even including dividend payments.
And since its inception, Gap has grown its sales and earnings more than 15% per year, doubling in size repeatedly in less than five years' time. The company has also authorized three significant share-repurchase plans over the last 10 years. Adjusting for splits, Gap repurchased 24 million shares in 1988, 18 million shares in 1994, and 30 million shares in October of 1996.
Finally, according to Gap's most recent prospectus, company directors and officers presently own 29.8% of The Gap's outstanding common stock.
Concerns Going Forward
Ok, let's consider seven of the greatest risks facing our company:
According to Gap's own assessments in years past, the most critical factor in its profit growth is its total growth in the number of well-placed stores. If the Gap division is unable to continue a nice trend here and can't persist at driving its comparable store growth ever higher, the company and its stock will hit trouble spots. We'll be watching those same-store sales growth rates, as well as new store developments in our Rule Maker Daily Reports in the months ahead.
But expansion has to be managed and measured. The company also runs the risk of growing sloppily via its expansion into new channels of distribution and new markets (primarily international developments). There are established regional and national chains here in the United States and abroad that could whittle away at our company's lead. Gap has to expand scientifically, aggressively, and well... conservatively.
And the growth will not come its way too quickly. For example, Gap's investments in stores in Germany and France are not yet profitable. It's too early to tell if we're going to "win" there. Of course, this is natural in any developing business (we sometimes wonder if Barron's understands this when it reports on Internet companies). For Gap, this unprofitable top-line growth in new international stores is resulting from early stages of expansion, a soft retailing environment, low brand awareness early on, and company investments in infrastructure.
Gap's life in the international markets is, as yet, largely unproven. There is tremendous potential here; it's just tremendous -- of Coca-Cola proportions, even. But the jury is still out on the expandability of the brand into foreign markets.
Next up, you know it and we know it, the retail apparel business fluctuates according to customer preferences... dictated by fashion and season. These variations have a significant impact on the inventory owned by retailers as merchandise is ordered well in advance of each season -- sometimes even before fashion trends are evidenced by customer purchases. These trends make the company vulnerable to demand and pricing shifts and to errors in selection and timing of merchandise purchases.
Exposure on the supplier side makes Gap vulnerable -- which is true everywhere inside this industry and out. Presently, Gap purchases merchandise from 1,200 suppliers located throughout the world -- 27% of its merchandise comes from domestic suppliers and 73% comes from suppliers located outside the United States (the most significant of these is Hong Kong at 6% of the company's supply). Any event causing a sudden disruption of imports from any of Gap's foreign suppliers, including the imposition of additional import restrictions, trade restrictions, or tariffs, could hit Da Gap hard.
Finally, again, Gap's business is highly competitive. Our stores compete with national and local department, specialty, and discount store chains and independent retail stores that handle similar lines of merchandise. Some of our competitors have larger sales and more assets than we do.
The company's stock presently trades at a premium to its 5-year growth rate. The company is expected to grow at around 17.3% per year and its stock is trading at 36x earnings. We have never believed that the Fool's PEG ratio could be applied to companies with over $1 billion in sales (as writ in The Motley Fool Investment Guide). But the YPEG calculation for larger companies does set a fair price of around $33. Though this is a concern, for a variety of reasons -- explained in our 11 Steps to Rule Maker Investing -- we think the company should be valued well in excess of its YPEG.
We consider those to be the seven chief concerns facing Da Gap and Gap investors.
Prospects Going Forward
And here's a brief look at six great opportunities and strengths at Gap:
1) The trend is very much our friend here. A growing trend in the business world today is to allow employees to wear "business casual" clothes to work. The clothes sold in both The Gap and Banana Republic stores are increasingly surrounding the water coolers of our nation's corporations.
Yep, informal wear is all the rage as the workforce gets younger. The trend is so strong, in fact, that at Fool HQ, our leaders are about to institute a policy called "Dress-Up Tuesday" -- to combat the casual momentum trend (CMT); they have even given it an acronym. On the first Tuesday of every month, apparently Fools will be dressing up at Fool HQ. So, out of the 240 some-odd workdays each year, they'll be going formal for just 12 of those days.
We consider that to be representative of some extremely strong indicators for Da Gap.
2) The Gap very closely fits our model of the low-priced, repeat-purchase business. Many Gap shoppers return from month to month to pick up Gap jeans, slacks, T-shirts, socks, etc. The repeat purchasing provides Gap with free marketing/promotion value, as consumers remind themselves regularly of the value of our company just by being there.
On the price side of the equation, the majority of Gap's items are set at price points that consumers can reach -- in both spectacular and poor economic times. Affordable prices are the critical driver behind global expansion. Gap's got 'em.
3) Let's face it, our company has built tremendous brand loyalty among its customers. How? By listening to them. By interpreting their comments and offering products that some didn't even realize they needed. In order to help maintain and strengthen that brand loyalty, Gap has been increasing its investment in advertising and marketing as a percentage of sales. Baseball fans see our company's name on outfield fences across the country (in the gaps of left-centerfield and right-centerfield). Magazine fans have seen photos of all sorts of business leaders hanging out in Gap attire.
And to further its name, Gap is also exploring the possibility of issuing store label credit cards (look out for the interest rates, though, Fools!) as well as expanding its number of flagship stores and increasing its television advertising. The company is also planning to expand its brand through new product offerings such as home accessories and personal care items. Our managers have even started experimenting with outside partners to produce such merchandise as Gap Barbie (eeeeek!), first sold during the 1996 holiday season.
4) The ace in the hole for Gap shareholders is our prospect for international growth. Gap is still largely an American phenomenon, with foreign stores only in Japan, Germany, France, the UK, and Canada. No stores in China. None in Indonesia. None in Eastern Europe or Russia. Nope. Italy, Ireland, Latin America, Spain, Thailand, Australia, Mexico? No, no, and no, no, no, no and no. Just like our other businesses, Gap has tremendous (even limitless) opportunities for growth around the world. The question is... can it capitalize on them, gradually and deliberately?
5) Not surprisingly (or else we wouldn't be buying it), the company is also one of the best managers of inventory in the retail business. Product sales are carefully tracked, which enables Gap to quickly identify slow moving merchandise and broken assortments (items no longer in stock in a sufficient range of sizes). From this information, Gap can quickly mark down prices to clear merchandise. Believe it or not, that's ultimately a positive -- it's better to sell slightly marked-down inventory than to absorb its carrying costs.
Inventory management is of extreme importance to us in all of our businesses -- it's particularly critical in apparel retailing. And Gap has mastered it to date.
6) Finally, the company has proven its ability to discipline its expansion with mathematics. Truly, years from now we expect to see annual reports from Gap that resemble Coca-Cola reports today -- celebrating an inching global expansion, broadening gross and net margins, and a brand name that resonates with people of all ages, all nationalities, all shapes and sizes, all interests.
Is Gap a Rule Maker Stock?
Let's remind ourselves of the basic Rule Maker criteria. We'll start with the qualitative measures:
Worldwide product affordability
Attractive consumer name brand
Gap meets these three qualifications. But what about the quantitative measures?
Market-beating historical performance
Sales over $1 billion; capitalization over $5 billion
Gross margins over 50%
Net margins over 7%
Cash at greater than 1.5x long-term debt
A Foolish Flow Ratio below 1.25
Gap glides past all of these but one. The company has crushed the market (and 99% of managed mutual funds) over its 22-, 15-, 10-, 5-, 3- and 1-year periods. As for point (b), the company has $6.5 billion in trailing sales and is valued at over $18 billion. Elsewhere, net margins for the business are running at 8.2% and inching higher. The company has over 1.8x more cash than debt. And product-and-cash flow management is strong -- with a Flow Ratio of 0.93 (and an Unleveraged Flow of 1.01) and nary a receivable to be found on its balance sheet.
The only Rule Maker criterion that Gap falls short on is the gross margin requirement. Typically, we look for companies that have very low material costs to their business, whose gross profits are more than 50% of their sales. Gap is settled in at 42% gross margins today, below our standard. But, to call it "settled in" is actually a key mistake! Gap has been driving its gross margins higher, click-click like an automaton. Gross margins have risen from 35.6% in 1994 to 42.0% today. We'll be watching this item carefully in the years ahead, rooting it higher, looking for it to run above 50% a decade hence.
And so, there you have it, Fools.
We'll be buying $1,875 worth of Gap stock at some point over the next five business days. We're extremely excited about this purchase, but as always, we hope you don't blindly accept it for your own portfolio. The single best way to beat the market consistently is to be consistently engaged in trying to understand public businesses. Even though the national financial media seems peculiarly committed to the idea that when an individual learns how to invest in this country, he or she is some kind of penny-ante huckster (how absurd!), we're continuing with our mission to learn more and target market-beating returns.
We hope we've taught you something valuable about Gap and we look forward to learning more about it from your opinions and analysis in the months ahead. We're putting some money down on our belief that Gap will measurably outperform the market's average returns in the years (even decades) ahead. We'll see. It'll be enlightening to follow their progress.
Drop by the Rule Maker message folder if you have thoughts, questions, or you want to praise this report (or otherwise!). Fool on,
- Phil Weiss