Brand revitalization isn't as simple as slapping a new logo on it, buying some TV time, and then letting the world beat a path to your door. Gap (GPS +0.77%) has found out the hard way that futzing with a logo can backfire, while its TV commercials brought in a big fat zero for years. But last year, things started to click, and a year later, the stock has skyrocketed -- a major achievement for a long term brand -- up 72% since last November. The company's newest earnings report and conference call highlighted what's coming to keep up the pace.
Skipping the third quarter highlights
Normally, this is what investors are looking for in an earnings report -- earnings. But for Gap, I'm less interested beyond the basics. Yes, income went up 60%. Yes, revenue went up as well, 8%. The big difference between the two is that costs of goods sold went from being 63% of sales last year to being 59% this year. That meant that this quarter, operating margin was 13.5%. Last year, due to high cotton prices and a weaker infrastructure, operating margin was only 9.6% in the third quarter.
And that point -- the drop in average unit cost -- is the starting point of the real story about what's going on at Gap.
What Gap is doing
Listening to the conference call that Gap had after the earnings release, it's clear what's really going on. Gap is making a move to become a more meaningful global brand. The first step toward that goal was the management restructure that Gap announced a month ago. Instead of having management be determined by locale, Gap is now managing the company based on brands. That means that each brand has a unified vision, one person in charge of the purse strings, and one person overseeing the overall message that the brand presents to the consumer.
This time last year, Gap was hamstrung by high cotton costs. Its margins were down, it was selling in a heavily promotional environment, and it therefore had little extra cash to advertise any changes it was making in-store. But even if it did, who would want to? Units per store were depressed, again, due to high inventory costs. If Gap was successful in getting people through the doors, they were likely to find the stores lacking in selection. Most notably, the company's factory stores and Old Navy brand suffered from lack of product on the shelves. This year, Gap has been able to use the extra cash to drive more feet through the doors.
That's meant higher sales, which has increased the brand's value to consumers. On top of the popularity factor, Gap has been faster to market with stylish clothing, and has increased its denim sales, drawing even more customers into the store. The gap -- tiny 'g' -- between the company's average retail sale and average unit cost has widened, giving it more flexibility in pricing and in marketing.
What Gap wants to do
All that has given the company some breathing room to advance its international operations. Right now, Gap is a U.S. brand. It has stores in lots of places, but international same-store sales continue to lag, down 3% this quarter, while domestic same store sales are up 6% to 9% across the company's core brands. Sales are up 7% outside the U.S., but the speed of growth is not high enough.
Part of the company's growth lust -- which is a fantastic term that I'm coining right here before your eyes -- comes from the success that the Athleta brand has had. CEO Glenn Murphy said on the call:
[I]t helps having Athleta in the business because we realize how high is high, because their [regular] price selling is very attractive.
Athleta is Gap's answer to Lululemon (LULU 0.12%), and the company opened eight new stores in the third quarter. Revenue in the Athleta/Piperlime segment is up 31% over last year, although it is still a small portion of overall revenue.
With the holidays coming, Gap is trying to make an end-of-the-year push to get all the income and momentum it needs to make 2013 an expansion year. It has already announced plans to open 20 new Athleta stores next year, and grow the Old Navy brand. Gap is also going to try and change its mix a bit toward the factory stores, which are currently underutilized and suffered after last year's inventory issues.
The bottom line
Overall, Gap is in a good position to have a solid holiday and a rip-roaring time in 2013. Investors may be in a tizzy about Abercrombie & Fitch (ANF 2.30%) right now, but the teen brand holds a dim candle to Gap, in my view. The only bump to watch out for would be another spike in material costs, which would severely set the company back. Barring that, I think Gap is definitely worth looking at as an addition to investors' portfolios.
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