Why Investors Are Falling (Back) Into the Gap
Turnarounds take time, and the road isn't without hurdles—just ask the struggling J.C. Penney.
But some turnarounds have happy endings, and for global specialty retailer Gap, the current outcome is a positive one. Both consumers and investors are again falling into the Gap.
"The consumer across all brands is waking up and saying Gap and Old Navy are a potential choice in their shopping trips now versus years ago when they wouldn't have considered going in the stores. The brands are back in the consumer psyche," said Randal Konik, an analyst at Jefferies.
Wall Street credits the renewed success to a number of factors including strong inflow of talent, improved supply chain efficiency, ecommerce prowess, and of course, those brightly colored skinny jeans.
"One of the most compelling elements of the Gap turnaround is, we think they have identified what Gap really is, and that's a uniquely American voice," said Ed Yruma, an analyst at KeyBanc. "It's about being American, it's about being bright, it's about being colorful, and we think that's been driving the Gap turnaround."
But those American roots aren't limiting the company's potential overseas. Part of Gap's long-term growth strategy is anchored in international growth. Gap told CNBC Monday that, this year for the first time, it will enter Hungary and Paraguay with Gap, Mexico will get its first Banana Republic store, and Costa Rica will get both Gap and Banana Republic locations.
Gap has made major strides in the past five years despite the headwinds of a financial crisis in 2008 and ensuing recession along with historic high cotton prices in 2011. Sales, earnings, operating margins, and shares have all handily improved since CEO and Chairman Glenn Murphy joined the retailer in August 2007.
KeyBanc's Yruma credits Murphy for much of the company's recent success. "People have a very positive bias on the leadership team, I think they have done a great job controlling expenses and building the business for the longer term."
Further, Konik added, "Murphy has made a huge effort to include talent that have to do with product, which has been hugely important."
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In response to questions about the turnaround, Murphy issued the following statement to CNBC: "Gap Inc. has been executing its strategic plan to become a global retailer with a dominant portfolio of brands since 2008. We've made meaningful progress each year, and we're pleased that investors have taken notice, especially since early last year."
In fact, over the past two years, Gap shares have returned 78 percent to investors, double the S&P Retail Index's performance. Over the past five years, Gap shares rose 127 percent, better than the S&P Retail Index's 96-percent gain, though not as strong as competitor L Brands (formerly Limited Brands), whose shares have grown 185 percent over that same time period.
The company has streamlined its leadership in all of its brands and channels. In 2007, there were six presidents for each of its retail store brands—one for every channel (specialty, outlet, franchise, online, North America, and global). Now, there is one president per brand. Each president is in charge of all brand channels, which substantially improves brand consistency in a so-called omnichannel world, where the lines between shopping online, on mobile devices, and at traditional stores have become blurred.
"When you click on Gap today, you are not only getting Gap, you're getting Old Navy, you're getting Banana Republic, you're getting Piperlime, all in one website, all in one shopping basket, and we think that's a huge differentiator relative to competitors," said Yruma.
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While Gap, Banana Republic and Old Navy are the company's three strongest brands, yoga apparel brand Athleta, online accessory brand Piperlime and recently acquired, high-end boutique Intermix are what Murphy described to shareholders as "incubation" brands. The three youngest leverage the strength and the knowledge of their older siblings.
Konik recently raised his price target from $51 to $56 dollars per share, pegging $5 to $10 of incremental value attributable to Athleta.
"The biggest underappreciated part of the story that no one talks about is that Altheta is support by the Gap mothership. They have a ton of cash, cash flow and a huge marketing budget and real estate expertise. We expect them to put stores near Lululemon stores," Konik told CNBC.
Margin growth also has helped boost Gap's earnings. Overall, Gap's operating margin improved to 12.4 percent in 2012 from 7.6 percent in 2007, and the company estimates it will rise to 13 percent this fiscal year.
In the fiscal fourth quarter, profit increased 61 percent year-over-year. For the full year 2012, net income grew 36 percent and sales increased every quarter, up 7.6 percent for the year. Just last week, the company posted a same-store sales gain of 7 percent for April and it increased its first-quarter guidance above Wall Street's average analyst estimate. On Friday, ratings agency Standard & Poor's upgraded Gap's credit to investment grade.
Some analysts wonder if the strength is sustainable. While the average analyst rates Gap shares a "buy," Stern Agee analyst Ike Boruchow has an "underperform" rating on the stock, with a $32 price target. He is concerned about the recent departure of Creative Advisor Tracy Gardner.
While Yruma has a long-term positive bias, he rates Gap shares a hold, believing the stock is already fairly valued.
-By CNBC's Courtney Reagan. Follow her on Twitter @CourtReagan
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