Glenn Murphy: Here's How You Fix The Gap

By Will Ashworth | June 29, 2011 AAA

Never say never. In 2008, I wrote two articles outlining the reasons investors shouldn't own Gap (NYSE:GPS) stock and why Old Navy needed to go. I was an unabashed critic. Exactly one year later in October 2009, I was recommending the large-cap retailer at $22, suggesting its cash management skills, combined with a newfound sense of fashion, would see its stock return to the $50 level where it traded in 2000. Anyone who follows the San Francisco company knows this didn't happen. Instead, it's slowly moved lower and 21 months later, it trades at $4 less than where I recommended it with little hope of a near-term revival. While I haven't given up on it because I'm a big believer in buy-and-hold investing, I do have some suggestions for Gap CEO Glenn Murphy. (To learn more about retail stock, check out Analyzing Retail Stocks.)
TUTORIAL: Earnings Quality

One Too Many Brands
As far back as 2007, I can remember reading a blog post by marketing guru John Moore at BrandAutopsy.com that debated the merits of Gap Inc. closing its namesake retail stores and then licensing the brand to Kohl's (NYSE:KSS) or JCPenney (NYSE:JCP). The two retailers already have successful deals with VF Corp. (NYSE:VFC) and Liz Claiborne (NYSE:LIZ) so it's possible Gap could do the same. The brand still holds value. And while it's tempting, I don't believe that's the way to go. Especially when you consider Murphy's recent announcement that it was closing 200 Gap brand stores in North America by 2013, bringing the total number of stores from 900 down to 700 while expanding the number of outlet stores for the brand to 250. Outlet stores deliver a higher return on capital so it makes sense to alter the mix. As part of this move, it will be less a specialty retailer and more a value player in North America, and that's exactly why Old Navy should be sold instead of the Gap. The two brands will sell similarly priced merchandise further cannibalizing revenues. Add the fact Old Navy's lease commitments in terms of square feet are double those of the Gap and Banana Republic combined and you have operating expenses that are unnecessarily high. Regardless of Old Navy's return on capital, this overlap must end. By Murphy moving the Gap into value and adding outlet stores, he's paving the way for an Old Navy exit. At least he should be. (For more on investing in retail, read The 4 R's Of Investing In Retail.)

Real Growth
No matter what Murphy and company do with the three (or better two) legacy brands, its best growth days are behind it, even if it expands to every possible emerging market. In the first quarter, revenues outside the U.S. accounted for 20% of its overall total. In the same quarter, five years earlier, international sales accounted for 14% of overall revenues. Between Q1 2007 and Q1 2011, international revenues went from $540 million to $673 million, a compound annual growth rate of 4.5%, hardly awe-inspiring results. One needn't look farther than its Athleta brand for the solution. Since acquiring the activewear e-commerce business in 2008 for $150 million, its slowly taken steps to test the brand in a retail setting, opening a first store in Mill Valley, a suburb of San Francisco, and then a 5,000-square-foot flagship in January on Filmore Street. The next will be in New York City. Frankly, I don't have a clue why it's taking so long to rollout stores. Activewear is clearly the sweet spot in retail right now. Lululemon (Nasdaq:LULU) has an enterprise value of $7.1 billion, just $1.7 billion less than Gap, despite trailing 12-month revenues that have yet to crack a billion. Meanwhile, Gap's revenues are 14 times greater. Athleta's product obviously has a following. For every dollar that MillValley residents spent online at Athleta, they spent $4 in the test store. There's a market just waiting to buy. Build it and they will come. Since 1999, Lululemon's opened 122 stores in North America. Each store averages 2,874 square feet in size, costs $618,000 to open and generates $5 million in annual revenue when up to speed. So let's assume every Athleta store that opens going forward is also 5,000 square feet, which is highly unlikely. The approximate cost to open 122 stores would be $1.3 billion, one-fifth the cost of buying Lululemon at the going rate. Assuming sales per square foot of $684 (50% higher than Banana Republic and 60% lower than Lululemon) and a six-year build, the Athleta brand could be generating as much as $4.2 billion in annual revenue by that time. If Athleta were to reach those revenue numbers, its operating margins would be higher than Banana Republic. (To learn more about the potential growth and what it can mean, see Great Expectations: Forecasting Sales Growth.)

Capital Allocation
Since 2004, it has returned over $10 billion to shareholders with about 85% in the form of share repurchases. That would be great if it did anything for the stock price. However, since the end of 2003, the total return on Gap stock is negative 14.4% compared to a gain of 15.8% for the S&P 500 and the index's return doesn't include dividends. $8.5 billion is a lot to spend to produce a negative return. Instead of wasting more money on share repurchases, why not actually put it in the hands of shareholders through special dividends or use it to better the business by developing its growth brand. Share repurchases have done neither. As of today, Gap has $2.5 billion in cash and $1.65 billion in long-term debt for a net cash position of $850 million. At the end of 2010, when it had no debt, its net cash position was $1.7 billion, meaning net cash dropped by $850 million in the first quarter, in large part because of the $548 million in share repurchases it made at an average price of $22.09, significantly higher than what it could have paid today. That's not good judgment in my books. A sensible plan would be to unload Old Navy for $4 - $5 billion, reinvest $1.5 billion to grow Athleta and another $1 billion for the e-commerce division and you'd have at least $1.5 billion leftover to pay a $2.50 special dividend; a 15% yield. With one bold divestiture, longtime shareholders would be back to even. That's a good start.

Bottom Line
When a sports team gets into a funk, a drastic shakeup usually makes the difference. That's precisely what Gap must do. Something tells me it won't, but I hope I'm wrong. (To see what effect a CEO can have on a company and their share price, check out CEO Savvy And Stock's Success Go Hand In Hand.)

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